This article is part of the Risk Response Development process. This is considered to be a activity inside that process. To understand the full picture please read this article first and follow the links provided to navigate the post.
Contingency funds are established to cover project risks—identified and unknown. When, where, and how much money will be spent is not known until the risk event occurs. Project “owners” are often reluctant to set up project contingency funds that seem to imply the project plan might be a poor one. Some perceive the contingency fund as an add-on slush fund. Others say they will face the risk when it materializes.
Usually such reluctance to establish contingency reserves can be overcome with documented risk identification, assessment, contingency plans, and plans for when and how funds will be distributed.
Size of Contingency Reserves
The size and amount of contingency reserves depend on uncertainty inherent in the project. Uncertainty is reflected in the “newness” of the project, inaccurate time and cost estimates, technical unknowns, unstable scope, and problems not anticipated.
In practice, contingencies run from 1 to 10 percent in projects similar to past projects. However, in unique and high-technology projects it is not uncommon to find contingencies running in the 20 to 60 percent range.
Use and rate of consumption of reserves must be closely monitored and controlled.
Simply picking a percentage of the baseline, say, 5 percent, and calling it the contingency reserve is not a sound approach.
Also, adding up all the identified contingency allotments and throwing them into one pot is not conducive to sound control of the reserve fund.
In practice, the contingency reserve fund is typically divided into budget and management reserve funds for control purposes. Budget reserves are set up to cover identified risks; these reserves are those allocated to specific segments or deliverables of the project. Management reserves are set up to cover unidentified risks and are allocated to risks associated with the total project. The risks are separated because their use requires approval from different levels of project authority.
Because all risks are probabilistic, the reserves are not included in the baseline for each work package or activity; they are only activated when a risk occurs. If an identified risk does not occur and its chance of occurring is past, the fund allocated to the risk should be deducted from the budget reserve. (This removes the temptation to use budget reserves for other issues or problems.)
Of course if the risk does occur, funds are removed from the reserve and added to the cost baseline. It is important that contingency allowances be independent of the original time and cost estimates. These allowances need to be clearly distinguished to avoid time and budget game playing.
These reserves are identified for specific work packages or segments of a project found in the baseline budget or work breakdown structure.
For example, a reserve amount might be added to “computer coding” to cover the risk of “testing” showing a coding problem.
The reserve amount is determined by costing out the accepted contingency or recovery plan. The budget reserve should be communicated to the project team. This openness suggests trust and encourages good cost performance.
However, distributing budget reserves should be the responsibility of both the project manager and the team members responsible for implementing the specific segment of the project. If the risk does not materialize, the funds are removed from the budget reserve. Thus, budget reserves decrease as the project progresses.
These reserve funds are needed to cover major unforeseen risks and, hence, are applied to the total project.
For example, a major scope change may appear necessary midway in the project. Because this change was not anticipated or identified, it is covered from the management reserve.
Management reserves established after budget reserves are identified and funds established. These reserves are independent of budget reserves and are controlled by the project manager and the ‘owner” of the project. The “owner” can be internal (top management) or external to the project organization. Most management reserves are set using historical data and judgments concerning the uniqueness and complexity of the project.
Placing technical contingencies in the management reserve is a special case tried, innovative process or product. Because there is a chance the innovation may not work out, a fallback plan is necessary. This type of risk is beyond the control of the project manager. Hence, technical reserves are held in the management reserve and controlled by the owner or top management. The owner and project manager decide when the contingency plan will be implemented and the reserve funds used.
It is assumed there is a high probability these funds will never be used.
Just as contingency funds are established to absorb unplanned costs, managers use time buffers to cushion against potential delays in the project. And like contingency funds, the amount of time is dependent upon the inherent uncertainty of the project. The more uncertain the project more time should be reserved for the schedule.
The strategy is to assign extra time at critical moments in the project.
For example, buffers are added to
- activities with severe risks.
- merge activities that are prone to delays due to one or more preceding activities being late.
- noncritical activities to reduce the likelihood that they will create another critical path.
- activities that require scarce resources to ensure that the resources are available when needed.
In the face of overall schedule uncertainty, buffers are sometimes added to the end of the project.
For a 300-working-day project may have a 30-day project buffer. While the extra 30 days would not appear on the schedule, it is available if needed.
Like management reserves, this buffer typically requires the authorization of top management.
The Contingency Funding and Time Buffers article is part of a much larger post on risk management. If you have landed on this article directly from a search engine I would recommend you head to this article Risk Management Guide, where you can get the full picture on how I have organized the series and have the the correct sequence.