© 2002 hulett & associates, llc will your project overrun? do a cost risk analysis presented by...

© 2002 Hulett & Associates,

LLC

Will YOUR Project Overrun?Do a Cost Risk Analysis

Presented by

David T. Hulett, Ph.D.

Hulett & Associates, LLCLos Angeles, CA 90049

(310) 476-7699 / [email protected]


LLC

Cost Overrun Risk

• Estimate at Completion (EAC)

• Sources of Overrun Risk

• Steps in Cost Risk Analysis

• Collecting Risk Analysis Data


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Estimate at Completion (EAC)

• Basis of estimates -- at the cost element level– Historical data– Engineering estimates– Bids from contractors and suppliers– Labor productivity rates– Pricing Experience– Parametric– Industry database

• Each of these produces a single-point estimate for the cost elements


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Traditional Project Estimate At Completion (EAC) Methodology• We usually:

– Estimate the cost by cost breakdown element– Add up the elements’ costs– Present the total as the total project cost– Cross our fingers

• But, is this what the project “will cost?”– Only if everything goes according to plan


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Real Projects

Do projects usually go according to plan? NO!

Do projects sometimes overrun their budgets? YES!

Do we always have the right contingency? NO!


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Is the Traditional EAC Accurate?

• The traditional single-point EAC is precise– It can be audited for summation accuracy

• But it may be wrong– Cost estimates are often overrun

Traditional cost estimates are “precisely wrong”


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Why Conduct a Cost Risk Analysis?

• We do not know what the estimate means -- e.g. – How much risk is there of overrun?– What is the overrun exposure?– How does it relate to ultimate cost at completion?

Cost Risk Analysis answers these questions


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Cost Risk Analysis -- A New Opportunity

• Opportunity to improve the accuracy of the estimate

We can determine the contingency needed

to reduce the risk to an acceptable level

• Opportunity to improve our risk management

We can determine where the risk is in a complex project


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Steps in a Cost Risk Analysis

• Develop cost analysis model (e.g. WBS)• Identify risky cost elements• Determine the two dimensions of risk by element

• Likelihood of occurring and impact if it does

• Explore correlation between elements of cost• Insert model and data into simulation software• Simulate the model• Calculate risk of overrun, contingencies• Prioritize risky cost elements for risk management


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Example -- Risk Analysis Model of Project Cost

• What is the likelihood this project will cost $29,200,000?

Cost Category Value for EAC($000)

Project Design 1,500Equipment 5,000Foundation, Structure 7,000Piping, Elect. HVAC 1,000Labor 8,700Indirects 6,000

Total Project Cost 29,200

Project Cost Risk Analysis


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Interview to Quantify Cost Risk by Element• Identify “experts” in the project area

– Probably area or team leaders– May have estimated the cost and have considered risk

• Sometimes experts are biased– Project Manager who is committed– Subcontractor looking for relief

• Interview them for risk information– Optimistic extreme scenario– Pessimistic extreme possible costs– Most likely possible cost


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Pessimistic Scenario -- High Range

• Worst -case scenario -- the 99% case– What happens if everything goes wrong?– Include failure and need to do it over if possible– Can several things go wrong simultaneously?

• Criterion -- at least a 1% chance of occurring– Has it ever happened? At least once?– Are you uncomfortable with this specification?– Not yet unbelievable never-never land


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Optimistic Scenario -- Low Range

• Lower costs than included in the estimate– Estimates usually include contingency for some things going wrong “most

likely

• Optimistic scenario -- the 1% case– Even expected problems do not materialize– “Murphy” takes a holiday– Equipment works fine– Labor productivity is uncommonly high– Material, equipment comes in as advertised


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Most Likely Scenario

• Sometimes the EAC is not the “most likely” cost• Too Low to:

– Get the contract (contractor) or please the boss– Keep the bankers and other stakeholders happy

• Too High to:– Provide cushion– Include contingency in estimate -- not bare bones

• Explore this possibility before ending the interview


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Triangular Probability Distribution

– Relative likelihood determined by the height of the triangle– Impact determined by X-Axis– Easy to use, commonly used

Relative Likelihood of Occurring

Possible Element Costs

Low Most Likely High

ThreatsOpportunities


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Some Analysis Usingthe Triangular Distribution

Average (expected) cost = (low + most likely + high) / 3(70 + 100 + 180) / 3 = 350 / 3 = 116.7

RelativeLikelihoodofOccurring


70 100 180

Expected Cost = 116.7


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Uniform Probability Distributions

• Uniform distribution, little information early in project, cannot determine “most likely” cost

