Eight to Late

Many projects are plagued by cost overruns and benefit shortfalls. So much so that a quick search on Google News  almost invariably returns a recent news item reporting a high-profile cost overrun.  In a 2006 paper entitled, From Nobel Prize to Project Management: Getting Risks Right, Bent Flyvbjerg discusses the use of reference class forecasting to reduce inaccuracies in project forecasting. This technique, which is based on theories of decision-making in uncertain (or risky) environments,¹ forecasts the outcome of a planned action based on actual outcomes in a collection of actions similar to the one being forecast. In this post I present a brief overview of reference class forecasting and its application to estimating projects. The discussion is based on Flyvbjerg’s paper.

According to Flyvbjerg, the reasons for inaccuracies in project forecasts fall into one or more of the following categories:

• Technical – These are reasons pertaining to unreliable data or the use of inappropriate forecasting models.
• Psychological  – This pertains to the inability of most people to judge future events in an objective way. Typically it manifests itself as undue optimism, unsubstantiated by facts; behaviour that is sometimes referred to as optimism bias. This is the reason for statements like, “No problem, we’ll get this to you in a day.” – when the actual time is more like a week.
• Political – This refers to the tendency of people to misrepresent things for their own gain – e.g. one might understate costs and / or overstate benefits in order to get a project funded. Such behaviour is sometimes called strategic misrepresentation (commonly known as lying!) .

Technical explanations are often used to explain inaccurate forecasts. However, Flyvbjerg rules these out as valid explanations for the following reasons. Firstly, inaccuracies attributable to data errors (technical errors) should be normally distributed with average zero, but actual inaccuracies were shown to be non-normal in a variety of cases. Secondly, if inaccuracies in data and models were the problem, one would expect this to get better as models and data collection techniques get better. However, this clearly isn’t the case, as projects continue to suffer from huge forecasting errors.

Based on the above Flyvbjerg concludes that technical explanations do not account for forecast inaccuracies as comprehensively as psychological and political explanations do.   Both the latter involve human bias. Such bias is inevitable when one takes an inside view, which focuses on the internals of a project – i.e. the means (or processes) through which a project will be implemented.  Instead, Flyvbjerg suggests taking an outside view – one which focuses on outcomes of similar (already completed) projects rather than on the current project. This is precisely what reference class forecasting does, as I explain below.  

Reference class forecasting is a systematic way of taking an outside view of planned activities, thereby eliminating human bias. In the context of projects this amounts to creating a probability distribution of estimates based on data for completed projects that are similar to the one of interest, and then comparing the said project with the distribution in order to get a most likely outcome. Basically, reference class forecasting consists of the following steps:

1. Collecting data for a number of similar past projects – these projects form the reference class. The reference class must encompass a sufficient number of projects to produce a meaningful statistical distribution, but individual projects must be similar to the project of interest.
2. Establishing a probability distribution based on (reliable!) data for the reference class.  The challenge here is to get good data for a sufficient number of reference class projects.
3. Predicting most likely outcomes for the project of interest based on comparisons with the reference class distribution.

In the paper, Flyvbjerg describes an application of reference class forecasting to large scale transport infrastructure projects. The processes and procedures used are published in a guidance document entitled Procedures for Dealing with Optimism Bias in Transport Planning, so I won’t go into details here. The trick, of course, is to get reliable data for similar projects. Not an easy task.

To conclude, project forecasts are often off the mark by a wide margin. Reference class forecasting is an objective technique that eliminates human bias from the estimating process. However, because of the cost and effort involved in building the reference distribution, it may only be practical to use it on megaprojects.

 Footnotes:

¹Daniel Kahnemann received the Nobel Prize in Economics in 2002 for his work on how people make decisions in uncertain situations. His work, which is called Prospect Theory, forms the basis of Reference Class Forecasting.