The Effects of Mental Accounting on Project Performance
32 Pages Posted: 4 Nov 2018 Last revised: 24 Mar 2019
Date Written: October 13, 2018
Project managers are responsible for setting and then revising projects' goals. As uncertainty related to project performance is resolved, a project manager is tasked with comparing ongoing costs, and potentially achieved scope, to a baseline plan. We question whether project managers can rationally anticipate and track this revision process.
In practice, projects often fail to meet their goals. Typically, projects cost more than budgeted, take longer than planned, and are subject to scope changes. We consider the implications of behavioral tendencies, both at launch and at the revision points, on decisions made and on overall project performance.
Our stylized model compares a rational project manager to a behavioral one. Specifically, we offer a framework for modeling mental accounting -- which includes loss aversion and reference point updating -- and narrow framing. We use the model to explore how project-level decisions are made.
We show that mental accounting results in insufficient adjustments of project scope and cost during revisions, and prevents abandoning projects even when doing so is optimal. In addition, narrow framing discourages launching projects. Ultimately, mental accounting and narrow framing decrease projects' net benefits.
We offer practical prescriptions for mitigating harmful effects of loss aversion, reference-point updating, and narrow framing. Beyond training, hiring less loss averse project managers, and practicing scenario planning, we show that using a "cost-based revision" approach helps maintain the reference points constant and equal to the budgeted cost and initial scope, and induces overall better decisions.
Keywords: project management, behavioral operations, mental accounting, planning fallacy, earned value analysis
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