Unachievable project outcome expectation Discuss the factors that cause unachievable project outcome expectations to be set by senior management. What do t

Unachievable project outcome expectation Discuss the factors that cause unachievable project outcome expectations to be set by senior management. What do the authors recommend to remedy these factors? Submit a discussion summary approximately 450 words in length. www.hbr.org
In planning major initiatives,
executives routinely
exaggerate the benefits and
discount the costs, setting
themselves up for failure.
Here’s how to inject more
reality into forecasting.
Delusions of
Success
How Optimism Undermines
Executives’ Decisions
by Dan Lovallo and Daniel Kahneman
Reprint R0307D
In planning major initiatives, executives routinely exaggerate the
benefits and discount the costs, setting themselves up for failure.
Here’s how to inject more reality into forecasting.
Delusions of
Success
How Optimism Undermines
Executives’ Decisions
by Dan Lovallo and Daniel Kahneman
© 2003 BY HARVARD BUSINESS SCHOOL PUBLISHING CORPORATION. ALL RIGHTS RESERVED.
In 1992, Oxford Health Plans started to build a
complex new computer system for processing
claims and payments. From the start, the
project was hampered by unforeseen problems and delays. As the company fell further
behind schedule and budget, it struggled,
vainly, to stem an ever rising flood of paperwork. When, on October 27, 1997, Oxford disclosed that its system and its accounts were in
disarray, the company’s stock price dropped
63%, destroying more than $3 billion in shareholder value in a single day.
Early in the 1980s, the United Kingdom,
Germany, Italy, and Spain announced that
they would work together to build the Eurofighter, an advanced military jet. The project
was expected to cost $20 billion, and the jet
was slated to go into service in 1997. Today,
after nearly two decades of technical glitches
and unexpected expenses, the aircraft has yet
to be deployed, and projected costs have more
than doubled, to approximately $45 billion.
In 1996, the Union Pacific railroad bought
its competitor Southern Pacific for $3.9 bil-
harvard business review • july 2003
lion, creating the largest rail carrier in North
America. Almost immediately, the two companies began to have serious difficulties merging
their operations, leading to snarled traffic, lost
cargo, and massive delays. As the situation got
worse, and the company’s stock price tumbled, customers and shareholders sued the
railroad, and it had to cut its dividend and
raise new capital to address the problems.
Debacles like these are all too common in
business. Most large capital investment
projects come in late and over budget, never
living up to expectations. More than 70% of
new manufacturing plants in North America,
for example, close within their first decade of
operation. Approximately three-quarters of
mergers and acquisitions never pay off—the
acquiring firm’s shareholders lose more than
the acquired firm’s shareholders gain. And efforts to enter new markets fare no better; the
vast majority end up being abandoned within
a few years.
According to standard economic theory, the
high failure rates are simple to explain: The
page 1 of 9
Delusions of Success
No matter how detailed, the
business scenarios used in
planning are generally
inadequate.
Dan Lovallo is a senior lecturer at the
Australian Graduate School of Management at the University of New South
Wales and a former strategy specialist at
McKinsey & Company. Daniel Kahneman is the Eugene Higgins Professor of
Psychology at Princeton University in
New Jersey and a professor of public affairs at Princeton’s Woodrow Wilson
School; he received the Nobel Prize in
economic sciences in 2002.
harvard business review • july 2003
frequency of poor outcomes is an unavoidable
result of companies taking rational risks in uncertain situations. Entrepreneurs and managers know and accept the odds because the rewards of success are sufficiently enticing. In
the long run, the gains from a few successes
will outweigh the losses from many failures.
This is, to be sure, an attractive argument
from the perspective of executives. It effectively relieves them of blame for failed
projects—after all, they were just taking reasonable risks. But having examined this phenomenon from two very different points of
view—a business scholar’s and a psychologist’s—we have come to a different conclusion. We don’t believe that the high number of
business failures is best explained as the result
of rational choices gone wrong. Rather, we see
it as a consequence of flawed decision making.
