Have you ever clung to a project that slipped to a good degree in the hope that it will recover before the project completion?
Didn’t you hope to correct any cost anomalies of a new project which was similar to an earlier unsuccessfully completed project that concluded with Sunk Cost?
Have you ever felt happy about your project because it is ‘doing well’?
If you answered ‘yes’ to any of the above, you are only human, falling into some common behavioral finance traps. Behavioral finance – a relatively new branch of economics that studies the application of psychology in financial economics – is now proving that the shortcuts we take and our preconceived attitudes induce us to willingly and repeatedly do things that cost us more money than originally estimated. Behavioral finance is rapidly rewriting rules on the rational aspect of traditional economics.
As humans we are prone to being irrational, emotional and impulsive. And this includes dealings on finance. We can make mistakes. As project managers, we use mental shortcuts to make everyday decisions on project cost management. In this context, let’s examine the mindsets that influence financial decisions based on the study of behavioral finance.
Mental Accounting
When a project manager negotiates for an incentive from the sponsor for completing the project ahead of schedule but never pays attention to the ‘free float’ or ‘total float’ of the project tasks, then that is ‘mental accounting’ at work. People tend to compartmentalize their world and ignore the overall picture.
Having mental accounts in our spends is also typical. Let us say that a distributed project team’s inventory requires Item A and B costing $100 and $150, respectively. If these items need to be shipped after central procurement, a 5% charge on shipping could get compounded. On the other hand, the same items at the other location where it has to be shipped could be cheaper by 10%. But, we need to factor the expense to have another person deputed to procure at the other site, pay local taxes etc which may offset the 10% gain. This may make the total loss/gain in both the cases almost identical. It would then be prudent on the part of the project manager to look at other factors like time, convenience and quality apart from the cost angle.
Loss Aversion
We hate to lose. In a situation where the project’s health is slipping due to cost overruns, we can simply postpone an accurate assessment of the potential negative risk, or even stall the project until a final ‘Go/No-Go’ decision of key stakeholders is attained. We often wait a bit longer to act than we should. This procrastination stems from the fact we weigh each dollar lost twice as much as much as every dollar gained. In a potential losing situation, we are also prone to waiting to recover our costs before quitting: we are ‘regret averse’.
Past Patterns
As in anything, our instincts and beliefs can be governed by our earlier experience when it comes to cost management. This state of mind tends to make one believe a trend will reverse simply because of a similar reversion experience of the past. If a certain pattern on a similar project caused cost overruns in the past, our preconceptions may cloud our judgment going forward. It’s easy to make an assessment that downplays some of the current factors that influence the actual trend now. Remember: Every project is unique and won’t fail or succeed necessarily in exact conformance to past patterns.
False Alarm
A recent decision to spend additional dollars to tide over the indirect impact of a natural disaster (like hurricane, flood or earthquake) on the project schedule could raise a false perception (or bias) for more such negative impacts to be expected by the project manager than is realistic. When a particular event consumes a lot of the contingency budget, it is natural for the project manager to forecast more slippage — and, hence, raise alarms with the sponsor and other stakeholders.
However, a detailed analysis on the trigger for the recent event, its chance of recurrence, its direct impact on the project and a remedial measure to be tackled as part of the risk plan would ensure that this trap is avoided. It would also ensure that only the factual reasons are attributed to the contingency plans and not perception or preconception.
Overconfidence
As we all know, people can be overconfident in their own abilities in areas where they have some knowledge. For instance, if a project manager has successfully stewarded many short-term fixed price projects with no overruns, he or she may naturally be prejudiced toward success on the next similar project that arises, even if it means a fixed price contract with a longer duration.
However, increasing levels of confidence often fail to correlate to greater success. As a safeguard against overconfidence entering the picture and biasing estimates, the financial projection details worked out for the project need to be reviewed by another competent and objective professional so that managerial overconfidence does not result in excessive effort levels. In other words, every project needs to be undertaken with a new approach and often a “fresh set of eyes” confirming the conclusions to ensure there is no room for overconfidence based on past success.
