Project Cost Overruns – Reasons, How to Prevent and Manage

16 min. read

Companies initiate projects for several reasons. In a medium to large size organization, there are several departments working on different projects. The Project Management Office, also known as PMO, manages the initiation, execution, and successful project delivery in an organization. However, project cost overruns are an inevitable fact that happens in every organization.

We will be going over the following in this post:

  • Three real-life project cost overruns
  • The common reasons leading to project cost overruns
  • How to prevent and manage project cost overruns.
  • The role of the Project Management Officer in project success

Let’s go through each of them one by one.

Researches About Project Cost Overruns

Before going through the details of the project overruns, let’s go through some research about the project cost overruns.

1,471 projects were analyzed, comparing their budgets and projected performance benefits with the real costs and outcomes. Based on this Harvard Business Review (HBR) research, the average overrun was 27%, but that figure hides a far more alarming figure. Graphing the budget overruns of the projects shows a “fat tail”- a large number of gigantic overruns. Fully one in six of the projects that HBR studied was a black swan, with a cost overrun of 200 percent, on average, and a schedule overrun of nearly 70 percent.

When we’ve surveyed our 425 participants who attended our corporate training programs, schedule delays, incompetent resources, and project cost overruns are the most common issues in project delivery organizations.

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So, if the project cost overruns are a common issue in project management, what are the reasons and how can we prevent it, and how can we manage if we could not prevent it? Let’s go over them now.

Real-life Project Cost Overrun Cases

Here, we will provide three real-life budget overruns caused by different reasons.

  • Case#1: The sales manager sells a technically undeliverable solution. Result: the project team works on new features and this causes a 17% budget overrun.
  • Case #2: The HR personnel does not approve the vendor team’s premises access papers on time. Result: The vendor accesses the premises two days later and this costs $13,000 to the organization.
  • Case #3: The finance department approves the project budget two days later after the deadline. Result: the project resources assigned to the team wait for two days doing nothing and this costs $37,000 to the organization.

Note that, these are the real-life project overrun cases from our clients. We have trained 200,000+ professionals and I am sure you have experienced similar cases that “non-project” people caused project overruns. That is why we have launched PM Core™ – Project Management for Business People Training program to create project management awareness among non-project people.

The PMI’s research about PM competency backs up our findings. Based on PMI’s researchproject management competency of the business people in an organization can increase on-time project completion by 49% and on budget by 40%.

Reasons for Project Cost Overruns

There could be several reasons for project cost overruns in an organization. However, the most common reasons are unclear scope definition, irrelevant estimation, unanticipated risks, and incompetent resources. We will be talking about these reasons in detail below.

1- Unclear Project Scope

Having a scope that is not clear, which is ambiguous or confusing is bound to cause issues. The project team will do what they will think they have understood from the project scope. Often, the resources tend to make assumptions and these in the end could prove to be wrong. Whether the scope was not defined or communicated well or it was not understood correctly either way, there will be undesirable outcomes coming out of the project. These, in turn, may result in the need for corrections or rework, causing project cost overruns.

2- Irrelevant Activity Estimation

Correct estimations are crucial in the project. Estimation about the activity duration, the number of resources required, for example, are just a few things that often are incorrectly estimated. Let’s say for instance an activity that could have been done by two resources, were assigned three resources. So, you will be incurring costs for an extra, unnecessary resource. Or, if an activity could be done in 5 days were given 8 days. This too will cost you more.

3- Unanticipated Risks

Absence or ineffective risk management are very common reasons for project issues and project cost overruns. Risks related to employees, cost, materials, equipment, suppliers, etc. – all could lead to project issues.

Often, organizations have risk management processes in place. However, the staff assigned for the risk management activities might be incompetent. This could become the reason for forgotten risks, improperly planned or ineffectively managed risks. And, when these risks occur, the higher cost is incurred in managing them. If there is not a plan or budget to overcome a risk that has not been anticipated during project planning, obviously, it will cost time and budget for the project.

4- Incompetent Resources

Assigning a lesser skilled resource to an activity may be a cheaper option. However, when the same resource makes mistakes or takes longer to complete an activity, there will be challenges to face.

Let’s say, for instance, if there is an activity estimated to be completed in five days for a $20,000 cost, it may cost you may be $5,000 more with an incompetent resource. Resource management in projects is an art. You should neither find overqualified resources nor incompetent resources. Overqualified resources will increase the cost while incompetent resources will increase the cost as well.

How to Prevent Project Cost Overruns

Not every cost overrun might seem significant. However, if every project is overspending 2% or more, for instance, it will add up to a lot at the end of the year. It also means that at the end of the year, there may be no bonuses or incentives. These are the things that the employees are often eyeing for long.

Unfortunately, it has become a norm for many projects to go over the budget. However, the reality should be different. Fortunately, with good and thorough planning, effective tracking, and supportive stakeholders, you can prevent project cost overruns. Below, we list the top four ways on how to prevent project cost overruns.