When forecasting the outcomes of risky
projects, executives all too easily fall victim to
what psychologists call the planning fallacy. In
its grip, managers make decisions based on delusional optimism rather than on a rational
weighting of gains, losses, and probabilities.
They overestimate benefits and underestimate
costs. They spin scenarios of success while
overlooking the potential for mistakes and
miscalculations. As a result, managers pursue
initiatives that are unlikely to come in on budget or on time—or to ever deliver the expected
returns.
Executives’ overoptimism can be traced
both to cognitive biases—to errors in the way
the mind processes information—and to organizational pressures. These biases and pressures are ubiquitous, but their effects can be
tempered. By supplementing traditional forecasting processes, which tend to focus on a
company’s own capabilities, experiences, and
expectations, with a simple statistical analysis
of analogous efforts completed earlier, executives can gain a much more accurate understanding of a project’s likely outcome. Such an
outside view, as we call it, provides a reality
check on the more intuitive inside view, reducing the odds that a company will rush blindly
into a disastrous investment of money and
time.
Rose-Colored Glasses
Most people are highly optimistic most of the
time. Research into human cognition has
traced this overoptimism to many sources.
One of the most powerful is the tendency of
individuals to exaggerate their own talents—
to believe they are above average in their endowment of positive traits and abilities. Consider a survey of 1 million students conducted
by the College Board in the 1970s. When asked
to rate themselves in comparison to their
peers, 70% of the students said they were
above average in leadership ability, while only
2% rated themselves below average. For athletic prowess, 60% saw themselves above the
median, 6% below. When assessing their ability to get along with others, 60% of the students judged themselves to be in the top
decile, and fully 25% considered themselves to
be in the top 1%.
The inclination to exaggerate our talents is
amplified by our tendency to misperceive the
causes of certain events. The typical pattern of
such attribution errors, as psychologists call
them, is for people to take credit for positive
outcomes and to attribute negative outcomes
to external factors, no matter what their true
cause. One study of letters to shareholders in
annual reports, for example, found that executives tend to attribute favorable outcomes to
factors under their control, such as their corporate strategy or their R&D programs. Unfavorable outcomes, by contrast, were more
likely to be attributed to uncontrollable external factors such as weather or inflation. Similar self-serving attributions have been found
in other studies of annual reports and executive speeches.
We also tend to exaggerate the degree of
control we have over events, discounting the
role of luck. In one series of studies, participants were asked to press a button that could
illuminate a red light. The people were told
that whether the light flashed was determined
by a combination of their action and random
chance. Afterward, they were asked to assess
what they experienced. Most people grossly
overstated the influence of their action in determining whether the light flashed.
Executives and entrepreneurs seem to be
highly susceptible to these biases. Studies that
compare the actual outcomes of capital investment projects, mergers and acquisitions, and
market entries with managers’ original expectations for those ventures show a strong tendency toward overoptimism. An analysis of
start-up ventures in a wide range of industries
found, for example, that more than 80% failed
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Delusions of Success
When pessimistic opinions
are suppressed, while
optimistic ones are
rewarded, an
organization’s ability to
think critically is
undermined.
harvard business review • july 2003
to achieve their market-share target. The studies are backed up by observations of executives. Like other people, business leaders routinely exaggerate their personal abilities,
particularly for ambiguous, hard-to-measure
traits like managerial skill. Their self-confidence can lead them to assume that they’ll be
able to avoid or easily overcome potential
problems in executing a project. This misapprehension is further exaggerated by managers’ tendency to take personal credit for lucky
breaks. Think of mergers and acquisitions, for
instance. Mergers tend to come in waves, during periods of economic expansion. At such
times, executives can overattribute their company’s strong performance to their own actions and abilities rather than to the buoyant
economy. This can, in turn, lead them to an
inflated belief in their own talents. Consequently, many M&A decisions may be the result of hubris, as the executives evaluating an
acquisition candidate come to believe that,
with proper planning and superior management skills, they could make it more valuable.
Research on postmerger performance suggests that, on average, they are mistaken.
