Appendix C Actors and Processes
In Appendix B, we reviewed studies comparing groups of projects to find similarities when it comes to cost overrun and deviations between estimate and outcome. Such studies usually relate explanations of cost overrun and growth to the technology of the project. The earlier the decision to go ahead is made, the longer it takes to implement the project, the more complex the project is, the larger the advance in technical knowledge, and the more changes that are made, the more time and cost tend to increase. These are explanations that describe a tendency in a larger number of similar projects, and researchers of this tradition often search for rational explanations to these tendencies, as we did in Appendix B.
There are also numerous case studies advancing different theories and ideas about the causes of cost overrun and why investors and managers put more money into failing projects instead of abandoning them. Thus, there are case studies of such projects, questionnaire studies asking respondents about their reactions to and causes of cost growth and cost overrun, and studies in which people’s reaction to cost growth in experimental situations is recorded – studies which try to explain the phenomena by applying theories borrowed from social sciences. They assume that decision makers have limited information and ability to process information, and they often come close to what we term ‘bounded rationality’. It is a large and diverse area of research.
In Appendix C, we will review this literature as we previously did with studies of groups of projects. The explanations for, and perspectives on, cost overrun and growth in these studies are many. They can be categorized according to research methodology, from which branch of social science the perspective originates, or key themes, and we will focus here on three such themes – namely: cognitive biases, information asymmetry, and path dependence.
Optimistic bias relates to the well-established fact that most people believe they stand a smaller risk of losing than other people do. An example is the boxer who believes that he will defeat his opponent, although only one can win. It is a bias more common in entrepreneurs than in managers, and in Western and Chinese cultures than in Japanese, and it offers one way of explaining why cost and problems are constantly underestimated.
Self-serving bias refers to the tendency to enhance self-esteem by attributing success to one’s own capabilities while attributing failures to others and unforeseeable events. This tendency is also more pronounced in Western and Chinese cultures than in Japanese.
Later estimates are related to the first bias. This anchoring bias makes the first estimate important.
Information asymmetry exists when actors do not have access to the same information, which creates many obstacles which must be tackled if the project is to be implemented at its anticipated cost. It may be that the proponents of the project and those appropriating funding do not have access to the same information and knowledge, or that the procurer does not have the same information and knowledge as the contractors.
To bring a project from idea to decision, various choices have to be made which reduce the number of options available in the next step. Later decisions are restricted by earlier ones, restrictions that can be created by both technology and social factors. The project and those engaged in it become locked in to a project-specific path, which makes it difficult to revise estimates or abandon plans and projects.
Cost Overrun and Decision Biases
Optimistic bias.
As was clear from Tables A.1, 2 and 4, cost overrun is considerably more common than cost underrun. Similarly, there is a lot of research showing that people in different situations tend to underestimate the time and the cost required to implement what they plan to do. People making estimates are generally overoptimistic. Researchers use the term ‘optimistic bias’, which they define as a tendency to overestimate the probability of a certain outcome to occur, a tendency which is often accompanied by an inability to interpret and accept new, contradicting information and modify the original estimate accordingly.
Such overoptimism has been confirmed in a number of different types of decisions which we normally do not see as a lottery, although they might be, such as economic forecasts, stock market estimates, starting a company, investing in a new venture or in an existing company, and buying decisions. There are numerous studies confirming decision makers being overoptimistic.1 One could claim that decision makers tend to have more confidence in their own judgement than reason suggests they should have.
With regard to investment decisions, optimistic bias has been confirmed to exist in experimental situations in which decision makers are subjected to cost estimates for investments,2 new products,3 and market growth rate.4 Lawrence Pruitt and Stephen Gitman5 take their point of departure from Edward Miller,6 who formulated the hypothesis that business managers generally believe that investment estimates are overoptimistic and that they therefore compensate for this overoptimism when they assess investment requests. Pruitt and Gitman found support for this in a mail questionnaire sent to Fortune 500 companies. As many as 78.5 per cent of the managers who responded to the questionnaire thought that those requesting investment typically overestimated revenues, and 43.0 per cent thought that they also underestimated costs in their requests. Furthermore, 86.5 per cent thought that marketing overestimated sales, 61.9 per cent that research and development underestimated development costs, 81.5 per cent that development cost deviates more when the proposed project represented a major step in production or research, and 61.2 per cent that the actual profit tended to become lower than estimated. A lot of business managers seem to believe that there is an optimistic bias in investment estimates.