1- Prevent Scope Creep

The Scope Creep is basically adding additional functions or features to the new product, work, or requirements that are beyond the agreed-upon scope. Scope creep can happen in any project. And it can cause project cost overruns as well as time delay and decreased satisfaction. Adding an additional feature that yields good results isn’t bad. However, if it is not approved, it is scope creep, and this must be prevented.

There could be many reasons why Scope Creep could occur, such as:

  • Lack of clarity on what exactly is required.
  • Customer trying to get extra work done for free.
  • Beginning development of something before thorough planning.
  • Very little customer interaction with the project team.
  • Lack of change control.
  • Differing stakeholder opinions.
  • A poor time or cost estimation.

Fighting Scope Creep is simple. You have to firmly establish the requirements that match the customer’s needs, requests, and expectations. When this is done, it’s important for the project team to have a thorough understanding of what really is required. This step is crucial. It’s because based on this understanding, the team will develop and deliver the required product.

So, the project manager must clarify each requirement with the customer. The project team should also clarify the project scope or activities where they have a doubt. The project team should stick to the requirements. And, if there is a doubt, they must clarify it from the project manager. Moreover, no favoritism, nepotism, or bias should be allowed in the projects. Any additions that may be done must be approved first then incorporated into the product.

2- Acquire the Right Skills Needed

Once you know the project requirements and needs of the customer, you should acquire the resources with the right skills. E.g, if an activity requires a senior resource, but you assigned a junior resource, you might think you’re saving money. In reality, the activity may take a longer time to complete and exceed your planned cost.

You must choose the resources that have the right skills as well as the appropriate level of experience. Why this is important? Well, because a lesser skilled resource may understand the requirements wrong. Or they may be incompetent in developing something exactly as expected. It may even happen that the resource is doing something right but they are too slow. These reasons can cause the project to delay or you may need to rework some of the activities. This, in turn, will cause project cost overruns.

If your planning is perfect, the documentation is thorough but your resources are not skilled enough, you will face issues. And, we know that managing issues will always incur costs. Therefore, you should acquire only the resources that you think have the ability to work on your project. Based on IBM’s training report, every dollar spent on corporate training programs return $30 in return. So, corporate companies value to train their employees to increase project delivery competence.

3- Effective Risk Management

Risk management plays a very important role in keeping the project under budget. If risks are not thoroughly identified or if the proper contingency reserve is not set for these risks, extra costs spent while dealing with the risks will cause project cost overruns.

So what happens when there is no effective risk management is that some risks may pop up as a surprise. And you will have no preparation to deal with them. What you will do at that time is try to utilize your resources to overcome the consequences of the risks. However, a sudden reaction to the risks may require you to use the resources outside the budget of the project. You may even have not many options to choose from in order to deal with the sudden risk occurrence. So, you will end up doing whatsoever possible for you to manage the risks quickly, and this may cost you a lot more money.

A project manager must make an effort to consider all the possible scenarios. To do that, they should use experience, historical data, and brainstorming to identify the risks. Yes, the risks should also be found throughout the project but early identification is far better. So, once the risks have been identified, each risk should separately be assessed for its probability, impact, and priority. Risks may also be categorized. Categorization could be based on safety, technical, financial, internal, external, resources, or other criteria, as suitable. Categorization helps the project manager to understand where the maximum level of uncertainty lies. It also helps in monitoring and reporting purposes. With every risk, the appropriate amount of reserves must be calculated and kept.

4- Train Project and Non-Project People

The fact that people also cause the project cost overruns, and not always the project plan, work procedures, or other things, is often ignored. Usually, the project manager focuses on the project activities, project documents, and the resources necessary to complete the project. However, they should also consider the fact the untrained project people, with no fundamental project management knowledge or enough experience, may also be an obstacle to success. That is why we have launched PM Core™ – Project Management for Business People Training program to create project management awareness among non-project people.

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Work done by untrained non-project resources especially can actually make things worse. They are not aware of the processes that to follow. Furthermore, no one is centrally controlling them and they do not tend to work under plans. So the untrained resources could, for instance, cause inefficiencies in work, produce errors in deliverables, or make wrong decisions. The negative impact of untrained people could be insignificant but it could also be disastrous for the project. Issues caused by untrained people could require product repair or rework. This would consequently lead to project cost overruns.

How to Manage Project Cost Overruns

No one wants a project cost overrun. However, if it happened, what are the ways to overcome and manage the overruns? Read on for effective ways to manage project cost overruns.

1- Make Sure the Project Cost Overruns Are in Your PM Limits

Every organization has a different level of PM authority. In some cases, there are cost and schedule delay limits that a PM is allowed to manage the overruns. E.g. a PM might be allowed to manage a project with up to 5% deviance in budget and 7% schedule delay.