Managers are also prone to the illusion that
they are in control. Sometimes, in fact, they
will explicitly deny the role of chance in the
outcome of their plans. They see risk as a challenge to be met by the exercise of skill, and
they believe results are determined purely by
their own actions and those of their organizations. In their idealized self-image, these executives are not gamblers but prudent and determined agents, who are in control of both
people and events. When it comes to making
forecasts, therefore, they tend to ignore or
downplay the possibility of random or uncontrollable occurrences that may impede their
progress toward a goal.
The cognitive biases that produce overoptimism are compounded by the limits of human
imagination. No matter how detailed, the
business scenarios used in planning are generally inadequate. The reason is simple: Any
complex project is subject to myriad problems—from technology failures to shifts in exchange rates to bad weather—and it is beyond
the reach of the human imagination to foresee
all of them at the outset. As a result, scenario
planning can seriously understate the probability of things going awry. Often, for instance,
managers will establish a “most likely” sce-
nario and then assume that its outcome is in
fact the most likely outcome. But that assumption can be wrong. Because the managers have
not fully considered all the possible sequences
of events that might delay or otherwise disrupt the project, they are likely to understate
the overall probability of unfavorable outcomes. Even though any one of those outcomes may have only a small chance of occurring, in combination they may actually be far
more likely to happen than the so-called most
likely scenario.
Accentuating the Positive
In business situations, people’s native optimism is further magnified by two other kinds
of cognitive bias—anchoring and competitor
neglect—as well as political pressures to emphasize the positive and downplay the negative. Let’s look briefly at each of these three
phenomena.
Anchoring. When executives and their subordinates make forecasts about a project, they
typically have, as a starting point, a preliminary plan drawn up by the person or team proposing the initiative. They adjust this original
plan based on market research, financial analysis, or their own professional judgment before arriving at decisions about whether and
how to proceed. This intuitive and seemingly
unobjectionable process has serious pitfalls,
however. Because the initial plan will tend to
accentuate the positive—as a proposal, it’s designed to make the case for the project—it will
skew the subsequent analysis toward overoptimism. This phenomenon is the result of anchoring, one of the strongest and most prevalent of cognitive biases.
In one experiment that revealed the power
of anchoring, people were asked for the last
four digits of their Social Security number.
They were then asked whether the number of
physicians in Manhattan is larger or smaller
than the number formed by those four digits.
Finally, they were asked to estimate what the
number of Manhattan physicians actually is.
The correlation between the Social Security
number and the estimate was significantly
positive. The subjects started from a random
series of digits and then insufficiently adjusted
their estimate away from it.
Anchoring can be especially pernicious
when it comes to forecasting the cost of major
capital projects. When executives set budgets
page 3 of 9
Delusions of Success
for such initiatives, they build in contingency
funds to cover overruns. Often, however, they
fail to put in enough. That’s because they’re
anchored to their original cost estimates and
don’t adjust them sufficiently to account for
the likelihood of problems and delays, not to
mention expansions in the scope of the
projects. One Rand Corporation study of 44
chemical-processing plants owned by major
companies like 3M, DuPont, and Texaco found
that, on average, the factories’ actual construction costs were more than double the initial
estimates. Furthermore, even a year after
start-up, about half the plants produced at less
than 75% of their design capacity, with a quarter producing at less than 50%. Many of the
plants had their performance expectations
permanently lowered, and the owners never
realized a return on their investments.
Competitor Neglect. One of the key factors
influencing the outcome of a business initiative is competitors’ behavior. In making forecasts, however, executives tend to focus on
their own company’s capabilities and plans
and are thus prone to neglect the potential
abilities and actions of rivals. Here, again, the
result is an underestimation of the potential
for negative events—in this case, price wars,
overcapacity, and the like. Joe Roth, the
former chairman of Walt Disney Studios, expressed the problem well in a 1996 interview
with the Los Angeles Times: “If you only think
about your own business, you think, ‘I’ve got a
good story department, I’ve got a good marketing department, we’re going to go out and
do this.’ And you don’t think that everybody
else is thinking the same way.”
Neglecting competitors can be particularly
destructive in efforts to enter new markets.
