A cost overrun is the sum of unpredicted expenses that exceeds initial budget estimates at any point throughout the course of project realization.
Cost overruns can be dangerous to project success since they imply that, for maintaining project activities, a firm has to spend funds intended for entirely other purposes at first. In the context of financial constraints, unexpected expenses may also provoke the growth of the organizational dept. Hence, it is pivotal to understand the reasons why cost overruns occur and address them accordingly.
In light of this, we have prepared a guide explaining how to prevent and calculate cost overruns.
What is Cost Overrun?
Cost overrun (budget overrun) refers to situations when actual project costs exceed the estimated costs. It’s essential that every project manager knows how to prevent, identify and manage project cost overruns, otherwise, they can cause project delivery delays and even project failure.
Learn how to master project cost management and avoid overruns from our free guide.
Signs of Cost Overrun
Project managers should know how to spot cost overruns early on. Here are some signs that your project is at risk of cost overrun:
- You don’t have a time and cost tracking system in place
- Project budget is not specified
- No contingency plan is developed and documented
- You don’t schedule and track project resources
- You don’t track costs for each task (at least with a work breakdown structure)
- You have never reviewed and learned from the previous projects’ performance
How to Calculate Cost Overrun?
Calculating cost overrun is easy: you may calculate either the amount or the percentage of the exceeding costs in a following way:
Cost Overrun Amount = Actual Expenses – Budgeted Amount
Cost Overrun Percentage = (Actual Expenses – Budgeted Amount) / Budgeted Amount * 100%
5 Primary Causes of Cost Overrun
1. Improper Risk and Uncertainty Management
Troublefree completion of project activities by following a designed plan is a cherished desire of every result-oriented manager. However, this perfection isn’t that easy to attain – deep business waters are swarmed by all sorts of risks, which are often very easy to stumble upon but are difficult to cope with. Besides, in the environment that evolves apace and spawns new trends each month (if not more often), it becomes incredibly challenging to predict the outcomes of scheduled events.
Therefore, without careful environmental analysis and a risk response strategy, all project designs and approaches to management are bound to fail, regardless of how thoughtful and elaborate they may be. An unpredicted – either internal or external – may cause a direct financial loss and requires unexpected expenses for its handling. When this risk is significant and damaging enough, cost overrun is inevitable.
Solution
The best way to reduce the adverse impacts of environmental risks and uncertainty is the adoption of a valid risk management system that incorporates
- Comprehensive risk analysis allowing the identification of the most probable and relevant external risks,
- Risk mitigation and response plans focusing on the strengthening of weak areas in the company’s internal factors and increasing its adaptiveness to external changes,
- Contingency reserve development aimed to allocate a justified amount of money for the reduction of possible risk overruns.
Of course, managers cannot influence such potentially impactful external events as natural disasters and economic recession directly. Nevertheless, both internal and external risks must be paid equal attention during risk management. In this way, unexpected expenses will be less likely to occur and put the project’s success on the line.
2. Estimation Errors
Underestimation of future costs (or the making of overly optimistic estimates) is the primary cause of project overruns in a vast majority of cases. The main reason why estimation errors take place is forecasting biases, either intentional or unintentional. As noted by Condon and Hartman in their “Playing the Game” paper, these biases can be a consequence of
- Naivety – belief that everything will go as planned,
- Ignorance – lack of necessary knowledge and expertise,
- Deception – deliberate misrepresentation of the project’s expense picture to make it look viable.
It means that underestimation frequently occurs due to sponsors’ and managers’ eagerness to see their project ideas being brought to life. Those without prior experience in project management face an even higher risk of cost overruns. Inexperienced managers have nothing to compare their current undertakings with and, thus, are prone to make mistakes and miss some essential risk factors out of consideration.
Solution
To avoid cost overruns, aim to improve your cost estimators’ competencies and skills and increase accountability for forecast inaccuracies within your projects. More specifically, it would help to
- Allocate estimation responsibilities to experienced specialists as a means to increase rigor and decrease the influence of “gut instinct” on forecasting results,
- Encourage inter-professional collaboration among various stakeholders during the estimation phase,
- Determine who would have to carry cost overruns if they take place,
- Scrutinize and evaluate the created cost estimates multiple times.
All in all, by taking time and effort to make initial cost calculation more precise and evidence-based, it is feasible to make sure that the project won’t surpass the estimated budget and that its outcomes will be positive.
3. Uncontrolled Scope Changes
Since the business environment is highly dynamic and rarely develops according to our plans, changes in projects and their scopes are usually hard to get away from. The unchecked growth of the project’s scope, also known as scope creep, is a massive problem for project managers, and it happens on the following occasions:
Underestimated project complexity
If a manager lacks the understanding of the project’s nuances and is unable to predict its complexity, the risk of improper allocation of resources increases.