An optimistic bias has also been confirmed with regard to financial markets, as demonstrated in, for instance, macro-economic prognoses issued by US authorities,7 profit estimates of American stock market analysts,8 and among investors,9 CEOs,10 consumers,11 and project managers.12 Profit estimates are largely dependent on sales estimates, which financial analysts tend to overestimate, although13 the optimistic bias is larger for profit than for sales forecasts. Rules of disclosure seem to play a role here. In a comparison of estimates made by financial analysts in different countries,14 overoptimistic profit estimates were less common in countries with more complete financial disclosure rules.
One area where overoptimism is especially obvious is entrepreneurship and new ventures. Many studies have confirmed that entrepreneurs – people starting new businesses – are overoptimistic,15 that they are more optimistic than managers,16 and that they start their companies when they do not fully realize all the risks involved.17 They overestimate the possibility of being right and generalize on fewer observations18 than non-entrepreneurs do. Other studies show that entrepreneurs seldom contemplate what else they could have done, or admit or express regret concerning a mistake.19 This optimistic bias is not balanced by venture capitalists as similar studies have found that they too exhibit an optimistic bias.20 Optimistic bias among entrepreneurs has been shown to have a partly cultural bias,21 so optimistic bias could be one of the factors explaining differences in the propensity to start new firms in different cultures. For instance, both optimistic bias and the propensity to start new companies are high in the USA and China, but low in Japan. Europe can be found somewhere in between these extremes.
Other studies22 show that less knowledgeable people have more confidence in their own abilities than more knowledgeable people. Their ignorance seems to make them more optimistic and thereby more likely to commit themselves to new ventures without knowing what these actually imply. One can wonder how many ventures fail because of ignorance and overoptimism.23 The failure rate of new firms is extremely high. In the USA, only 45 per cent of new companies are estimated to last for more than five years, and only 30 per cent for 10 years,24 and the figures do not seem to be much higher in other countries. The fact that some new firms become very successful although costs and problems were greatly underestimated at the outset might sometimes be explained by the fact that the windows of opportunity would have closed had not the entrepreneur sized the chance without first properly investigating it. This ability to disregard problems and to act on vague and incomplete information could also explain why entrepreneurs often do not function very well as managers in established organizations, and perhaps it can also explain speculative bubbles.25
Behavioural studies have identified a number of biases, but few are as well-documented as optimistic bias. Humans underestimate the chance of being involved in a car accident or getting cancer, and overestimate the possibility of winning the lottery, succeeding in their daily work, and how much of their life remains (the latter to the benefit of pension funds and life insurance companies). Some 80 per cent of the population do this. Mildly depressed people hold a more realistic view, but optimism seems to be an advantage as optimists live longer and are healthier.
Optimistic bias has been explained as a consequence of natural selection and an advantage in the evolution of species26 and also as a prerequisite for the development of human civilization. The anthropologist Lionel Tiger27 goes as far as to speculate that optimistic bias has been a driving force in human evolution as it presupposes thinking about and making plans about the future. Doing so created fear of the unknown that could be partly counteracted by being overoptimistic. An obstacle to the latter reasoning is that optimistic bias is not unique to human beings. Biologists have shown that many animals, even pigeons, also exhibit an optimistic bias. It seems like evolution has favoured the development of an optimistic bias. Those that have underestimated future work, problems, and dangers have fared better than those that have held more realistic images of the future.
Leaving the reasons behind optimistic bias, we can conclude that planners tend to underestimate the time and resources needed when estimating the cost of implementing their plans. We can also conclude that entrepreneurs are more optimistic than managers. Entrepreneurs tend to underestimate the actual time, cost, and resources needed to implement the projects they want to achieve, and in many cases this optimism, sometimes based on ignorance, seems to have been a precondition for their decision to go forward with their business idea.
Self-serving bias.
Another well-established bias which could contribute to cost growth is self-serving bias. It can be defined as a distortion of the cognitive process in order to maintain and enhance self-esteem.28 We absorb positive feedback and reject the negative, forget past failures and errors, and credit ourselves for the success and achievements of those we work and associate ourselves with, all to enhance our self-esteem.
The support for the existence of self-serving bias is very strong. A meta-analysis29 based on 266 studies of self-serving bias found it to be high in Western and Chinese cultures, unnoticeable in Japanese culture, and moderate in Indian culture. Disregarding seven Japanese studies, this type of bias was confirmed to exist in all parts of the world. People have a tendency to attribute positive outcomes to themselves and negative outcomes to others or unforeseeable events. They tend to have a positively distorted image of their own role and performance. There are many studies confirming this, and there are also studies showing that self-serving bias is associated with greater perceived happiness, less depression, better problem-solving skills, stronger immune systems, and lower mortality, and that this distortion of reality is more pronounced during childhood and after the age of 55.
