Affording Contingency. "How much is Enough"

1. Affording Contingency. "How much is Enough" Andrew Nicholls

2. Contingency for Defence is the management of Risk and Opportunity New Opportunities Portfolio Risk Management Provisions Introduction

3. Outline • Introduction • Unbiased estimate • Estimating contingency • Balancing portfolio risk and opportunity • Conclusion

4. Focus of this presentation • Australian Defence Major Capital Equipment Projects • Major Capital - (10 years worth of Projects) let us say $50bn. • Assume on average medium level of contingency (simple approach) = 20% • Total Contingency will be ~8bn Introduction

5. What Contingency are we talking about? • An amount added to an estimate to allow for items, conditions, or events for which the state, occurrence, or effect is uncertain and that experience shows will likely result, in aggregate, in additional costs. • Contingency is generally included in most estimates, and is expected to be expended. Source: AACE International Recommended Practice No. 10S-90, COST ENGINEERING TERMINOLOGY, TCM Framework: General Reference Introduction

6. What contingency normally excludes: • Major scope changes such as changes in end product specification, capacities, building sizes, and location of the asset or project; • Extraordinary events such as major strikes and natural disasters; • Management reserves; and • Escalation and currency effects. Introduction Source: AACE International Recommended Practice No. 10S-90, COST ENGINEERING TERMINOLOGY, TCM Framework: General Reference

7. Clearly understand the choices Vehicles, Radios, Vessels, ESM, ECM New Opportunities $8 Billion Portfolio Risk Management Provisions Introduction

8. Project: Unbiased Estimate • Estimation is a human endeavour. • Humans display biases that they may be: • Unaware of; • Aware of; or • A combination. • Humans are influenced by others: • Willingly; • Unwillingly; • Unknowingly; or • Combination. Unbiased Estimate

9. Importance and Impact • Is the estimate unbiased • Self Assessment • External tools to understand what can be known: • Hackney Model • Rand Model Unbiased Estimate

10. Hackney Model Unbiased Estimate

11. RAND Model Unbiased Estimate

12. Unchecked Optimism/Entrenched Bias Source: Delusion and Deception in Large Infrastructure Projects: Two Models for Explaining and Preventing Executive Disaster,, B Flyvbjerg M Garbuio D Lovallo, California Management Review Vol 51, No 2 Winter 2009. Unbiased Estimate

13. Excessive Optimisms/Entrenched Bias • Problem of Gaming • Reference Class Forecasting • Basis • General Approach Unbiased Estimate

14. Lets assume we have a true and fair estimate

15. Range of Techniques for Contingency Estimation Estimating Contingency

16. General Issues for Contingency • Needs to be part of a process. • Fit for use. • Clear relationship between risk, uncertainty and impacts. • Accounts for systematic and project specific risks Estimating Contingency

17. Defence’s Primary Approach • Traditional Percentage: • Key reasons for approach • Historic • Transparent • Accepted • Problems with this approach Estimating Contingency

18. Alternative 1: Expected Value • Expected value is: • Expected Value = Probability of risk Occurring x impact if it does occur • Advantages of Approach (e.g.) • Explicitly link risks to financial treatments • Relatively simple • Very easy to incorporate into current Defence cost model. • Disadvantages (e.g.) • Difficult to address Systemic vs Project Specific risk. • Unknown/unknowns. Estimating Contingency

19. General Approach • Ensure project and cost model appropriately documented. • Identify key knowledge staff. • Develop list of risks through consultation/research. • Ideally there exists a risk register • Run workshop to: • Confirm Risks • Identify New risks • Identify probability of occurrence and consequence. • Assess likely impact of risks on overall project. • Remove those risks from calculations that are regarded as not significant. • Guide – anything that might impact bottom line by more than +- 0.5% Estimating Contingency

20. Submarine ProjectExpected Value Example Base Estimate Estimating Contingency Purely illustrative. No consultation or discussion with Defence. Not an estimate of Submarine construction costs