No one should take this to the advantage though. Even if there is a cost overrun limit, the PM should try to adhere to the planned cost. Adhering to the planned cost not only saves the organization money but also reduces waste. If for any reason, the cost overruns are beyond the limits, the PM should act soon. They should try to bring the overruns within the acceptable limits.

In a situation when cost overruns happen, this is the ability of the PM then that would handle this. They should look at the various ways as well as the project priorities to bring the spending under the limit. They should also consult with the key project stakeholders to find a mutual and effective solution.

The cost baseline serves as a reference for measuring and controlling cost performance. So, the PM should keep a constant eye on the cost baseline and actual cost, to look for cost variance. And they can do it by utilizing several cost measurement tools. For instance, they can look at the cost S-curve or the cost histogram. By looking at these, they will be able to know the amount of deviance. And then they would determine the best course of action necessary in that situation.

2- Assess Make-Buy Decisions

Both the options, make and buy, have their own pros and cons. The make or buy analysis is conducted at both the operational and strategic levels. And, whether buy or make depends on many factors. The organizations choose the option that is most suitable for the project.

When buying, you do not need to worry about your expertise and the management of the making process. On the other hand, the in-house making of the product gives you better control of the product. You can customize it however you like. And there is no need to establish and adhere to any contractual terms or conditions. Cost is the common factor in both options. And the project manager would determine both the make and buy options along with the other factors and decide what to do.

In some cases, however, buying might be more budget-friendly than making. It is because you don’t have to spend on the infrastructure and the resources needed to make the required thing. For either of the options, the PM should analyze the project requirements, the available budget, schedule, and other constraints. And after this PM can assess if there are certain work packages that can be outsourced and accomplished at a lower cost.

3- Use Contingency Reserves to Minimize Overrun Impacts

No project goes 100% as per plan and this is a universal fact. There are always many factors that trigger the need to overspend. Though there may be a need to overspend, overspending will cause project cost overruns and negatively impact the project’s reputation.

Hence, there should always be contingency reserves in the project for unforeseen. The reserves could be kept at the project level, work packages level, or at the activities level. And since, the reserves are part of the approved budget, utilizing these in a certain situation wouldn’t harm the project. So, project managers should make sure that they determine the amount of contingency reserves to keep for the unforeseen blow. And, this can only be done with the help of effective risk management.

You should never calculate contingency reserve based on assumptions.  Rather, you should calculate it using various risk management techniques. For example, using the risk register and the Expected Monetary value approach. The project managers have full authority to use this reserve and they control it. At the time of the need, they can decide how much of the reserve to use and for which activity.

Most often, the contingency reserves tend to be lower near the end of the project and higher near the beginning. And, with the help of graphs and charts, the PMs can track the use of the contingency reserves over time and manage it to the best outcome.

In addition to protecting project cost overruns, another use of contingency reserve is that you can use this information to communicate the project’s risk profile to stakeholders. Hence, contingency reserve is a valuable risk response strategy that protects the project against cost overruns. And it should be part of every project planning.

4- Consult Your Superior

If the project is about to face cost overruns, it is appropriate to use the allocated contingency reserve. But what if the cost overruns are more than your set limits? In this situation, you would not have been left with contingency reserve anymore. In this case, do not wait to consult your seniors, act immediately. Your organization must have set a management reserve to overcome risks worth more than your contingency reserve. Use management reserve in this situation.

Management reserve is often derived from a percentage of the overall project budget. How much management reserve needs to be set may depend on the type of the project. It also depends on how much of the project cost overruns you want to manage. And often, for research and development projects, the reserve is higher and for known product development, the reserve is lower. However, the project manager can also look at the other ways to determine the management reserve. For example, they can look at the performance of similar past projects and then determine an appropriate management reserve.

Summary

Experiencing a project with a cost overrun is not unusual. Doesn’t matter what type of project, whether IT, construction, medical, or any other, cost overruns can occur in any project. Any project can have a cost overrun but large or complex projects tend to suffer from cost overruns more. Although, conditions beyond human control could impact the project cost. Conditions such as extreme weather, inflation, etc., however, most of the time there are other reasons. Inadequate analysis, inadequate planning or incorrect estimation, and other factors like these are mostly the causes of the cost overruns.

In this post, we explained some of the common reasons for project cost overruns. We also explained the ways to prevent and manage the overruns. Among the factors associated with cost overruns, risk management is something that organizations would be unwise to neglect. Some threats even have the power to bring the businesses to their knees. High-cost deviations can cause undesirable results. Such as, canceling or postponing the projects, reduction of the project scope, and loss of the public faith.

Planning and utilizing the project’s contingency and management reserves is one of the best ways to manage project cost overruns. Instead of allowing the project costs to exceed the budget, it is better and acceptable to use the reserves and still stay under the budget.

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