Cost Overrun

Cost overrun, also known as budget overrun, is the scenario when the cost of a project or business tends to increase than what was it budgeted for and can be due to the increased cost due to improper budgeting or underestimation of the actual cost on account of some unforeseen scenarios which was not accounted for during the process of budgeting.

This is an unavoidable scenario that is faced by every business or project, but how to minimize it or mitigate it depends a lot on the management or the project manager. A proactive approach can help the business reduce the chances of cost overrun with proper planning and a thorough analysis of the estimates.

Cost overrun is the term that refers to failure to stick to the budget allocated to cover the cost of overall project or parts of it. It is a situation in which the actual cost incurred becomes more than the estimated one, resulting in projects getting delayed or even terminated permanently.

It requires a lot of planning and strategic decision making in order to make a project process remain within the budgeted resources. As the operation proceeds further and more resources get involved, complex situations arise, giving rise to the requirement of better planning, allocation and continuous monitoring of situations so that any deviation resulting in cost overrun in construction projects can be easily identified and handled in the best way possible.

The actual project cost exceeding the initial or estimated cost is a common situation. It remains a huge challenge in different types of planning and operational process like engineering, construction, software development and implementation in various departments, etc. Both internal and external factors play an important role in cost estimation and cost overrun management.

In the process, managers may have to reassess the entire operational procedure, its scope, timeline, the factors that have changed and contributed to changes, which will help in mitigating the financial strain and lead to process towards a successful completion.

Let us learn the various characteristics of the concept of cost overrun in construction projects which will help us to easily identify the situation and design procedures to handle it on time.

• Cost overrun is generally prevalent in infrastructure, building, and IT projects, which see a lot of unexpected costs during the project completion phase.
• They are primarily because of three factors: political, psychological, and technical
• It is primarily due to a lack of financing, coordination, unplanned cost, or project delays.
• It is always uncertain, and budgeting for the same is not possible. It is deemed to happen when certain phases of a project or business tend to cross the actual budgeted cost.
• The measurement of cost overrun is different for different industries or companies.

#1 - Estimates

Cost regarding the business may be underestimated due to factors like personal bias and complicated procedures involved in completing the task. We can use the reference class forecasting methodology to enhance the chances of deriving more accurate estimates. The problem is that the best forecasts may prove wrong to calculate the perfect estimate. Thus, keeping a contingency as a part of the budget is always a good practice to face adverse scenarios in the future.

#2 - Risk

Risk can be any scenario for which we cannot assign a probability. They cannot be predicted earlier and, at times, are not within the control of the business, like natural calamity, which may delay the completion of a project or vendor performance, which may eventually hurt the business which is cost overrun risk. A proper risk management plan may help the business mitigate the risk to some extent, but the risk is the primary type faced by every business or project.

#3 - Scope Creek

Scope creek is defined as occasions when unaccounted activities crop up in the project or business which were not included in the budget or the actual cost. It can happen when the management goes on adding features to the project as and when it is evolved or required or in the cases when the project team gets too creative and begins the inclusion of undocumented activities. Project management and controls are primarily designed in such a way to prevent such scenarios by the constant reassessment of the budget.

#4 - Cost Escalation

Cost escalation is more related to economic factors like inflation, which may include the rise in the price of a particular item over a period that was not accounted for in the initial budget.

1. The unplanned cost: Unforeseen scenarios may bring about a couple of activities that were not initially taken into the plan or budget. Project cost overrun can be due to technical, political, or psychological reasons.
2. Communication Breakdown: A misunderstanding between two departments or people involved can incur unnecessary costs.
3. Change in Project Scope: The event, which leads to scope creek, is one of the prime reasons. Scope creek is defined as occasions when unaccounted activities crop up in the project or business which were not included in the budget or the actual cost.
4. Underestimation of Project Complexity: Certain phases of a project or business are so complex that proper budgeting is sometimes a tough job. It is more likely involved with large, expensive projects.
5. Inadequate Financing: Financing serves as the backbone of every business or project. The capital shortage may eventually lead to cost overrun, where the project or the business may face a crunch in funding their common activities.
6. Lack of Leadership Experience: A relatively inexperienced or inefficient management may lead to improper project planning and inaccurate project budgeting resulting in project cost overrun. Thus over time, the project may fall victim to wrong budgeting and fall into a case of cost overrun.
7. Absence of Contingency Plan: Business also suffers when there is no backup planning or a contingency plan for unavoidable scenarios. A backup plan is a must, especially for large-scale projects, as some deviations from the usual budgeted cost may cost millions.
8. Project Delays: Delays in the project completion from its usual planned completion eventually give rise to cost overruns as those activities beyond the completion deadline were not accounted for in the budget.

Let us understand the concept of cost overrun risk with the help of a suitable example.

We assume that ABC Restaurant is undergoing renovation for which it has hired an interior designing company Best Interiors, which has planned a beautiful design for the internal look of the restaurant. They bought furnitures, wallpapers, tiles, fixtures, paints, etc worth $1000. However, ABC Restaurant has given them a budget of $1500, beyond which they will not pay, and the process is supposed to wrap up within 3 months.