21. Example Key Risks • Module more complex that anticipated • Design work more complex than anticipated • Greater proportion of skilled labour required • Labour rates higher due to demand in mining industry Estimating Contingency

22. Estimated Value Simple Worked Example Estimating Contingency

23. Estimated Value (simple) Estimating Contingency Purely illustrative. No consultation or discussion with Defence. Not an estimate of Submarine construction costs

24. Alternative 2: Simple Three Point Estimate • Similar to previous approach, but now defining range of impact • Can easily be incorporated into Defence approach • Usually follows form of: • Most Likely (Mode) • Minimum • Maximum • Plausible extremes • Needs to be clearly defined • Generally assume Minimum and Maximum ~1 and 99 percentile respectively. • Focus on critical items • Those that impact total cost by >0.5% • Expect <20 Estimating Contingency

25. Expected Value (example 2) Estimating Contingency

26. Estimated Value (example 2) Estimating Contingency Purely illustrative. No consultation or discussion with Defence. Not an estimate of Submarine construction costs

27. Alternative 3: Three Point Estimate (Monte Carlo) • Similar to previous approach, but now including Monte Carlo. • Number of Excel add-in Available (using @Risk) • Currently would require off-line processing within Defence. Estimating Contingency

28. Expected Value (example 3) Estimating Contingency

29. Three Point + Monte CarloCumulative Density Fx 10,000 Iterations @ Risk Estimating Contingency Purely illustrative. No consultation or discussion with Defence. Not an estimate of Submarine construction costs

30. Three Point + Monte CarloProbability Density Fx Estimating Contingency Purely illustrative. No consultation or discussion with Defence. Not an estimate of Submarine construction costs

31. Three Point + Monte CarloEstimate Estimating Contingency Purely illustrative. No consultation or discussion with Defence. Not an estimate of Submarine construction costs

32. Programming Big Picture Issues • Background • Major Capital - (10 years worth of Projects) let us say $50bn. • Assume on average medium level of contingency (simple approach) = 20% • Total Contingency will be ~8bn • That is a lot of money tied up (now or into the future) • If all Contingency is spent was does that mean for governance? Risk vs Opportunity

33. Background to Defence Projects • Approved by Government • Each Group and DMO are transferred their share of funding as determined in the approved cost estimate model (including Contingency) • Complex arrangements cash flow. • Governance over contingency use. • Excessive reluctance to reduce contingency allowance. Risk vs Opportunity

34. Minimize Contingency Use • Develop two estimates of contingency • Traditional simple percentage • More risk focussed approach (e.g. 3 point) • Gain approval for the greater • From example: • Traditional Simple Contingency ~$10.2B (20%) • 3 Point(MC) ~ $9.4B (80% confidence) • Project funding authorization to DMO for the lesser amount • Another agency hold remainder (FASCIR or HCS or CFO or Finance) • Additional funding only released following detailed report on current contingency usage. • DCP carries financial provision for lesser contingency provision Risk vs Opportunity

35. Impact • If released contingency is ultimately expended. • An average reduction of released contingency of 20% • (from 20%  16%) • results in realised savings of around $1.6bn over a 10 to 15 year period. Risk vs Opportunity

36. Summary Conservative Contingency Estimate Minimalist/Risk Specific Estimate Difference Risk vs Opportunity

37. Summary To Project Minimalist/Risk Specific Estimate To Portfolio Difference Risk vs Opportunity

38. Next steps? • Confirm the average Contingency of project approvals. • Confirm the average contingency returned by DMO/DSG to DCP. • Identify appropriate methodologies for dual contingency model. • Model potential impacts of approach (policy, workload, potential return). • Go/No Go decision. Risk vs Opportunity

39. Conclusion • Human Endeavour • Traditional Approach • 3 Point Estimate • Reduce Contingency Usage • Test opportunities and assess approach Conclusion

40. Questions?

41. Backup