Optimism bias, Strategic Misinterpretation and Reference Class Forecasting (RCF)

Abstract

Most major projects around the world are facing the problems regarding planning and underestimating the costs of a project in the initial phases. These setbacks can cost an enormous sum of money and cause major setbacks of the planned schedule.

The initial planning and make a reliable budget are some om the main organizational managerial skills for a project manager. .

But unfortunately, it is today seen that most projects will not fulfill the initial plans and will not met the initial budget goals. It is logically a utopian idea of predicting the unpredictable (known unknowns) or even the things that is impossible to foreseen. And that is why we, as project managers need tools and learn from the past and others.

The Danish professor Bent Flyvbjerg did research into cost overrun of major projects. By sub-dividing the broader aspect of this into the two topics: Optimism Bias and Strategic Misrepresentation Flyvbjerg explored and explained more about the cost and benefit shortfall of major projects. And through further investigation, Flyvbjerg came up with a possible solution: the use of Reference Class Forecasting . The Reference Class Forecasting approach provides a more general overview and “is beneficial for non-routine projects” .

Through reading this article, a clear and succinct explanation of the strategies and ideas mentioned above will be discussed. Furthermore, the idea of Reference Class Forecasting in larger projects will be covered as well as the studies' limitations.

Big idea

Optimism Bias

The term optimism bias was coined by the Nobel prize winner Daniel Kahneman describing the idea that most people consider themselves less likely to experience something unpleasant. This leads to the effect of overconfidence in personal judgements (which can be dangerous / negative for a project in terms of project management). Risks tend to be seen lower and own capabilities better although previous experience shows the opposite (RCF). This can result in project managers undertaking projects with too optimistic expectations about budget, risks and the project scope, which will most likely not be met. . Optimism bias is nearly linked to cognitive bias and applies when human beings think higher of themselves than what is likely or what previous experience has shown. In that way they think that they are less likely to experience car accident or get fired or other bad things. “…post-project and in-project optimism biases have significant effects on the escalation of commitment to failing projects”. .

Strategic Misrepresentation

You have a great idea for a book, and you find a publisher who is willing to pay. However, he needs to know more about the time perspective. “When can I have the first manuscript? Can you have it done by the end of next month?” You lower your eyes and gulp. “Of course, no problem” you answer. You have never managed that kind of timeline before, but you are aware that if you tell the truth the publisher will not go with your idea. You do not feel like you just lied. And in official social terms, you did not, you performed the behavior of Strategic Misrepresentation. In larger project this Strategic Misrepresentation can result in underestimating costs, pre-determining and quite likely also overestimating the potential clients' benefits. Applying additional pressure and strain on individuals through manipulation, competing for scarce funds or jockeying for a position all qualify for the same over-arching category. . Note that Strategic Misrepresentation is a form of bias as well, but is used more intentional, and more likely to be a form a technique. When project planners present their cases, they often brighten the numbers regarding the risk and the benefits of their projects. Regarding to Flyvbjerg, they are deliberately deceiving the decision makers, since the projects that look the best on paper will be approved. One of the things that can make a project more vulnerable to Strategic Misinterpretation is “the end date is a few years down the road” No one knows more about large-scale projects than Oxford professor Bent Flyvbjerg. Why are cost and schedule overruns so frequent? Because it is not the best offer overall that wins; it is whichever one looks best on paper. The deceit is socially acceptable, so we don’t get worked up about it. In addition, the report notes that “decision-makers seek short-term recognition and rewards, and the first option represented.

Reference Class Forecasting

Go back to the previous example with the book. How would you decide how much you actually needed? Reference Class Forecasting (RCF) is a used method. The problem can occur when to determine which class to place your project in. Would you compare with all books written? All books within your subject? Books at the same educational level as yours? This is idea and challenge of RCF. RCF is a method of looking to future events by taking relatable situations (in same class so to say) and their previous outcomes. This approach aims to give a much less biased view on a specific event. A study conducted by Daniel Kahneman and Amos Tversky in 1979 shows that when a project is in its beginning stages, judgement of the overall risks of any given events in the project, the total cost and time is biased. This phenomenon was further investigated in 2002 by Nobel Prize winner Daniel Kahneman. The base of this experience was the optimism bias, and the idea that most humans tend to underestimate the time and resources that you will need to achieve your goals. To overcome this problem Professor Bent Flyvbjerg, in 2007, constructed another detailed overview of RCF and incorporating both the 'Outside View' and the 'Inside View'. In doing this, Flyvbjerg created a basic yet efficient system to also further eliminate the overconfidence present in the 'Inside Views' reasoning. RCF process three-step approach states that. It is critical to identify a Reference Class of a past similar project and determining the outcome with the highest potential for the plan by comparing to previous works in the same field of category is fundamental for success.

Application

Background

Risk contingency “is expected to be expended [and is] an amount added to an estimate to allow for items, conditions, or events for which the state, occurrence, or effect is uncertain and that experience shows will likely result, in aggregate, in additional costs” (Anonymous, 2007). There are various methods that can be used to quantify the risk contingency, such as Reference Class Forecasting (RCF), the conventional contingency approach and risk-based estimating. This article focuses on the RCF. The cost estimates produced at different stages of the same project carries different levels of uncertainties/risks and thus different estimation accuracies. As a project progresses through its lifecycle, more information about the project's scope, design, and specifications become available, which enable the estimation team to more accurately estimate the quantity and price of material and resources. As a result, generally more risk contingency is applied at the earlier stages than in later stages. Studies have shown that the typical estimation accuracy is 30% to 50% at the conceptual stage (Ashworth & Skitmore, 1982) all down to 5% during preconstruction stage (Ferry & Brandon, 1991).

Project cost performance and causal factors for cost overruns

Examples

Concrete tools

Use other biases to limit the effects: This bias is particularly important for decision-makers creating health or safety products, where the dangers of being overly optimistic can lead to dreadful outcomes. There are two researched ways of reducing the Optimism Bias (Jolls & Sunstein, 2006): Highlight the Availability Heuristic (make past bad events more easily retrievable from one’s memory) and use Loss Aversion (highlight losses that are likely to occur because of these bad events). Make negative events obvious: Bringing negative events to our mind just before we’re likely to engage in an undesirable act can be a good behavior change technique. The aim is to make the negative effects of a certain action clear to the individual, and offer a clear, safer alternative. Project managers take note: It’s important to negate the potentially huge costs of the positivity bias when estimating the expected time to complete a task or project. As project manager, remember to factor in a proportional Optimism Bias multiplier into estimations given. Governments have this problem so consistently that there are even detailed documents outlining a 5-step approach of how to factor the bias into the planning of large projects. Unfortunately, past cost overruns in megaprojects have resulted in scandalous errors with projects finishing significantly higher than original estimated budgets. The literature abounds with examples. In general, these studies agree that nine out of ten projects exceeded budget. “Overruns of 50% are common; cost overruns over 50% are not uncommon.”