Understanding project finance modelling is essential for businesses aiming to manage large-scale projects effectively. However, the case for over-budgeting raises questions about whether modelling practices encourage inflated budgets through overly cautious risk assumptions and contingency buffers. This can lead to financial strain, resource misallocation, and reduced profitability, highlighting why over-budgeting can be harmful to businesses. Striking the balance requires refining risk assessments, adopting realistic scenario-based forecasting, and exploring alternative methods like agile budgeting. By improving project finance modelling, organisations can create accurate financial plans, optimise resource allocation, and enhance project success while avoiding unnecessary financial burdens.

Is project finance modelling truly helping businesses, or is it contributing to inflated budgets? With 50% of projects completed over budget, it’s worth questioning its effectiveness.

Project finance planning is a tool used by businesses to forecast costs, risks, and returns for large projects. It’s designed to create accurate budget projections, but the reality is that the average project cost overrun is 27%.

So, the central question arises: Is project finance planning encouraging businesses to overestimate costs, creating unnecessary budget buffers, and ultimately inflating budgets rather than delivering more realistic financial plans?

How to understand project finance modelling?

Collectively, organisations waste $1 million every 20 seconds due to poor project management practices, leading to a staggering $2 trillion lost annually. This highlights the importance of accurate planning and forecasting, which is where project finance modelling comes into play.

Project finance planning is a financial tool used by businesses to assess the viability of large-scale projects. It creates detailed financial models that forecast project outcomes, focusing on key elements like cash flows, risks, and potential returns. By simulating different scenarios, businesses aim to make informed decisions about financing, operations, and investments.

Purpose:

The primary purpose of project finance planning is to ensure that projects are financially feasible by identifying and mitigating risks. It helps businesses forecast potential costs, revenues, and cash flows, ensuring that all financial aspects are thoroughly considered before moving forward with a project. This process aims to reduce uncertainty and safeguard against unforeseen financial burdens.

Key elements:

1. Cash flow projections: Estimating the inflow and outflow of funds throughout the project.
2. Debt repayment schedules: Planning how loans or credit will be repaid throughout the project’s life.
3. Risk assessments: Identifying potential risks—such as market fluctuations, project delays, or regulatory changes—and factoring these into the model to mitigate their impact on financial outcomes.

By incorporating these elements, businesses can create a clearer picture of the financial feasibility of their projects and make better-informed decisions.

The case for over-budgeting: Is it being driven by modelling?

When businesses embark on large projects, multiple factors drive their budgeting decisions. For 18% of companies, strategic alignment is the top priority; for 14%, expected benefits and ROI are the primary considerations. But could project finance modelling be pushing organisations to overestimate budgets, and in turn, create financial buffers that may not be necessary?

Over-estimating risks

One of the key elements in project finance modelling is risk assessment, but overly conservative assumptions about risk can lead to inflated cost estimates. If a project team factors in worst-case scenarios as likely events, they may significantly increase the overall budget to protect against unforeseen circumstances. While risk management is crucial, overestimating risks can cause businesses to allocate far more resources than necessary, leading to inflated budgets that may not reflect the actual risks involved.

Buffering for uncertainty

Another common practice within project finance planning and modelling is the addition of contingency reserves or “buffers.” This is often done to account for the uncertainty that comes with any major project. These buffers are intended to cover potential cost overruns or unexpected delays, but sometimes, they become a catch-all for any perceived risks. As a result, businesses may end up with budgets that are much higher than what would be needed under more accurate risk assessments, perpetuating the cycle of over-budgeting.

Impact of modelling on budgeting

The structure of financial models themselves can also contribute to over-budgeting. By emphasising caution and accounting for every possible risk, these models often lead project teams to estimate costs more conservatively. In addition, financial models may not always account for the fluid, dynamic nature of a project, sometimes relying on outdated or overly simplistic assumptions. This can result in inflated budgets that do not align with the actual needs of the project, leading to misallocated resources and potentially wasted funds.

Why over-budgeting can be harmful to businesses

While project finance planning aims to provide financial security, over-budgeting can be detrimental to a business’s overall health. In fact, 45% of project managers report that their organisation has a track record of project success, but even successful projects can suffer when budgeting is inflated.

Financial strain

Over-budgeting ties up more capital than necessary, which can limit a business’s flexibility for other projects. If a company consistently allocates more funds than needed to cover perceived risks or contingencies, it reduces the available working capital for other initiatives. This financial strain can lead to missed opportunities, slower growth, or difficulty responding to changing market conditions, ultimately putting pressure on the company’s overall financial health.

