Causes for Cost Overruns in Infrastructure Projects
In the previous article, we explained the concept of cost overrun. We also explained how cost overruns have a negative effect on the finances of the entire project. However, it is strange that despite being so harmful to infrastructure projects, cost overruns are still ubiquitous. It is common for more than 50% of megaprojects to have significant cost overruns.
In this article, we will understand the leading factors which lead to cost overruns. We will also understand why cost overruns are difficult to prevent despite there being so much emphasis on them.
One of the biggest reasons that cost overruns are so common is that the costs are not correctly forecasted, to begin with. A lot of planning is a victim to what is commonly known as “optimism bias.” In simple words, this means that the project plans are too optimistic, to begin with. This is because human beings tend to have a lot of belief in their own abilities. Many times, this belief tends to take them towards wrong decisions. Also, in many cases, projects have to compete with other projects in order to get selected and obtain resources. This selection happens depending upon the initial cost estimate, which is provided by the companies.
Hence, there is a strong incentive to understate the costs and effort so that the project can beat other projects and have a shot at implementation. Wrong assumptions due to the paucity of appropriate data or because of sudden changes in the market conditions are therefore very common. In many cases, the government does not want to spend too much money before the actual execution of the project. As a result, they fail to take up the studies, which would have cost a little more money but would have provided vital information about the project.
In the above-mentioned scenario, the assumptions were incorrectly states because of negligence or lack of data. However, in some cases, there is likely to be a deliberate misrepresentation of data. This is because politicians and bureaucrats are incentivized to announce infrastructure projects. They can show the execution of these projects in their profile and get re-elected or get promoted at their jobs.
However, when it comes to cost overruns, these officials are almost never held accountable. This is because of the common belief that cost overruns are controlled by the company, which is executing the project. Since there is no downside to the politicians and bureaucrats, if the project overshoots its cost estimate, they tend to project extremely favorable assumptions deliberately. As a result, projects get selected for execution and later on experience overruns. The problem is that when the overruns are happening, there are no repercussions for the people which created the problem in the first place. It is assumed that the overruns are happening because of inefficiencies or delays caused by the party executing the contracts.
In a relatively small number of cases, project delays are caused by events beyond the control of both parties. This category includes force majeure events as well as economic events. However, these types of overruns typically affect an extremely small number of projects. Also, these overruns can be insured against. Hence, the financial impact of such cost increments is not very high.
Are Cost Overruns Truly Random?
Since so many projects experience cost overruns, one is forced to consider whether these overruns are random! The numbers actually suggest otherwise. If the cost overrun would have been random or due to some other statistical factor, it would have followed some kind of statistical distribution.
However, the reality is that cost overruns do not follow the normal or the binomial distribution. Instead, cost overruns are completely skewed towards infrastructure megaprojects. This means that whenever a large project is being executed, cost overruns can be routinely expected. Also, cost overruns are very common for projects where the bill will finally have to be paid by the government. This is because private contractors are very careful when they disburse payments. The same level of scrutiny is not undertaken by the government. This is because the bills are not paid from their own pockets. Instead, the bill is paid by using the taxpayer’s money. As a result, not many stakeholders seem to be concerned despite the high number of cost overruns.
Also, infrastructure projects are executed by professionals. When professionals face the same problem over and over again, they tend to find solutions to the problems. There have been many technical solutions that have been provided in this manner. However, even though cost overruns are persistent, no one has tried to look for any solution. This leads one to believe that maybe the cost overruns are deliberate and are caused due to poor planning.
The bottom line is that cost overruns can be classified into two categories viz. fools and liars. Fools are those who are accidentally overlooking important information about the project, whereas liars are those people who are wilfully ignoring important information about the project.
Authorship/Referencing - About the Author(s)
The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
- Infrastructure Finance: An Introduction
- Infrastructure as an Asset Class
- Infrastructure Finance Projects: Major Sources of Funding
- Why Doesn’t the Private Sector Invest In Infrastructure Projects?
- The SPV Structure in Infrastructure Finance
- Financing Needs of Infrastructure Projects at Different Stages
- Different Types of Contracts for Infrastructure Projects
- Distribution of Risks in an Infrastructure Project
- Risks Faced By Infrastructure Projects in Emerging Markets
- Bank Loans vs. Bonds: Debt Financing In Infrastructure Projects
- Key Decisions to Be Taken During Infrastructure Bond Issuance
- Parties Involved in Infrastructure Debt Issuance
- External Credit Enhancement in Infrastructure Financing
- Revenue Bonds and the Cash Trap Mechanism
- Managing Revenue Risks in an Infrastructure Project
- Cost Overruns in Infrastructure Projects
- Causes for Cost Overruns in Infrastructure Projects
- Third-Party Risks in an Infrastructure Project
- Vendor Finance in Infrastructure Projects
- Securitization in Infrastructure Finance
- Leasing in Infrastructure Finance
- Strategic Use of Land in Infrastructure Financing
- Usage of Collateralized Debt Obligations (CDO) in Infrastructure Finance
- Infrastructure Investments in Renewable Energy
- Should the Government be an Equity Partner in Infrastructure Projects?
- Lifecycle of Public Private Partnership (PPP) Projects
- Payment Mechanisms in Public-Private Partnerships
- Adjustment Mechanisms in Publich-Private Partnership (PPP) Contracts
- Early Termination of a Public Private Partnership