Cost Estimates, Cost Overruns, and Project Continuation Decisions

Abstract

Cost overruns on multi-period projects are large and frequent in natural environments. Reasons for these overruns include cost understatements in initial project proposals and escalation of commitment to projects when initial actual costs turn out to be higher than expected. Prior literature has suggested, and some firms have implemented, a device that limits escalation and thus potentially reduces cost overruns: changing decision makers (superiors) so that the manager who approves continuation of a project is not the same individual who approved the project initially. We provide theoretical explanations and experimental evidence about how changing vs. continuing superiors affect the underestimates of cost in initial project proposals. We find that although changing superiors, as expected, are more likely than continuing superiors are to react skeptically to continuation proposals when first-period cost overruns have occurred, this does not reduce initial cost understatements and overruns. On the contrary, in our setting it leads to greater initial understatements and overruns. Subordinates anticipate that new superiors will be more critical of their projects; hence they discount later-period payoffs and focus on gaining initial funding by providing understated cost estimates.

Keywords: capital budgeting, management control, multi-period budgeting

JEL Classification: M41, M10, M20