But at the end of two months, it is noticed that the furnitures are defective and fixtures are incorrectly fitted. This happened due to the fact that supervisors were not continuously vigilant towards the daily work process and often skipped supervision.

As a result, are large part of the work was repeated and in order to finish the job on time, additional labor was engaged, leading to rise in cost. The defective furnitures were replaced leading to rise in transportation cost. Overall, even though the work got completed on time, the cost rose to $2000. The extra $500 was borne by the designing company, resulting in cost overrun.

Such situations, with more severe complications and higher cost increase take place in larger projects. They become unmanageable and has to be terminated quite often due to lack of funds.  Thus, it is necessary to track each step strictly.

It is equally important to study the impact of this concept on not only the particular project but also overall cost of the organization and its profitability.

• Delay- Most of such situations do not work out within the stipulated time. They either get delayed or completely stopped due to financial issues and cannot restart again. There may sometimes be other departments of processes that are depending on these projects, which also suffer due to this situation.
• Low quality – Very often due to a time constraint or cost constraint, the resources used are of very low quality, resulting in lack of proper infrastructure. There may be faulty hardwares used that may compromise the safety issues, and result in accidents. The finally delivered product or service may not meet required quality benchmark and satisfaction standards.
• Financial impact – The finance is always impacted in such cases. Cost overrun itself means the cost is more than the estimation, which implies that the budget planned will not be enough to meet the requirements. Thus, extra funds will be needed to continue. Very often extra loans are taken that put unnecessary financial pressure on the entity, affecting profits.
• Loss of reputation – Loss of reputation of the organization leads to strain the relationship with clients, stakeholders and contractors. The company will lose trust in the market and customer base will be affected in the long run. The business may find it impossible to sustain in competition.
• Wastage of resource- All the above finally leads to wastage of resources and loss of valuable opportunities. Very often the situation can have legal issues and actions taken by stakeholders result in huge outflow of money as compensation for losses. Contractual claims and disputes are very common. It becomes highly difficult are costlier to relallocated the resources again to achieve objective.

Thus, the above are some noteworthy impacts of this concept.

#1 - Proper Planning

Planning serves as the base of every project or business, and the best way to prevent cost overrun is to plan it before the project gets executed. The more accurate the estimates are, the more are the chances that the project will stick to its budget.

#2 - Knowledge of Vendors

Vendors must be thoroughly assessed before they are hired. The project and business should obtain full knowledge about their capabilities and experience in the field to avoid worst-case scenarios. Proper due diligence is needed before the relationship with the vendor is cemented.

#3 - Avoid Scope Creek

A lot of undue activities should find no place in the project, and business or project should stay within the project's original scope with minimum deviation from the plan.

#4 - Use of Project Planning Tool

To monitor and control the project, modern tools like the Gantt excel chart or project tracking template should be implemented so that the project manager is aware of every stage of the project and the chances of cost overrun.

Overall, the above points can be summarized as follows:

• Traditional techniques involve applying project management tools like PRINCE, though results are not guaranteed.
• In the present-day scenario, more modern tools and applications like Agile are taking over traditional techniques to help businesses deal with cost overruns.
• Businesses as a unit should plan proactively and include several scenarios leading to such overrun.
• The monthly or quarterly forecast is a must for considering the changes in the actuals compared to the budget and planning accordingly.
• The business should pay much attention during the project planning stages, as this serves as the base.
• The vendor's capability to perform and deliver must be thoroughly checked at the time of vendor hire.
• The business should practice using modern scheduling tools and charts to control costs better.
• The project manager is required to monitor and control the project continually.
• Stakeholders of the project or the business should always be kept informed about the changing scenarios with all cost overrun calculation so they are on the same page, and in this way, the business can utilize their knowledge.
• Fighting with scope creek is a must, and businesses must see they stay within the scope that was initially planned.

The above are two completely different situations that arise while the project is underway, and resources are engaged to get the job done. Let us identify the differences of the same.

• The cost overrun calculation is a case where the cost incurred is more than the budgeted amount and the latter is a case where the cost is less than the budgeted amount.
• In case of the former, there is a loss in reputation of the organization leading to fall in revenue and profits. For the latter, the reputation of the entity rises because the cost is less than the estimated and planned budget.
• The former leads to wastage of resources and loss of valuable opportunities in the market due to loss of faith among stakeholders. The latter is just the opposite situation, where the performance of the entity impresses the stakeholders, because revenue is more than cost, leading to rise in profits.
• Low quality is an important issue in case of the former, while in case of the latter, quality is always the best because enough funds are available to meet standards.

Therefore the above are some basic differences between the two concepts.

This article has been a guide to Cost Overrun & meaning. We explain it with example, impact, causes, vs cost underrun, characteristics, types & prevention. You can learn more about it from the following articles –

• Objectives of Cost Accounting
• Cost-Based Pricing
• Cost Estimate
• Cost Control
• Budgetary Slack