Sick and Tired of Supplemental Funding: Businesses Are Demanding Better Estimates
A good carpenter knows to “measure twice and cut once”—that is, plan and prepare to avoid wasting time and materials. This adage is applicable to capital projects too! Unfortunately not everyone involved in capital projects heeds this guidance. Independent Project Analysis (IPA) research shows that major late changes add on average 12 percent to the total project cost. Late changes—and the associated supplemental funding they require—are a threat to achieving the planned return on capital. Business executives are caught off guard and none too pleased when project teams come back for supplemental funding. But very often extra funds are needed because the level of project definition—and therefore the quality of the cost estimate—was not well understood when the project was authorized.
Every business relies on capital managers to deliver a competitive rate of return for their shareholders. Capital managers in turn rely on project teams to plan and execute capital projects (engineering, procurement, and construction). Business executives are typically far removed from the project team, but they are not removed from the project risks. While capital managers and project teams develop project estimates, business executives are responsible for authorizing the funds to execute the project work. Therefore, it is in the best interest of the business sponsor of the project, working on behalf of shareholders, to understand the quality of the estimates presented for sanction.
How is a business sponsor to know if the estimate accurately accounts for project scope and risks? The level of definition, or front-end loading (FEL), drives the quality of the estimate and thus lets the sponsor know how accurate the project estimate is likely to be. Projects that are not well defined have more unknowns, and the more unknowns, the less accurate the estimate. However, business discipline that links the level of definition to the quality of the estimate is often missing at the start of project investments. Business sponsors typically cling to the first cost estimate they hear despite a wide range of probable outcomes. AACEI definition of early estimates (e.g., Class 4 estimates), when very little engineering is complete, indicates an outcome range of -30/+50 percent. However, based on IPA’s study of the difference between FEL 1 estimates and final project costs, the variance is really closer to 70 percent! Too often, we have seen business sponsors, eager to see the project field work commence, proceed to full funds authorization with limited definition and too much confidence in the estimate. Business sponsors then become very frustrated with projects for overrunning their budgets.
The problem is not with the estimates; it is a lack of understanding of the basis of the estimates. Business sponsors should make sure the business case is robust on the high end of the estimate, not the mid-point, before authorizing a project with limited definition. Or, better yet, business should provide the resources required to better define the project and develop a more robust estimate. Businesses often shift their focus to making the cut (i.e., starting construction) at the start of the project instead of measuring twice. It is easier to observe and appreciate the labor and material inputs for construction, but it is harder for business executives to observe and appreciate the resources required for upfront planning (e.g., defining a clear scope of work and developing control grade cost and schedule estimates). Business is often hesitant to provide early funding to complete this front-end work; in other words, business is reluctant to measure twice.
IPA has done extensive work with business decision makers on understanding the quality of the project estimates and other outstanding risk, which helps executives make more informed decisions when authorizing projects. Recently, IPA was brought in to help a transportation company improve gatekeeping governance for authorization of capital projects. The company was facing several problems, including large overruns on recent projects. IPA evaluated the company’s capital delivery process and interviewed key stakeholders to uncover the root causes of late changes. Based on our findings, the company has updated its work process to provide early funding and associated resources to complete basic design. This change gives project teams the bandwidth to further define the project and improve the accuracy of the estimates presented for full funds authorization. IPA also helped the company add a decision gate for construction readiness (to inform business of risks and get a final baseline before giving construction contractors notice to proceed). The IPA team supported the adoption of these new gatekeeping processes through workshops involving both business representatives and project teams, and trained the gatekeepers to ask the right questions to better understand risk.
As it relates to capital projects, “measure twice and cut once” encourages companies to ensure that the time and resources required for adequate project definition are available to project teams. This is the optimal approach to reducing the risk of cost overruns, as the accuracy of the cost estimate depends on the level of project planning. Whether a company authorizes with very limited definition or full design specification, those business sponsors who authorize the projects need to be aware of the risk. IPA’s Cost Group and Capital Solutions team work together to provide a wide range of services, including cost engineering systems and tools to produce better estimates, work process improvement, and guidance on project governance (e.g., what business should look for to obtain quality targets)—all targeting increased return on capital investments for our clients.