Self-serving bias is more difficult to study than optimistic bias. It is often difficult to establish whether an observed self-serving bias is due to overconfidence, hopes to recover sunk cost, a need to sustain a positive image so as to maintain good relations and access to resources, or some other reason. There is also an interaction between these biases, since they are mostly self-reinforcing. An unconscious drive to enhance one’s self can unconsciously affect the decision to maintain a course of action to recover sunk cost or a presentation to stock analysts at the same time as these acts will reinforce the presenter’s self, and the other way round. Consequently, self-serving bias is a recurring theme behind many reasons advanced to explain escalating commitment,30 i.e. why people invest more money in ventures where estimated costs keep increasing in the hope of regaining their previous investment. Explanations for why people throw good money after bad, such as the hope to recover sunk cost, the tendency to seek data that confirms one’s assumptions, the need to justify past decisions and actions, and the need to conform to perceived expectations and save face, can all be seen as manifestations of self-serving bias.
There has been a long debate over whether self-serving bias can be explained by cognitive causes or motivational reasons, and recent research in social psychology indicates that the latter might be more important.31 People highly committed to a project are more likely to overestimate its positive outcome. A cultural trait exists in both optimistic and self-serving biases, and it can sometimes be difficult to distinguish these two biases, but self-serving bias is considered by many to be the main explanation behind optimistic bias.32 It has, for instance, been shown that those initiating a project are more likely to continue to invest in a project when cost increases than later managers managing the same project,33 which is in line with studies showing that entrepreneurs are more optimistic than managers. Thus, there is a connection between optimistic and self-serving biases.
Whether this tendency to blame failures on others and unforeseeable events, and to credit success to oneself, is due to a cognitive bias or a conscious effort to influence others’ image of oneself or the focal organization is mostly impossible to know. A study of annual report narratives34 shows that the frequency of self-serving formulations increases in crisis situations, and that impression management is more important than self-serving attributional bias in this case. Companies need to maintain a positive image towards customers and financial analysts to sell products and to keep share prices up. Limited companies are dependent on selling a positive image of the company’s prospects. However difficult it is to separate impression management from self-serving bias, one cannot disregard that the latter also exists in companies.
It has been shown that most drivers consider themselves to have above-average driving skills.35 A similar overconfidence and self-serving attribution has been established in many other areas, including among business leaders.36 On average, people consider themselves to be a little better than average. We recognize this from stories told by well-known leaders in the business press. When companies are successful, the outcome is ascribed to the foresight and competence of the CEO and top management; when expectations are not met, as is usually the case in economic recession, failures are ascribed to external factors which nobody foresaw or could have foreseen. Explaining failures as due to unforeseeable events and denying responsibility is often probably not a conscious attempt to explain away a failure, but more often an unconscious effort to protect one’s own well-being. Responsibility is claimed for success, but rarely for failures.
Some high-ranking political and business leaders have been described not only as overconfident but also as exhibiting narcissistic traits, i.e. they have an unrealistic image of their own importance. They like – or need – to be admired, and to receive attention and positive reinforcement from others. It is better to be confirmed than criticized, although we know that flattery does not foster learning. However, learning and re-evaluation of old assumptions requires negative feedback, something some leaders prefer to avoid. This can lead to a single-minded search for information that supports the project and estimates the leader is in favour of, or that planners and cost estimators presume to be favoured by their superior.
Craig Galbraith and Gregory Merrill37 sent a questionnaire to senior managers asking them whether they asked subordinates to revise their sales forecasts and cost estimates after having reviewed these. The replies showed that almost 50 per cent claimed to have done so, and that half of these made the revision themselves. A third had asked for ‘backcasts’, i.e. forecasts that fulfilled a certain pre-specified outcome. Galbraith and Merrill underline that estimating and costing is a political process. Top management do not always want the best possible estimate, but rather the estimate that serves their purpose and needs at the time.
Careerists know that it pays to agree. They tend to provide their bosses with information that confirms the bosses’ beliefs. Honesty is highly prized, but honest people tend to be impossible to sway and as a result risk becoming seen as trouble makers. This can create room for a ‘yes’ culture, populated by careerists who hope to aid their chances of promotion by agreeing and supplying the positive reinforcement that their boss craves,38 and others who just agree because it is easier to agree than to disagree.
Groups have to reach some kind of agreement as otherwise it is difficult to cooperate. The problem is that good decisions on projects require accurate and undistorted information not only on the estimated cost, but also on factors that may make changes necessary later and thus cause costs to increase, such as realistic market estimates, competitors’ strength, and the knowledge and skills available in the organization. Once the project is finished, it can be beneficial to forget or conceal mistakes, as everyone involved will have to cooperate in the future, so a form of conflict avoidance is practised that can lead to a culture of distorting facts and groupthink39 if it goes too far. The solution is rules of conduct: in politics, a constitution that prohibits leaders from developing dictatorial traits, and in business, professionalism and good corporate governance.
