Cost Contingency Mng Mt 2005

7/31/2019 Cost Contingency Mng Mt 2005

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A New Approach of Project Cost Overrun

and Contingency Management

Said Boukendour, Ph.D.

Universit du Qubec en Outaouais

OCRI Partnership Conferences SeriesProcess and Project Management

Ottawa March 22, 2005


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Presentation Agenda

n Measuring cost overrunn Risk and contingency analysisn A project as a short sellingn Contingency as an option premiumn The value of estimation accuracyn Compensation of estimation accuracy


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Measuring Cost Overrun

n Usually the media and the public opinion focus on the huge costoverruns experienced by the mega projects such asq Canadian Firearms Program

n Planned cost: $119 m Final cost: $1bnq International Space Station :

n Planned cost: $8bn Final cost: $26bnq Channel Tunnel

n Planned cost: 4.9bn Final cost: 10bnq Concorde

n Planned cost: 90m Final cost:1.1bnIn addition, it has never made profit during its 40 years of operation

q Etc.

n The mega projects are only the visible pick of the iceberg


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n A large number of studies and surveys evidenced the fact that costoverrun affects all kinds of projects in all industries, and in allcountries either in the public or in the private sector

n Cost Overrun = Actual Cost Estimated Cost

n The problem is that several cost estimates are usually producedduring the project life cycle, but there is no standard rule todetermine which one must be considered for computing the costoverrun

n In consequence, the results could be significantly different from onesurvey to another depending on which estimate is considered


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n A survey based on 258 infrastructure projects in 20 differentcountries indicates that

q 9 times of 10, the actual costs are on average 28% higher than theestimated costs at the time of decision to build

q

Underestimate today is in the same order of magnitude as it was 10, 30,and 70 years ago

n Another survey in India finds that

q Of 617 infrastructure projects, only 149 are faced with cost overrunsamounting to 22.2% with respect to the latest approved estimates

q The cost overrun has come down from 62% in March, 1991 to 20.7% in

September, 2004


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n The Standish Group (www.standishgroup.com) has surveyed over50,000 completed IT projects in its biennial CHAOS research since1994. The results are summarized below

n Like most commercial companies, the Standish Group do not revealtheir research method and measurement information, which aretreated as a trade secret.

43%43%45%69%142%189%Averagecost overrun

200420022000199819961994Years


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n Asked for the chief reasons project success rates have improved,Standish Chairman Jim Johnson says, The primary reason is theprojects have gotten a lot smaller. Doing projects with iterativeprocessing as opposed to the waterfall method, which called for allproject requirements to be defined up front, is a major step forward.

n For some academics, the strong decrease of cost overrun from142% to 69% in two years is a reason to doubt the research methoditself since all surveys of cost estimation accuracy related to thisperiod suggest average cost overrun in the range of about 30%


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Risk and Contingency Analysis

n The objective of contingency allocation is to prevent a project fromexperiencing cost overrun

n Contingency is an amount added to an estimate to allow foradditional costs that experience shows will likely be required. Thismay be derived either through statistical analysis of past projectcosts, or by applying experience gained on similar projects (AACE1998)

n Contingency covers the costs that may result from incomplete design,unforeseen and unpredictable conditions, or uncertainties within thedefined project scope (DOE 1994)

n Contingency usually does not include changes in scope or scheduleor unforeseeable major events such as strikes or earthquakes


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n Contingency vs Management reserve

q Contingency is an element of a projects cost which is included toallow for the unknowns and to ensure project completion withinthe budget

q

Management reserve is an amount of the total allocated budgetwithheld for management control purposes in order to enhanceperformance

n As a part of a projects cost estimate, contingency under estimationor over estimation can lead

q To approve a project that should be rejected

q To reject a project that should be accepted

q To misallocate resources during the project implementation


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n Recommended practices and standards can readily be applied


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n Specific risk analysis methods include qualitative analysis andprobabilistic analysis

n Qualitative analysis relates projects characteristics directly to apercentage figure on the base estimated costs

q

The percentages may be developed from checklists or by matchingproject characteristics to the characteristics of previously completedprojects stored in the database

q The cost engineer makes a judgement should more or less contingencybe added to this situation


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n Probabilistic analysis determines the risk of the total project by:

q Assigning a low, medium, and a high estimate to each projectWBS element, and computing the expected cost and variance ofeach element and of the total project

q

Combining risks from various sources and events using asimulation technique

n In this way, the contingency is determined with respect to a certainlevel of confidence that the actual cost will not exceed a given costestimate