Reciprocal Trust
In a standard “principal-agent model” — where principal refers to the sponsor and agent to the project manager — the principal often moves into the project before the agent, as he/she funds the project including the agent’s time. This may lead to a problem: the rational, self-interested agent may hold an incentive to extend the project duration or include tasks in the project scope that are contrary to the principal’s objective, that hurts the principal. Given this problem, the principal in making the first move, may pursue a strategy that hurts the agent. The principal could overlook critical needs of the project by not funding those tasks, thereby paving the way for the project failure.
For example, an organization may require a sponsor to finance a new project. However, once the funds have been provided, the project manager may have an incentive to pursue value-reducing strategies (perhaps by exerting low effort to expedite completion of the ‘critical’ tasks or choosing a pet negative Net Present Value [NPV] project task that could be detrimental to the project’s overall health). A rational sponsor, aware of this vested interest-based hazard, may choose not to provide finance in the first place and the project cannot then be taken. This may hurt both parties.
Irrational non-abandonment of projects
Statman and Caldwell, writing in
Applying Behavioral Finance to Capital Budgeting: Project Terminations,” consider the effects of managerial irrationality in capital budgeting, and particularly in the decision to abandon projects. They describe cases where managers are reluctant to terminate projects, even if NPV analysis determines that the project should be abandoned. The abandonment decision should only be made based on future expected cash flows. Previous losses are ‘sunk’, and according to standard economic theory, should be ignored.
The authors distinguish between economic accounting, where sunk costs are ignored, and mental accounting, where the sunk costs are included. The authors argue that the managerial reluctance to abandon arises from a process called ‘framing’ (in which the manager forms a mental account including the sunk cost) combined with prospect theory and regret aversion.
They provide an example in which a project has currently lost $2,000 (which is sunk). If the project is continued, there is an equal chance of success (which will provide an income of $2,000) or failure (which provides an income of $0). If the project is abandoned, it will provide a liquidation income of $1,000. Under proper economic accounting (ignoring the sunk loss), a risk averse manager will abandon the project.
Now consider the ‘framing’ process. The manager forms a mental account, including the sunk loss. Success provides an income of -$2000+$2000=0. Failure provides an income of -$2000+$0 =-$2000. Abandonment provides an income of -$2000 + $1000 = -$1000. Under prospect theory, the manager will prefer the gamble associated with project continuation, rather than the sure loss from abandonment.
The manager’s desire to allow the project to continue is strengthened by regret aversion, which states that agents prefer to postpone the pain of loss. Furthermore, the incentive to continue the project is further strengthened by the manager’s commitment to the project. (This is termed as ‘entrapment’). Hence, a manager who has been heavily involved in the initial decision to take the project (a ‘project champion’) is more likely to become committed to and entrapped in the project. A manager who did not make the initial decision to take the project may find it easier subsequently to abandon it.
The presence of the above mindsets in project costing can hurt. Recognizing their presence is the first step to put them in right perspective. The next step is to see the complete picture and think of the overall cost impact — the key resources for which are information and understanding. If these bases are covered, the probability will improve of the budget at completion (BAC) aligning to the estimate.
References
Richard Fairchild, (2004) “Behavioral Finance in a Principal-Agent Model of Capital Budgeting”
Meir Stratman and David Caldwell, (1987) “Applying Behavioral Finance to Capital Budgeting: Project Terminations” Financial Management 1987
About the Author
Balasubramaniam Vedagiri (or Bala in short) is a Program Manager at EDS (Electronic Data Systems) in India. He holds a masters degree in computer application and a certified PMP. His current responsibilities include application delivery and people management for a business critical telecom application portfolio of a major Australian client. In his current role, he handles the project and program management that comprises a virtual team across two countries and four cities.
Bala has over 16 years of IT consulting experience focused on solutions and services and has managed projects at global level. He brings extensive knowledge on offshore program oversight, resource management, technology leadership, ISO/CMMI process implementation, vendor management and sales enablement. Overall, he focuses his abilities on planning, deploying and governing a well-structured global delivery program.