When a company identifies a rapidly growing
market well suited to its products and capabilities, it will often rush to gain a beachhead in
it, investing heavily in production capacity
and marketing. The effort is often justified by
the creation of attractive pro forma forecasts
of financial results. But such forecasts rarely
account for the fact that many other competitors will also target the market, convinced that
they, too, have what it takes to succeed. As all
these companies invest, supply outstrips demand, quickly rendering the new market unprofitable. Even savvy venture capitalists fell
into this trap during the recent ill-fated Internet boom.
harvard business review • july 2003
Organizational Pressure. Every company
has only a limited amount of money and time
to devote to new projects. Competition for this
time and money is intense, as individuals and
units jockey to present their own proposals as
being the most attractive for investment. Because forecasts are critical weapons in these
battles, individuals and units have big incentives to accentuate the positive in laying out
prospective outcomes. This has two ill effects.
First, it ensures that the forecasts used for
planning are overoptimistic, which, as we described in our discussion of anchoring, distorts
all further analysis. Second, it raises the odds
that the projects chosen for investment will be
those with the most overoptimistic forecasts—
and hence the highest probability of disappointment.
Other organizational practices also encourage optimism. Senior executives tend, for instance, to stress the importance of stretch
goals for their business units. This can have
the salutary effect of increasing motivation,
but it can also lead unit managers to further
skew their forecasts toward unrealistically rosy
outcomes. (And when these forecasts become
the basis for compensation targets, the practice can push employees to behave in dangerously risky ways.) Organizations also actively
discourage pessimism, which is often interpreted as disloyalty. The bearers of bad news
tend to become pariahs, shunned and ignored
by other employees. When pessimistic opinions are suppressed, while optimistic ones are
rewarded, an organization’s ability to think
critically is undermined. The optimistic biases
of individual employees become mutually reinforcing, and unrealistic views of the future
are validated by the group.
The Outside View
For most of us, the tendency toward optimism
is unavoidable. And it’s unlikely that companies can, or would even want to, remove the
organizational pressures that promote optimism. Still, optimism can, and should, be tempered. Simply understanding the sources of
overoptimism can help planners challenge assumptions, bring in alternative perspectives,
and in general take a balanced view of the future.
But there’s also a more formal way to improve the reliability of forecasts. Companies
can introduce into their planning processes an
page 4 of 9
Delusions of Success
objective forecasting method that counteracts
the personal and organizational sources of optimism. We’ll begin our exploration of this approach with an anecdote that illustrates both
the traditional mode of forecasting and the
suggested alternative.
In 1976, one of us was involved in a project
to develop a curriculum for a new subject area
for high schools in Israel. The project was conducted by a small team of academics and
teachers. When the team had been operating
for about a year and had some significant
achievements under its belt, its discussions
turned to the question of how long the project
would take. Everyone on the team was asked
to write on a slip of paper the number of
months that would be needed to finish the
project—defined as having a complete report
ready for submission to the Ministry of Education. The estimates ranged from 18 to 30
months.
One of the team members—a distinguished
expert in curriculum development—was then
posed a challenge by another team member:
“Surely, we’re not the only team to have tried
to develop a curriculum where none existed
before. Try to recall as many such projects as
you can. Think of them as they were in a stage
comparable to ours at present. How long did it
take them at that point to reach completion?”
After a long silence, the curriculum expert
said, with some discomfort, “First, I should say
that not all the teams that I can think of, that
were at a comparable stage, ever did complete
their task. About 40% of them eventually gave
up. Of the remaining, I cannot think of any
that completed their task in less than seven
years, nor of any that took more than ten.” He
was then asked if he had reason to believe that
the present team was more skilled in curriculum development than the earlier ones had
been. “No,” he replied, “I cannot think of any
relevant factor that distinguishes us favorably
from the teams I have been thinking about. Indeed, my impression is that we are slightly
below average in terms of resources and potential.” The wise decision at this point would
probably have been for the team to disband.
Instead, the members ignored the pessimistic
information and proceeded with the project.
Th…
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