Self-serving bias thrives in ambiguity, as it is easier to maintain alternative views when there is room for alternative interpretations. When a cost estimate can be based on historical records, such as in replacement or closures of plants, there is not much room for alternative interpretations if one accepts the norm of economic rationality. It is much more different when estimating the cost and revenues for an investment into a new market, especially if the technology is also new. Entering new markets and implementing new technology typically encounters unforeseen problems that delay the venture, making costs grow and delaying revenues. There are many possible outcomes, and this ambiguity creates room for alternative views; thus, although proponents and opponents might have exactly the same information, they might draw different conclusions. The less we know about the cost, the more the strength of our belief in the investment becomes, and hence the importance of our self-serving bias to enable us to justify decisions. Ventures in new areas are examples of projects more often based on belief in a vision than hard data.
Ambiguity opens up possibilities for negotiating data. It makes it easier to find options that might favour our interests and formulate rational explanations to support these interests. It makes it easier for those that work on or are committed to the venture in other ways to search for and find evidence confirming estimates that favour the venture, and for those that are against the venture to search for and find evidence to stop it. Ambiguity can also be used deliberately to make it difficult to evaluate and assess the outcomes of estimates. Project managers might tend to emphasize the uniqueness of their project, try to include cushions in estimates, and avoid specifying budgets more than necessary, all to make it more difficult to compare budget and outcome. That gives them flexibility and makes it easier to achieve the budget.
Anchoring bias.
The third bias we need to cover in this section is anchoring, which means that later pieces of information are anchored in earlier information. Once one establishes an estimate, this figure serves as the basis for future estimates. Individuals have a tendency to attach more belief to this first estimate than they have reason to and to downplay new information that conflicts with it. Thus, the level of the first offer in a negotiation affects the final level agreed on. The first offer defines the range of possible counteroffers and where the deal will end. Property buyers decide how much they can pay based on the price paid for similar properties. Earlier experiences limit our search for information and solutions. We search for solutions in the glow of the streetlight.
The phenomenon is well known in budgeting. Most budgets are just last year’s budget updated with incremental changes. The same weather as last year, perhaps a little colder or warmer, but no perfect storm. Similarly, forecasters may prefer to modify their forecasts so that they don’t deviate too much from other forecasters’ prognoses.40 To anchor your estimate on competitors’ estimates or historical data are two strategies a forecaster uses to avoid the risk of being criticized if the forecast turns out to be wrong. It is common to play down change as it is difficult to foresee the consequences of change and make others share that view of the future. Simple budgeting works well in stable environments, but needs frequent updates in more fast-changing business environments; also, the purpose of budgeting is not only forecasting for planning, but to specify responsibility and compensation, and create commitment and motivation.
It takes several years of planning to implement a major project, and several cost estimates are usually made before such a project is given the go-ahead. Major cost increases typically appear early in the process. The first estimate can be very simple and based on comparisons with earlier similar projects, or rules of thumb used to estimate cost, but it is still very important as it will serve as an anchor in negotiating funding. It will be remembered and compared with later estimates. If costs increase, project management will have to be able to explain why cost has increased. That might not be a problem in a private company, where management and the board have experience of similar industrial projects, but it can be very difficult to explain to a public that does not have such knowledge. The first estimate can then be compared with the final cost even if it means comparing apples and oranges, when, for instance, most of the cost increase can be explained by the fact that size of the project has increased or by high inflation. The public will not buy the excuse that the first estimate was very vague, so it can be wise not to let grossly uncertain figures be made public.
Cost Overrun and Lack of Information and Information Asymmetry
Investments have to satisfy the needs and requirements of many actors within and outside the organization to be approved and receive funding. Marketing people have the best knowledge of the market and engineers of the technical choices made, but to have their project approved they must be able to sell their idea, they must convince top management that their investment is of greater importance to the company than competing projects in search of funding.
One problem in this selling and commitment process is that those designing the projects have more and better information about project details, making it difficult for those approving the funding to question technical choices. We refer to this as an information asymmetry between those selling and those approving the project, and many (if not most) of the explanations for intentional underestimation in the literature are based on the presence of information asymmetry between two or more actors.
Raymond Giguet and G. Morlat,41 who postulated that the events causing cost overruns are not independent (see Appendix B), also postulated that when two investment alternatives filling the same purpose are competing for limited funds, the one underestimating the investment outlay stands a better chance of getting funded than the one that correctly estimates the investment outlay. From this, they concluded that underestimated investments will be over-represented in the capital budget, and the total investment budget thereby exceeded.
Based on statistics, one can also postulate that the more bids there are, the lower the lowest bid will be, and the higher the highest bid will be. The one who wins a popular auction will pay too much, and the one winning a much-wanted assignment tends to have underestimated the cost of delivering that assignment.
