1. © 2002 Hulett & Associates, LLC Will YOUR Project Overrun? Do a Cost Risk Analysis Presented by David T. Hulett, Ph.D. Hulett & Associates, LLC Los Angeles, CA 90049 (310) 476-7699 / info@projectrisk.com

2. © 2002 Hulett & Associates, LLC Cost Overrun Risk Estimate at Completion (EAC) Sources of Overrun Risk Steps in Cost Risk Analysis Collecting Risk Analysis Data

3. © 2002 Hulett & Associates, LLC 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

4. © 2002 Hulett & Associates, LLC 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

5. © 2002 Hulett & Associates, LLC 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!

6. © 2002 Hulett & Associates, LLC 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”

7. © 2002 Hulett & Associates, LLC 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

8. © 2002 Hulett & Associates, LLC 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

9. © 2002 Hulett & Associates, LLC 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

10. © 2002 Hulett & Associates, LLC Example -- Risk Analysis Model of Project Cost What is the likelihood this project will cost $29,200,000?

11. © 2002 Hulett & Associates, LLC 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

12. © 2002 Hulett & Associates, LLC 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

13. © 2002 Hulett & Associates, LLC 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

14. © 2002 Hulett & Associates, LLC 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

15. © 2002 Hulett & Associates, LLC 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

16. © 2002 Hulett & Associates, LLC Some Analysis Using the Triangular Distribution Average (expected) cost = (low + most likely + high) / 3 (70 + 100 + 180) / 3 = 350 / 3 = 116.7 Relative Likelihood of Occurring Possible Element Costs 70 100 180 Expected Cost = 116.7

17. © 2002 Hulett & Associates, LLC Uniform Probability Distributions Uniform distribution, little information early in project, cannot determine “most likely” cost Expected cost (high + low)/2 Relative Likelihood of Occurring Possible Element Costs

18. © 2002 Hulett & Associates, LLC Beta Distribution Beta distribution –Flexible, hard to use (shape parameters) –Expected cost approximated as (H - L) / 6 0.0024.1748.3372.5096.67 Beta 0.008.6717.3326.0034.67 Beta

19. © 2002 Hulett & Associates, LLC Normal Distribution Normal distribution –Symmetrical –Many automatically think of the Normal distribution 70.0085.00100.00115.00130.00 Normal

20. © 2002 Hulett & Associates, LLC Construction Project Interview and Display Low and High Ranges

21. © 2002 Hulett & Associates, LLC Assumptions and Results Highlighted Assumptions -- Input Distributions Result Distribution

22. © 2002 Hulett & Associates, LLC The EAC is Not the Average Cost. It is Not Even the Most Likely Cost! EAC = $29,200 Average Cost is Not the EAC

23. © 2002 Hulett & Associates, LLC Cumulative Distribution $29,200 is only 10% likely

24. © 2002 Hulett & Associates, LLC Cumulative Distribution Table EAC of $29,200 is just over 10% Need a contingency of $2,615 for 80% likelihood

25. © 2002 Hulett & Associates, LLC Contingency Percentages on Baseline Project Cost Estimate

26. © 2002 Hulett & Associates, LLC 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

27. © 2002 Hulett & Associates, LLC Which Elements Contribute Most to the Difference? Explain the Contingency at the Mean

28. © 2002 Hulett & Associates, LLC Compute the Average Project EAC Assuming Triangular Distribution

29. © 2002 Hulett & Associates, LLC Calculate the (Average - EAC) and Sort on It to Help Focus Risk Management

30. © 2002 Hulett & Associates, LLC 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