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n Limits of the traditional approach

q Contingency is arbitrarily determined or dependent on someonesrisk aversion

q There is no compensation for cost estimation accuracy

n Our new approach attempts to address these problems


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A Project as A Short Selling

n Unlike a long seller who already owns the asset he or she sells, ashort seller sells the asset without owning it

n At the delivery date, the short seller must close his or her position bybuying back and delivering the asset

n

By analogy, a contractor or a project manager committed to achievea project sells something without owning it

n At the starting date, the product to be developed does not yet existand nobody exactly knows how much it will cost when it will becompleted


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n Depending on whether the price will raise or fall down, the shortseller will gain or lose the difference

n To prevent the possible loss without losing the opportunity of apotential gain, the short seller can buy a call option on the sameasset maturing at the delivery date

n The call option gives to its buyer the right but not the obligation tobuy the underlying asset for the pre-determined price

n In consequence, le short seller will exercise the option only if theasset price raises beyond the agreed fixed price whereas theoptions seller is obliged to abide by the decision whatever the price

risen This unilateral price change risk thus assumed by the options seller

has value, which is the option premium


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n What is the risk premium that would be required by the market if theproject was a traded security or a commodity?

n Lets assume that there exists a twin security that is perfectlycorrelated with the project cost such as if the project cost increases,the stock price increases in the same range, and similarly if itdecreases.

n Lets also assume for simplification that all the actual cost incurs atthe project completion date

n Consider that we buy a call option that gives us the right to purchasethe security at a fixed price at the project completion date

n The option will relate to a total amount of stocks that equals the

project budget amount whereas the options seller is obliged to abide

by the decision whatever the price rise


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n If the cost goes up, we will exercise the option and we will get thestocks for the agreed fixed price. Then, we will sell them for the spotprice and we will earn the difference, which will equal the budgetoverrun for, the perfect correlation stated here above

n In contrary, if the cost goes down, we will abandon the option and wewill benefit from the budget under run

n Finally, the call option limits our total expenditure to a ceiling amountmade up of the budget amount plus the option premium, and withoutlosing the opportunity of a potential gain that may result from costdecreases

n By this way, we reach the same position than the short seller whobuys a call option.


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n However, there is a difference between the two situations

q The short seller deals with options that are really traded on themarket and that allow to virtually transfer the risk to the optionseller

q

In the case of the project, the option does not exist and nothing isguaranteed by a third-person

q The analogy is only made for a valuation purpose.


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Contingency as an Option Premium

n At the maturation date of the option, two situations may happen:

q The option is abandoned and expires worthless

q The option is exercised and it is worth its payoff that is thedifference between the spot price of the asset and the exercise

price of the option. This is called the intrinsic value of the optionn But, how is worth the option at the start date of the contract?

n The value of an option at the start date can be calculated byconstructing a portfolio of traded securities which has the samepayoffs as the option

n In virtue of no-arbitrage condition, the value of the option mustdynamically equals the value of the portfolio as the stock priceevolves.


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n Consider this very simple example:

q 0 : starting date of the project

q 1: completion date in one year

q $500,000 : estimated cost at date 0. At date 1, there will be only

two possibilities: the cost will either go up by 30% or go down by20%

q 5%: one year interest rate

q $500,000 : exercise price of the option that matures at date 1

n Suppose there exists a stock that perfectly mimics the project cost

movements. At date 1, the total amount of stocks will either go up to$650,000 or go down to $400,000, and consequently the optionvalue will equal $150,000 or $0, respectively.


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n To determine the option value at date 0, we construct a portfolioconsisting of a combination of the stocks and the bonds that exactlyreplicates the call option payoffs

n Let A and B be respectively the proportion of the stocks and thebonds, we state:

650A+1.05B=150

400A+1.05B=0

n The linear system equation solves to give A = 0.6 and B = -228.571.Thus investing 60% of the project budget in the stocks andborrowing $228,571 at 5% for one year will give payoffs of $150,000

if the stock price goes up and $0 otherwise.