Not only does the lowest offer stand a better chance of being funded, there is also an incentive to accept the lowest offer when projects compete for discretionary grants from a limited budget. This has been pointed out in studies of both military42 and civilian public sector procurement.43 It is especially a problem in public organizations as these are often obliged to accept the lowest offer. They have no choice unless they can argue that a higher offer fulfils their specifications better, meaning that they have to specify quality requirements clearly.
Underbidding is not a new problem. A 100 years ago it was perceived as a major problem causing unfair competition, especially in the new electro-mechanical engineering industry. Costing was more difficult in this new industry, which appeared in the 1880s, as products were assembled by parts manufactured at different manufacturing units. As is usually the case in a new industry, many new and relatively small firms were soon competing for contracts, and many of these small firms did not have the knowledge to properly cost their products. As the procurers tended to choose the lowest offer, many of the firms that had been too optimistic went bankrupt, which caused problems for both the producer and the buyer. Costing practices needed to be improved, and that was done in the USA by creating calculating cartels which collected data to help member firms to make more accurate cost calculations, and by standardizing cost accounting.44 Standardization meant first standardizing the terminology, and later the principles of cost accounting.45 It was a process that took several decades and, in the depression, the unfair competition argument resurfaced in the National Industrial Recovery Act passed in 1933. As a part of President Roosevelt’s New Deal, this Act prescribed ‘fair competition’ as meaning that firms were forbidden to set prices so low that competitors went into bankruptcy.46
Many bidders with poor information about the real cost no doubt create a risk of underbidding and cost overrun, but Giguet and Morlat’s conclusion that underbidding would also cause the total investment budget to exceed its limits does not receive conclusive support in empirical studies. It seems to be more common47 that the investment budget is not used up as there are always projects where implementation will be postponed or never happen. We are overoptimistic and plan to achieve more during the coming year than we actually manage to achieve. It has been reported that some companies are aware of this and therefore accept more projects than the investment budget allows so as not to miss out on lucrative investment opportunities.
One question which has been discussed in the literature48 is whether underestimation is unintentional or the result of a deliberate act to make a project look more appealing. If the estimator has developed an optimistic bias then the underestimate is unintentional; if the estimator realizes that the estimate is unrealistically low but still submits it to get the investment approved, then it is a deliberate act. The requestor or project planner may be convinced of the merits of the investment but cannot prove it in the way the company prescribes in its investment processes, or the investment may be in the interest of the planner. The first alternative has already been discussed, so now we turn to investment costs that are deliberately underestimated.
Case studies from both the public49 and the private sectors50 give examples of project costs that have been deliberately underestimated in order to have them investigated and even approved. An example was given in the second section of Chapter 4. The managing director of Frövifors Bruk AB said the new mill would cost 300 million to gain approval to do a feasibility study, well aware that the board would probably find it wiser to build a larger and more expensive machine to better utilize economies of scale later on. Because of this information asymmetry ‘[y]ou have to go about things gradually so that you don’t get a negative answer’, as the MD of Frövifors put it in Chapter 4.
The use of (or, more correctly, the misuse of) cost-plus contracts, which guarantee the contractor full compensation for costs plus a certain markup in military development projects, has long been criticized51 for not giving contractors incentives to keep costs down. Tougher competition has encouraged contractors to put in lower offers for cost-plus contracts as the benefit is far larger than the cost of not being able to meet the contract. As public authorities are forced to choose the lowest offer due to the rules for public procurement, and sometimes also lack the competence to assess offers correctly, they risk giving the contract to a contractor who consciously or unconsciously has put in a bid that is too low. Furthermore, the penalties for not being able to meet technical requirements are higher than the penalties for not meeting time and cost requirements. Hence, problems in meeting technical requirements are taken as time and cost overrun.52 This causes military authorities to reduce the amount of development work done on a cost-plus basis, and to supplement contracts with incentives to hold costs down.
To curb high and rising costs, President Reagan appointed David Packard to chair a commission on US government military procurement. The Packard Commission53 concluded that the problems with cost growth, delays, and performance shortfalls remained as documented in earlier studies, and recommended changes in the acquisition process and in the contracts used. However, this does not seem to have significantly reduced cost overrun in defence contracts. A study of 269 defence acquisition contracts during the period from 1988 to 1995 did not show improvements, and in fact Air Force contracts worsened.54
Developing new military technologies carries substantial technological risks, and Kenneth Arrow55 has argued that the primary reason for using cost-plus contracts in weapon development and acquisition has not been to reduce cost growth but to allocate risk between industry and government. Developing new military technology that government deems necessary is associated with such high risk and uncertainty that industry needs to share these risks with government. However, this type of contract has also allowed certain defence industry firms to take advantage of the situation by ignoring the financial risk, as they have a guarantee preventing bankruptcy. An instrument applied by government to reduce the risk firms have to take when developing new technology has been exploited by some firms for profit.
