The frequency with which capital projects substantially overrun their budgets is widely reported though you rarely hear of a project being cancelled because of a looming cost overrun. Presumably sometimes the intangible value of the completed asset just seems too high to stop, no matter what the cost (think of preparing a city to host the Olympic Games). However, when the goal of a project is simply to generate a financial return for its owner, why were projects that overran their budgets significantly never cancelled when only a fraction of the money was spent?
At least part of the answer lies in the dilemma of sunk costs and forward-looking economics. Take, for example, this characterization of a natural resource project made recently in the news:
“The unique challenges of Pascua-Lama are well known, and we have acknowledged the issues that led to the mine's suspension. But those are sunk costs, and the question before Barrick now is whether Pascua-Lama's economics going forward will justify resuming development.”
When asking: By how much would our project need to overrun its budget before we would cancel it? - the answer depends on how much we have already spent. The more money spent, the greater the loss absorbed by stopping and so the less attractive the project needs to be in order for it to be logical to continue. No doubt this will be intuitively obvious to any seasoned project manager or owner though it is instructive to consider just how large an impending overrun would need to be in order for cancelling the project to make mathematical sense (let alone emotional sense).
To illustrate, imagine a project with a $1.0BN capital cost (in current dollars) to create a net cash flow over its operating lifetime of NPV $1.5BN, giving the project an overall NPV of $500MM. The chart below indicates the relationship between the amount of capital spent (as a percentage of the original $1.0BN budget) and the extent of cost overrun that could be absorbed in the final project (also as a percentage of the original budget) before it would make sense to cancel it and absorb the sunk cost as a loss. For simplicity’s sake no discounting of the capital spend has been taken into account.
The border between the grey and red zones represents the breakeven point between continuing the project (and accepting the anticipated overrun materializing) and cancelling the project (and writing down the capital spent to date). A few points to note:
· When half the budget has been spent, the project would need to be tracking toward a 100% cost overrun or more before it would make sense to cancel it.
· When 100% of the original budget has been spent, the project could absorb up to a 150% cost overrun (i.e. 2.5X times the initial budget) before it would make sense to stop.
· The trajectory of this breakeven point continues upward indefinitely as more money is spent. Presumably at some point the value destroyed would eclipse the project’s initially anticipated return and it would no longer make sense to keep chasing it.
As such, it should not be surprising that projects projecting a cost overrun in mid-construction are rarely cancelled, as to do so in most cases would destroy the value. The most compelling question for these projects then becomes: How do you foster and cultivate a healthy motivation, among both the owner’s team and contractors, to improve upon and minimize the degree of overrun, when this is not strictly required to complete the project?
What experiences have you had with projects that were projecting a cost overrun? How did the organization respond to influence the extent of the overrun and was it effective? Please share your thoughts and comments below or email Scott Whitbread at email@example.com.
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By Scott Whitbread
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