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n From the non-arbitrage condition, which states that two assets orsets of assets that have the same payoffs must have the samemarket price, the call option at date 0 is worth:

q $500,000*0.6$228,571= $71,429, say 14%.

n That is the risk premium that would be required by the market forassuring the project against cost overrun given its cost rangeestimate. As a result, the total budget will be:$500,000+$71,429=$571,429


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The Value of Accuracy

n As a project matures throughthe design process, manydecisions are made, and manyuncertainties are resolved.

n As a result, the estimatebecomes more and moreaccurate

n Every one-point move in theestimate accuracy must betranslated into the change ofthe contingency provision.


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The Value of Accuracy

n The hedge ratio measures thischange

n Financially speaking, itmeasures how much the callsvalue changes if the underlyingasset price volatility changesby a small amount

n From the above example, weget : (150-0)/(650-400)=0.6

n The result is nothing else thanA, which is the share of stocksto invest in the portfolio toreplicate the calls value.

50

38,09

26,19

14,28

0

10

20

30

40

50

60

100% 75% 50% 25%

Contingency vs cost estimate accuracy


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Compensation of Estimation Accuracy

n In the earlier stages of any project, nobody exactly knows how it willactually cost when it will be completed. Thus, estimating is alwaysrisky.

n Nonetheless, due to their expertise and their experience, the costestimators can give a more reliable estimate than can do those whodecide for funding the project.

n The issue is then how to reward them as a function of their costestimate accuracy.


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n In the earlier stages of any project, nobody exactly knows how it willactually cost when it will be completed. Thus, estimating is alwaysrisky.

n Nonetheless, due to their expertise and their experience, the costestimators can give a more reliable estimate than can do those whodecide for funding the project.

n The issue is then how to reward them as a function of their costestimate accuracy

n Some would suggest that cost estimators and project appraisersshould be accountable for their estimates, and they should totally or

partially assume cost overrun. However, any rewarding system whichcreates high uncertainty in their income will translate into a higher

risk premium and consequently in a higher cost estimate


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n Virtually, the risk of cost overrun is not transferable because it willineluctably lead the estimators to bankruptcy

n Instead, a rewarding system with an acceptable risk can besuggested using an analogy with butterfly strategy

n

The butterfly strategy is used in the security market by investors whowant to bet that the underlying asset price will end up very close toits current price.

n The strategy is built on four trades at one expiration date and threedifferent strike prices.


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n Consider we are expecting a stock price currently at $60 to remainat that level at expiration date, say in 6 months.

n Assume that the premiums of calls maturing in 6 months are tradedas follows:

Strike price $55 $60 $66Call price $10 $7 $5

n We wish to take advantage of our reasonably established beliefsthat the stock price will remain at $60 at the expiration date


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n We can build a long butterfly spread which consists in buying one$55 call at $10, one $65 call at $5, and selling two $60 calls at $7.

n The net expense will be $1, i.e.:

q Buying 1 $55 Call at $10..= -$10

q Selling 2 $60 Calls at $7x2...=+$14

q Buying 1 $65 Call at $5.= -$5

q Net debit -$1


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n At expiration, if the stock price is at $70, the two $60 calls areexercised against us and we loss $20=2($60-$70), but we exerciseour $55 and $65 call, and we gain $20=($70x2-$55-$65) so the netdifference would be zero. In that case, we only lose our $1 premium.

n If the stock price is at $50, all four options would not be exercised,and again our only loss is the $1 premium.

n If the stock price is at $60, we would exercise our $55 call, and sellthe stock at $60 and gain the $5 difference. By subtracting the

premium of $1, we have a $4 profit.


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n The first break-even value iscalculated by adding the netdebit to the lowest strike price,i.e.: $56

n The second break-even value

is calculated by subtracting thethe net debit from the higheststrike price, i.e.: $64

n The maximum profit potentialof a long butterfly is calculatedby subtracting the net debitfrom the difference between

the middle and lower strikeprices, i.e.: $60-$55-$1=$4.n The maximum risk is limited to

the net debit paid for theposition


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Conclusion

n We pointed out the need to estimate the cost contingency regardlessthe individual preference or risk aversion

n For this we considered a project alike a short selling of a security, thecontingency provision was viewed as a call option premium. But, theanalogy was only made for valuation purpose

n This allowed us to estimate cost contingency as a risk premium thatwould be required by the market if the project was a traded security

n We also suggested an original rewarding system that encourages thecost estimators to produce accurate estimates without having to bearunreasonable risks

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Cost Contingency Mng Mt 2005