Covered with Oil: Incorporating Realism in Cost Risk Analysis

Abstract

When Jimmy Buffett sang the words “All of those tourists covered with oil” in his song Margaritaville he probably never imagined that this phrase might apply to crude oil instead of suntan lotion. Both the cost and the environmental impact from the 2010 oil spill in the Gulf of Mexico were much worse than anyone had expected or could have predicted. It was, in the words of financial writer, Nassim Taleb, a “black swan”—an unexpected event with tremendous consequences. These types of events, like Hurricane Katrina in 2005, the giant tsunami in the Indian Ocean in 2004, and the financial crisis that began in 2007, are all examples of events with huge impacts that were hard to foresee. In the arena of government projects, outsized events, such as the Challenger and Columbia Space Shuttle disasters, cost billions of extra dollars and are not budgeted against. It may be reasonable to not budget for some events that are outside of the project management’s control, since doing so will likely lead to excess reserves that go unspent. Unlike natural disasters, project managers have some control over their destiny to the extent that they can meet budget, schedule, and scope by cutting content, and in the cases of extreme overruns, those in authority can cancel projects once they become unmanageable. But budgets for public projects typically include very little risk reserves and do not account for even minimal changes in a project’s design or relatively mild external forces that should be accounted for. In this article, the author examines historical cost risk analyses and compares them to final actual costs, finding significant differences between the two. Reasons for under-representation of risk are discussed, and remedies for this situation are discussed, including the notion of calibration.