Investment Appraisals: Estimating Uncertainty and Exchange Rates

1. Investment Appraisals: Estimating Uncertainty and Exchange Rates Paul Duvall Principal Consultant HVR Practice – Through Life Cost Modelling 0117 952 8456 Dr Mark Gilmour Consultant HVR Practice – Through Life Cost Modelling 0117 952 8462 Society for Cost Analysis and Forecasting 9 February 2010

2. Sub-Title? • Cost Uncertainty – do we need pure mathematics in IA?

3. Contents • Introduction • Developing assumptions • Every day decisions • Assessing Uncertainty • Modelling Uncertainty • Modelling Foreign Exchange • Correlation • A Case Study …

4. Investment Appraisals – Common Errors • Poor Evidence for estimates • Poor Audit Trail • Arbitrary Uncertainty Ranges applied (+/-10%) • No justification for cost spread • Source: MoD Cost Assurance Guidance 20090626

5. …a Case Study…

6. CRBS – “In-Service”

7. Example CBS

8. V F 1 Inventory Management 20% 80% 2 Logs Man System 100% 3 Supply & Support 100% 0% 4 Sub-contractor's CLS 10% 90% 5 Repairs 100% 0% 6 Replenishment Spares 100% 0% 7 Consumable Spares 100% 0% 8 STTE Maintenance 100% 0% 9 SW Support 10% 90% 10 CLS Management 10% 90% 11 ProgManagement 0% 100% 12 Training Support 80% 20% 13 Obsolescence 0% 100% 14 Risk 14% 86% CLS CBS Manufacturer Supplied Breakdown

9. Developing Assumptions – Behaviour of the estimate?

10. Developing Assumptions – Behaviour of the estimate

11. Review – “sanity check” • Developed a Cost Breakdown Structure of 16 line items • 16 assumptions – Non-Rec/Recurring Cost • 16 assumptions – behaviour of constant cost through life • 16 assumptions – behaviour of cost relative to escalation • 16 assumptions – behaviour of uncertainty range (fixed or variable) • Assuming the CBS is a given • 64 assumptions made BEFORE any estimate developed • Are they Catalogued? • Are they Auditable? • Are they Robust? • Will they withstand Scrutiny?

12. Case Study SPE 64 items of estimated data or assumptions

13. Where to apply uncertainty?

14. Assessing Uncertainty - Annually?

15. Assessing Uncertainty – Line Item?

16. Assessing Uncertainty - Detailed

17. Methods Summarised

18. Uncertainty Output?

19. Correlation Looking at a few line items in the Case Study… Correlation = an assumption based on an assumption?

20. 2 Foreign Exchange (Focus on $/£)

21. DASA/DESA advice Uncertainty Range = +/-45% from FY12/13

22. Correlation in Foreign Exchange

23. $/£ Sep 99 – Jan 10 Source -HM Revenue and Customs: https://www.uktradeinfo.com/index.cfm?task=exchange&lastcountry=usa

24. Spread around Annual Mean: 5% (01/02) to 35% 08/09

25. Historic Trend Analysis Note: £:$ Reviewing trend from 1987 - maximum any year has differed is -17% (2007 : 0.4998 GBP = 1 USD) +15% (2001 : 0.6609 GBP = 1 USD). Over twenty three years: 14 have seen weaker sterling, and 9 stronger. The difference has been less than 10% in 18 years, and greater in only 5.

26. Review • 3-point estimates triple the quantity of cost line items • Each estimate needs to be an auditable assumption • Assessing costs prior to importing into SW packages is informative • Paucity of data is the enemy of detailed analysis • Correlation of data is building assumptions on assumptions • Therefore..? • The number of assumptions should be minimised • Uncertainty analysis should be based similarly on few assumptions

27. Summary • “Complexity is not desirable in a cost model. The cost, labour hours, and schedule required to set up and provide data for a complex model may prohibit its effective and timely use in the decision process. Although some analyses will inevitably require complex models, complexity in itself does not lend credibility to a model or its results.” • (UK MINISTRY OF DEFENCE: 20070129- Guidelines For Estimating and Assurance Issue 1 – U)