In civilian projects, there might also be an incentive for sellers to underestimate the real cost. However, cost can also increase when cost-plus contracts are not used if the seller is more knowledgeable about the project than the buyer. Construction companies sometimes accept deals that do not look profitable on paper because they foresee that the buyer will probably need to ask for additional work or changes in the agreed plan and therefore can be expected to want to renegotiate the deal later on.56 The construction company’s information and knowledge advantage allows them to sign unrealistic plans because they know that profitable additional work will be needed as the other party learns more about their own plans. Therefore, the procurer needs to match the seller in competence and knowledge, otherwise the seller might take advantage of the situation. If the procurer lacks the necessary competence, it can be better to let a consultancy firm evaluate offers, as well as handle procurement and contracts.
One might expect lenders to be aware when there is information asymmetry between procurers and sellers, but that is not the case. Even when a project is affected by very large cost overruns, lenders almost never make a loss. If it is a public project or company, then the state, and ultimately the taxpayers, take the risk. If it is a private company, then lenders look at the company’s ability to pay back the loan. The important thing is the borrowers’ ability to repay their loan, not their ability to avoid cost increases. Lenders do not usually evaluate projects; it is easier and cheaper for them to evaluate companies and management.
Information asymmetry exists not only between those proposing and approving a project, but also within organizations. However, removing this asymmetry is not always the best solution because cooperation is built on trust. An approved cost estimate is an agreement between two parties, and a commitment on behalf of those that have requested funding and, in particular, the project manager responsible for implementing the decision, as they have all signed the funding request and by doing so confirmed their belief in it. If those approving the funding question what is in the request too closely, this can be interpreted as questioning the qualifications and loyalty of those making the request. The higher the number of managers who have scrutinized and approved a request, the more difficult it becomes to stop it. Top management cannot reject projects approved lower down the organization without them losing face.57 Nor is it is always in the best interest of the company to show distrust openly, as that can damage the trust needed to cooperate in the future.
A questionnaire58 sent to Fortune 500 companies showed that management were aware that some proposers were more optimistic than others, and adjusted their profitability estimates downwards to compensate for this optimism. Managers accept projects even when they know that the true cost is underestimated, as they do not want to disbelieve committed project proposers. Company management is aware that investment requests are often too optimistic and learn to compensate for the optimistic biases of requestors.
It is also a widely held view in industry59 that it is better to approve a tight budget and be prepared to provide additional funding if needed, as all budgets tend to be used up. ‘Wasn’t cost overrun larger? I expected twice as much’, as the CEO of ASSI is said to have exclaimed when he got the follow-up review of the Frövifors investment. By approving a budget he thought was too small, he got more out of project management and ensured that funds were put to the most efficient use. Not surprisingly, it is extremely unusual for a project to be implemented below cost and unused funding returned; project management always seem to find a way to spend what has been approved.
This can also be an argument for keeping the estimates low in the planning process, and for being prepared for cost to rise gradually, as low-cost estimates put a pressure on project management to find economic solutions. Whether this is effective is another issue. Requesters who know that those responsible for approving requests will always make cuts in the budget can be expected to sneak in extra funds to counteract such cuts. Budgeting is called a game for good reasons.
Cost Overrun and Path Dependency
All projects need finance to be implemented, which means that there are always at least two processes involved in project planning. One is solving technical and economic challenges, and the other is the process through which finance is secured and approved. These two processes are often interconnected, as finance puts restrictions on the size of the project, and the design might have to be altered to attract support and finance. During the process, the number of alternatives is usually reduced to one, and consensus around a specific design and project is gradually built up through commitments from all the interested parties. These commitments are based not only on rational choices but also on emotions. In fact, emotions always come first. Rational choices are reconstructions, efforts to test and prove visions which are sometimes associated with strong emotions. People engaging in getting projects implemented, or indeed stopped, can become very emotionally involved, and assessments and decisions become a mixture of emotions and reason.
The formal investment decision is seldom between different projects. The alternatives are gradually discarded until only one remains. Many different design alternatives, technical solutions, sizes, and localizations can be studied; however, cost estimates are still undetailed and based on comparisons with earlier investments and rough estimates. Only when the board approve the invitation of tenders can reliable estimates be made, and then the choice is not between different localization options but whether to proceed with the alternative chosen or not. The early decisions and choices that are necessary to push the project idea towards implementation can create a path dependency by imposing restrictions on future decisions.