Imagine learning that your team must do much more than was expected to achieve formulated project goals only after the actual work begins. In this case, you will likely have to establish new deadlines and re-coordinate activities, personnel and technologies. Therefore, the need for additional expenses will arise as well.
Schedule extension
The misunderstanding of project content and nature is only one possible cause of deadline extension. Others include
- Emergence of new project requirements,
- Delays in supply of essential materials,
- Discharge of important employees, and many more external and internal events, both planned and unforeseen.
As such, a prolonged project schedule can be regarded as the primary sign of scope creep. It induces cost overruns as much as the handling of issues that called it forth requires extra efforts and funds.
Poor stakeholder communication
Improper communication and disagreeable relations between parties involved in the project’s realization end in the absence of clarity regarding project objectives, requirements and progress.
For instance, if employees engaged in the project do not fully comprehend its objectives and task approval parameters, they will tend to make mistakes. In turn, managers and sponsors will become dissatisfied with the performance results and will have to demand revisions and corrections from their subordinates.
Clearly, it is much cheaper to make things properly straight away than to remake them multiple times. Hence, inadequate stakeholder communication may give rise to not only scope creep but also large-scale cost overruns.
Solution
The success of the project in the context of constant change depends on how controlled that change is. Therefore, to prevent scope creep and consequent cost overruns, Agile Certified Practitioner, Chuck Millhollan recommends implementing a change control strategy that includes the following:
- Design of a lean project workflow in order to be more adaptive to alterations in the environment and keep away unnecessary complexities in the course of work;
- Definition of preliminary project scope, as well as the development and approval of scope documentation, to set more explicit boundaries and make more reasonable project change decisions;
- Application of a systematic approach to stakeholder communication that would integrate well-structured methods for requesting, evaluation and approval of project changes.
Additionally, to eliminate the risks of scope changes, it can be suggested to pay more considerable attention to the quality of time estimation and work progress monitoring. With this regard, time tracking software, which enables managers to overview hours spent on various assignments, is very handy. It helps control how much work is already done and how much time is still needed, making it easy to detect the risk of changes in project deadlines and processes early enough.
4. Project Performance Failures
Small mistakes and fatal errors during the execution of project activities can occur due to multiple reasons, such as
- Poor resource coordination,
- Lack of essential skills and technology,
- Inadequate employee motivation and communication,
- Ineffective project execution plan,
- Absence of clearly defined operational metrics that could be used to standardize and evaluate employee / contractor performance.
Naturally, when something in the project goes wrong, managers have to invest time, money and effort to direct it back on the right track. In this way, big execution mistakes induce a significant risk of surpassing the estimated budget.
Solution
Elimination of causes for the abovementioned performance failures is the primary responsibility of project managers and leaders. Thus, to avoid the risk of cost overruns due to execution errors, a well-organized approach to leadership and project management is obligatory.
Overall, for a faultless work on the project, managers and leaders should systematically control EVERY project performance factor, starting from the hiring of skilled personnel and ending with the selection of appropriate progress assessment tools. For the latter, assume applying a piece of project management software that allows planning workflows, distributing workloads and supervising employee task performance all in one place. With its assistance, the administration of project management will become much simpler and more efficient.
5. Errors in Project Design
Project design forms the basis for the execution and management processes. It specifies
- Which contents the project must have,
- How it should be performed and supervised,
- What kind of outputs it is expected to produce.
Obviously, with flawed project design, it is naïve to anticipate positive project outcomes – even the most unnoticeable and presumably uncritical deficiencies in the initial plan are likely to be manifested at the later stages in the project’s life cycle, leading to performance failures and other problems provoking unforeseen expenses and jeopardizing project success.
Solution
As it is easy to guess, an antidote to cost overruns due to poor project planning is the creation of a proper, comprehensive project design. Besides scope definition, time estimates, communication and risk management strategies that we have discussed before in this article, a perfect project plan contains the following key elements:
- Idea justification,
- List of stakeholders and their needs,
- Outline of project objectives, requirements and deliverables,
- Definition of roles and responsibilities,
- Resource allocation targets,
- Description of quality assessment methods.
Most importantly, it is vital to conduct a detailed cost breakdown and develop an accurate project budget. These two practices are the core elements of effective project cost management and a significant prerequisite for successful expense control throughout project realization.
Summary
Summing up our overview of the five leading causes of cost overruns, let’s recall them once more. The list consists of
- Inadequate risk management,
- Underestimation of project costs,
- Uncontrolled scope changes,
- Project execution failures,
- Errors in project design.
To prevent unnecessary waste of money when fixing mistakes and achieve the desired project outcomes, address the above issues promptly. Be sure to utilize the discussed solutions – they will be of significant aid in evading risks and enhancing performance efficacy.