Expected cost(high + low)/2

RelativeLikelihoodofOccurring



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Beta Distribution

• Beta distribution– Flexible, hard to use (shape parameters)– Expected cost approximated as (H - L) / 6

0.00 24.17 48.33 72.50 96.67

Beta

0.00 8.67 17.33 26.00 34.67

Beta


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Normal Distribution

• Normal distribution– Symmetrical– Many automatically think of the Normal distribution

70.00 85.00 100.00 115.00 130.00

Normal


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Construction Project Interview and Display Low and High Ranges

Cost Category Value for EAC Low Most Likely High($000) ($000)

Project Design 1,500 1,200 1,500 2,000Equipment 5,000 4,500 5,000 6,000Foundation, Structure 7,000 6,200 7,200 8,600Piping, Elect. HVAC 1,000 800 1,000 1,600Labor 8,700 4,500 5,000 5,900Indirects 6,000 5,000 6,000 6,700




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Assumptions and Results Highlighted

Cost Category Value for EAC Low High

Project Design 1,500 1,200 2,000Equipment 5,000 4,500 6,000Foundation, Structure 7,000 6,200 8,600Piping, Elect. HVAC 1,000 800 1,600Labor 8,700 7,500 12,500Indirects 6,000 5,400 6,700



($000)

Assumptions -- Input Distributions

Result Distribution


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The EAC is Not the Average Cost. It is Not Even the Most Likely Cost!

Frequency Chart

Mean = 30,733.000

.008

.015

.023

.030

0

37.75

75.5

113.2

151

27,000 29,250 31,500 33,750 36,000

5,000 Trials 0 Outliers

Forecast: Total Project Cost

EAC = $29,200

Average Cost is Not the EAC


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Cumulative Distribution

Cumulative Chart

Certainty is 10.24% from -Infinity to 29,200

Mean = 30,733.000

.250

.500

.750

1.000

0

5000

27,000 29,250 31,500 33,750 36,000



$29,200 is only 10% likely


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Cumulative Distribution Table

EAC of $29,200is just over 10%

Need a contingency of $2,615 for 80%

likelihood

Forecast:Total Project CostPercentile Value

0% 27,29610% 29,17220% 29,62030% 29,98940% 30,30550% 30,63360% 31,01070% 31,37780% 31,81590% 32,461100% 35,143


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Contingency Percentages on Baseline Project Cost Estimate

Percentile Value Contingency0% 27,296 -7%10% 29,172 0%20% 29,620 1%30% 29,989 3%40% 30,305 4%50% 30,633 5%60% 31,010 6%70% 31,377 7%80% 31,815 9%90% 32,461 11%100% 35,143 20%



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How do You Identify the Most Risky Cost Elements? • Which cost elements contribute most to overrun risk?• One measure of total project risk

– Difference between the EAC and the average cost from the simulation

• The Method of Moments (MOM) rule is that:The average total project cost is the sum of the

average cost from the elements’ distributions• For the triangular distribution (only) remember:

Average = (low + most likely + high) / 3


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Which Elements Contribute Most to the Difference?

Frequency Chart

Mean = 30,733.000

.007

.013

.020

.026

0

33

66

99

132

24,000 27,500 31,000 34,500 38,000



Explain the Contingency at the Mean


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Compute the Average Project EAC Assuming Triangular Distribution

Cost Category Value for EAC Low High AverageProject Design 1,500 1,200 2,000 1,567Equipment 5,000 4,500 6,000 5,167Foundation, Structure 7,000 6,200 8,600 7,267Piping, Elect. HVAC 1,000 800 1,600 1,133Labor 8,700 7,500 12,500 9,567Indirects 6,000 5,400 6,700 6,033

Total Project Cost 29,200 30,733



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Calculate the (Average - EAC) and Sort on It to Help Focus Risk Management

Cost Category Value for EAC Average Average - EACLabor 8,700 9,567 867Foundation, Structure 7,000 7,267 267Equipment 5,000 5,167 167Piping, Elect. HVAC 1,000 1,133 133Project Design 1,500 1,567 67Indirects 6,000 6,033 33

Total Project Cost 29,200 30,733 1,533

Identifying High-Risk Elements Using Method of Moments


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Will YOUR Project Overrun?Do a Cost Risk Analysis -- Summary

• The EAC is not even the most likely cost• A cost risk analysis can improve the accuracy of the estimate,

provide a contingency amount, and identify the high-risk elements

• Correlation is important in developing cost risk estimates• Data collection is the main part of the risk analysis

– There are several steps that have proved effective– It is important to recognize several important biases

© 2002 hulett & associates, llc will your project overrun? do a cost risk analysis presented by...

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