Furthermore, projects are learning processes. We shall not delve into the many theories of learning, but, for learning to take place, there must be some motivation or goal and some form of negative feedback that makes us aware when there is something in our assumptions or images that is not as we assumed. To learn something new, we need to be made aware of the difference between what we think we know and what we do not know. An important supplier of such feedback is the control systems that exist in organizations. They force estimators to learn more about the project before they are allowed to implement it.
Another important aspect of learning is that it has to be focused. One cannot investigate and solve all problems at the same time. To move the project forward, it is necessary to focus on one or a few problems at a time. This typically gives planning processes a sequential character. Richard Cyert and James March termed it ‘sequential attention to goals. … Organizations resolve conflict among goals, in part, by attending to different goals at different times’60.
Trying to solve all problems simultaneously would make the level of uncertainty unmanageable. Instead, one has to focus on solving one or a few problems at a time and assume that other factors will remain constant. The same applies when there are multiple and possibly conflicting interpretations of the information available. One has to proceed in steps to keep perceived uncertainty at a manageable level. Keeping some goals or solutions constant while experimenting with others also means that some solutions will be developed before others, and so project planning becomes an iterative process. All this – early decisions, commitments, learning, and many other factors reducing alternatives – can create a path dependency that will drive cost.
Path dependency connects our next step with where we come from.61 It explains how past decisions limit the choice of future possible decisions. Such path dependence can create cost growth both before and after the decision to invest. We have so far focused on commitments to early decisions created by an interconnection between definition and funding processes, and the reduction of alternatives in the definition process. Path dependence can also be inherent in the technology, be a consequence of specialization, driven by hopes of re-couping sunk cost, and individual commitments, causes that are not always easy to distinguish from each other.
A concept related to path dependence is escalating commitments,62 often expressed as the tendency to ‘throw good money after bad’, particularly when this action cannot be ascribed to impartial rational reasoning. The reasons advanced for escalating commitments are much the same as for path dependence, and vary from expectations of good profit, to social pressure from peers and the role, and a hope to recover investment already made, i.e. sunk cost. The term ‘escalating commitment’ is not an explanation but a symptom. The explanations given vary in the relatively rich literature around this topic. We have already described how the definition and impetus processes are interlinked and that those advocating the project must convince those allocating resources of the merit of the project, and get their commitment to the cause. This process of committing support starts right at the beginning of the project, and is one of several explanations for escalating commitment. A related term is ‘entrapment’, which can be defined as instances of escalating commitment leading to an ineffective course of action.63 Escalating commitment can lead to both effective and ineffective courses of action.
Starting with technology as a cause of path dependence, an often cited example is the QWERTY keyboard layout which, due to its early dominance in the market, has been able to retain its dominance in spite of better layouts. The more people using it the more difficult it becomes to switch to another layout, a fact well known in the IT industry, where the number of users creates an increasing rate of return. The concept is not new. Harry Turner Newcomb,64 for instance, showed in 1898 that ‘the law of increasing returns’ in industries with low operating costs which did not need to increase their investments or increase them in proportion to increases in production, such as the railway industry, leads to the firm with the largest network out-competing other firms. But W. Brian Arthur65 presented the first formal theory showing how increasing rate of return can lead to ‘lock-in due to historical events’ to a less efficient technology. Characteristic here is that there are several possible future paths, that the outcome is unpredictable, that the choices made limit future possible choices, and that the path dependency can lead to inefficient ends.
Specialization is another factor that places a firm on a certain path, or commits an individual to a certain profession. Gary Becker66 distinguishes between general and firm-specific human capital. The former is applicable to firms in general, while the latter is of more value to a specific firm in creating an incentive to remain in the organization. Managers and workers with more specialized, firm-specific skills are of lower value outside the firm, which is why they have fewer options to leave the firm. This could make them more prone to continue investing in failing courses of action.67
When it comes to investments, this is true also in a broader sense. Competing firms can be expected to have almost the same information about the market. What makes an investment more profitable for one firm over another is that it has capabilities, i.e. firm-specific resources, better suited to making it profitable. Firms have to specialize and invest in developing capabilities further in areas where they have a competitive advantage, which often implies assets that are so firm-specific that they cannot be traded. Thus, specialization locks the firm into a certain path of investment, in the same way that specialized employees become locked into their firm. This also means that the first investment is the most important. Later investment utilizes earlier investment.
To the employee, firm-specific skills become sunk cost when leaving the firm. Sunk cost is gone and irrelevant, and cannot be recovered. It should not influence future decisions, but can in fact do so due to psychological factors. The gambler makes yet another bet to recover earlier losses, investors make additional investments in the hope of recovering earlier investment, or a bank gives additional loans to recover earlier loans. Hopes of recovering losses can lock an investor into path dependence.