Misallocation of resources

Overestimating budgets can lead to a misallocation of resources. When companies allocate excessive funds for contingency purposes, they may not fully utilise all the resources available. For instance, the additional capital reserved for unforeseen risks might go unused but still be locked away in the project’s budget. This can lead to inefficiencies in other areas of the business, where resources could have been better utilised elsewhere, such as in innovation, marketing, or other strategic initiatives.

Impact on profitability

Inflated budgets can directly impact a company’s profitability. When budgets are overestimated, projects might end up costing more than what was originally needed, creating unnecessary financial uncertainty. This wasted capital reduces profitability by tying up funds that could have been invested in more productive or profitable ventures. Moreover, the pressure to meet inflated budget expectations may cause businesses to scale back on other crucial activities or under-deliver on project scope to remain within the budget, further hindering profitability.

Stakeholder reactions

Over-budgeting also affects stakeholders in a variety of ways. For investors, inflated budgets create a sense of financial instability, which can erode trust and confidence in the company’s ability to manage resources effectively. Stakeholders may become concerned about whether future projects will deliver the promised returns or if funds are being mismanaged. For project teams, excessive budgets can lead to inefficiencies or misaligned priorities. Teams may feel pressured to justify larger budgets rather than focusing on delivering value within a more reasonable financial framework. This can result in disengagement, frustration, or lack of motivation among employees who perceive that the project is not being run efficiently.

While over-budgeting may appear to be a safe choice on paper, it can lead to financial strain, misallocation of resources, reduced profitability, and negative stakeholder reactions, all of which can undermine a business’s long-term success.

Striking the balance: How to improve project finance modelling

Organisations that prioritise soft skills in project management see better results. For example, those who focus on soft skills have a 72% project success rate, compared to 65% in organisations that do not. 

Moreover, 40% of projects in companies that don’t prioritise soft skills experience scope creep, compared to only 28% in those that do. These insights underscore the importance of a balanced approach, which also applies to project finance planning.

Revising risk assumptions

One of the most significant contributors to over-budgeting is the tendency to overestimate risks. To improve finance modelling, businesses should revisit their approach to risk assumptions. This could involve incorporating historical data or lessons learned from similar projects to make risk assessments more accurate and realistic. It’s important to avoid blanket assumptions, such as assuming that all risks will occur or that worst-case scenarios will inevitably come to pass. Instead, businesses should use data-driven insights and learn from past project performance to refine their risk evaluation methods.

Realistic scenarios

Rather than relying on overly cautious assumptions, businesses should focus on more realistic, scenario-based forecasting. This involves creating financial models based on several possible outcomes—best-case, worst-case, and most likely scenarios. By evaluating how different factors, such as market shifts or regulatory changes, could affect the project, businesses can create a more balanced and accurate view of potential costs and benefits. Scenario-based forecasting enables decision-makers to be better prepared for uncertainty without padding budgets unnecessarily.

Alternative methods

Another way to improve the accuracy of finance modelling is by exploring alternative budgeting methods, such as agile budgeting or incremental modelling. Agile budgeting allows for more flexibility by continuously reassessing financial needs as the project progresses, rather than locking in a set budget at the outset. Incremental modelling takes a step-by-step approach, adjusting budgets as each phase of the project is completed, ensuring that funds are allocated in alignment with actual progress and needs. These methods can be more adaptable to changing circumstances, reducing the likelihood of overestimating costs due to rigid assumptions.

Collaboration with experienced professionals

A crucial element in striking the right balance is collaboration with experienced professionals who understand the full scope of a project. By working closely with finance experts and project managers, businesses can gain a deeper understanding of the project’s specific risks, opportunities, and financial requirements. These professionals can offer insights into how certain assumptions might be skewed or unrealistic, ensuring that the financial model is more aligned with the project’s true needs. Close collaboration fosters more accurate budgeting, as experienced professionals can provide a grounded perspective on the challenges and requirements of the project.

Improving project finance planning requires a focus on realistic assumptions, flexible budgeting methods, and collaboration with knowledgeable professionals. By striking the right balance, businesses can avoid the pitfalls of over-budgeting and create more accurate financial plans that foster project success and financial efficiency.

Get in touch with a project management consultant 

The success of your projects directly impacts your organisation’s growth and sustainability. By leveraging expert project management consulting, you can navigate challenges more effectively, optimise your resources, and ensure your projects are delivered on time and within budget.

If you’re ready to take your project management to the next level, get in touch with a procurement consultant today. Our team of experts can help guide you through every phase of your project, ensuring you achieve the results you need. Reach out now to explore how our project management consulting services can support your business.