Sunk cost should not matter, but financial obligations can make sunk cost relevant. Investments can be divided into basic and additional investment. The basic investment can be a new plant or production unit. Basic investments can be very expensive and may be partly financed by borrowed capital which has to be repaid. The company therefore becomes locked in to making the basic investment profitable. This forces the company onto a path of making additional investments to be able to pay rents and loans back. The basic investment has several names: in the vehicle and software industry, for instance, it is called a platform. A platform is developed upon which several car models, or many customer software projects, can be based. The principle is the same. A platform is not profitable if it is used only to develop one car model or software for one customer one time only. It has to be made profitable by additional investments.
Sunk cost can also be used intentionally to gain additional funding and investments. An extreme example is the Peruvian regional director referred to by Albert O. Hirschman68 who, due to lack of funding, used up all his funds to build bridges, which were useless if, later on, funding was not also appropriated to build roads connecting the bridges. Similarly, there is the tale of a regional director in the south of Sweden who spent all his funding on secondary roads, knowing that this would give him strong arguments for extra funding to build highways catering for long-distance transport. This has been claimed to have been behind the Swedish Road Administration developing a fairer allocation system in the 1960s based on cost–benefit analysis.
The world of ideas that exist in organizations can also create path dependence. Gothenburg, the second largest city in Sweden, decided to turn its railway station into a drive-through station by constructing an underground railway loop with two new stations. In the 1980s, a local politician had proposed an underground line connecting three local transport junctions which was considered too expensive, but it later reappeared as a railway line project.69 However, it turned out to be too difficult and costly to build a whole railway station underneath one of the three local traffic junctions, due partly to space but also to the blue clay substrata underneath the junction, so the station was moved eastwards where it could be constructed in rock. This then made it necessary to scrap another junction, whereby the new loop did not serve the purpose the original underground line was supposed to fill. Still, this did not stop the project. Some project ideas are the result of a search process and others an idea imported from outside, but many are just based on ideas that have been around for a long time. Such ideas are found in both public organizations and private firms, and can create their own path dependency.
Individual actors may also be locked into a course of action. An ambitious entrepreneurial managing director of a public utility saw an opportunity to reverse the downward economic development in his region by developing a biomass energy industry system. He was not alone in promoting this venture, but became identified with it as he promoted it widely in the media. However, as project planning proceeded and more became known about the risks involved, he became gradually more hesitant, and was already doubtful about the prospects for the project when he made his presentation to the board to get the go ahead:
I had this unpleasant feeling that it was going to be difficult. … It was said then that the oil price would increase in real terms by two per cent. We had the government’s word for that. … I’ve realized since then that we were whistling in the dark, that’s what we wanted to believe. We put great store on them saying that the oil price would never go down to such a low level as to make domestic energy sources uncompetitive. That was an additional reason we believed in this. Deep inside I was very worried about this part. One should probably have trusted one’s intuitive feelings that this was bloody risky and slammed on the brakes at an earlier stage, but by then the contracts for the project had already been placed.70
His fears came true, and, on top of the economics, serious technical problems emerged. The project was shut down, and the entrepreneurial managing director had to shoulder much of the blame as he had become personally associated with the venture through the media. It was seen as his project.
We might wonder why no one hits the brake before a seemingly impossible business idea crashes. Maybe it is not always easy to stop momentum when an idea has become widely accepted as truth, and, as in this case, many people have attached great hopes to the venture. As the highly engaged entrepreneur, our managing director had built up expectations. When he started to doubt his earlier promises, he did not want to make those that had believed in him disappointed, which is why he had to go through with the project and try to make it succeed.
Key actors can become locked in to the promises they make in order to get their project implemented. Even if they realize that the assumptions they have made do not hold, it is often difficult and painful to re-evaluate these assumptions, especially if they were the ones selling the assumptions in the first place. It is easier to hope that they are right and that everything will solve itself.
We started by explaining how emotions, visibility, and rigid decision processes can lock decision makers and other actors in to early estimates and commitments, and make it difficult to revalue old ones and make objective assessments of new information. An estimate needs approval in order to develop an idea further. In this respect, there is no difference between the private and public sectors but, as has been pointed out, it can be more difficult to explain cost growth in the public sector as the requirement for transparency is higher. Large sunk cost and many actors committed to a project can make it more difficult to terminate the project if the cost estimates increases. However, it is not only the organizational context that creates commitments and rigidity. Key actors can become locked in to commitments that they made earlier in the process. Those that have been working with the project for a long time and have put their name on the figures become committed to achieving the figures promised. Personal commitments are built up and can by themselves become a force that helps overcome doubts and drive plans forward, making it difficult to stop plans once they have gathered enough momentum. All these factors mean that plans can be approved even when they should not have been.
