Contingency--are you covered?

Abstract

Contingency, an amount of funds added to the base cost estimate to cover estimate uncertainty and risk exposure, is a topic of interest for both project managers and sponsors alike. Incorporation of contingency into authorized total project cost allows a project management team to cover estimate accuracy and risk exposure; thereby improving transparency and reducing the tendency for some projects to drive contingency underground. Supplying a project with a reasonable level of contingency also facilitates the creation of more realistic project business cases and cash flows. In addition, incorporation of contingency into a project budget discourages potentially harmful tradeoffs in schedule and/or scope and functionality. Once a project is underway, contingency reserve analysis, including the use of contingency coverage ratios, can improve project certainty and performance. Reserve analysis can aid in the setting, and adjustment, of project contingency and is a useful tool for Project managers, program management teams and portfolio directors. Reserve analysis can be used to risk–inform capital allocation budgets and provide senior stakeholders with a subjective view of project certainty—how likely is the program or portfolio to remain within budget. This paper provides a solid overview of how to formulate the initial project request for contingency, through an assessment of estimate uncertainty and risk exposure, and how to perform contingency reserve analysis, through the use of contingency coverage ratios and rule of thumb for projects already underway.

Introduction

Congratulations, you've just been hired as the project manager for an 18-month long system upgrade project, scheduled to be approved for funding next month! On your first day of work, you learn that an estimate has been put together by the development staff. The project is estimated to cost $10 million, not including contingency. When asked if a contingency estimate has been offered up, the development lead informs you “no, we were hesitant to add contingency to the estimate.” As it turns out, a preliminary estimate of $9 million had been floated around last year when the project was first being considered, and the development team was concerned about management's reaction to the higher cost now being put forth. Adding contingency would only make the conversation harder; so, the development team decided to the leave the topic of contingency and the defense of the new estimate to the new project manager (you). The development lead did inform you, in parting, “management sponsors have approved contingency on projects before, but only when justified.” So, what do you do now?

  1. Jump into execution and hope you can pull it off? Look for opportunities to quietly cut scope to cover overspending as it occurs?
  2. Take a moment to estimate how much contingency is reasonable to cover estimate uncertainty and risk exposure. Then request additional funding from your sponsors?

Contingency Management

You select option B (good choice), and have a brief meeting with the lead project sponsor to discuss your intent to estimate a reasonable level of contingency. The lead sponsor agrees with your approach, but counsels you to put together a well thought out justification for adding contingency, especially since the additional dollars will decrease the value, or business case, of the project.

Estimate Uncertainty and Risk Exposure

 

Exhibit 1: Estimate Uncertainty and Risk Exposure

Though option A may be an appealing path forward, at best it only defers a difficult discussion. Selection of option B is recommended. Option B enables you to have a risk–informed discussion with the project sponsor, and provides you the opportunity to request a justifiable amount of contingency to cover a portion of the estimate uncertainty and risk exposure facing the project, both of which increase the potential for cost overruns, schedule delays and deviations in scope/functionality (Exhibit 1).

As you develop your business case for the incorporation of contingency into authorized total project cost, you decide to include a slide depicting the major components of total estimated project cost at completion (Exhibit 2), into your presentation to the sponsor and these list of benefits that the inclusion of contingency provides;

  • Covers a portion of estimate uncertainty and risk exposure
  • Improves transparency and builds trust (reduces need to drive contingency underground)
  • Provides a more realistic business case and cash flows
  • Discourages potentially harmful tradeoffs in schedule and/or scope and functionality
Components of Total Project Cost, and Contingency

 

Exhibit 2: Components of Total Project Cost, and Contingency

As shown in Exhibit 2, the total estimated project cost at completion includes the base cost estimate and contingency. The base cost estimate is expected cost of known scope and contingency the amount of funds being requested to cover risk exposure and estimate uncertainty.

As previously noted (in our ongoing example), the development team provided you with a base cost estimate of $10 million. You have decided to take a moment to estimate how much contingency is reasonable. As shown in Exhibit 3, you decide the first step in doing so is to determine the level of uncertainty of the estimate provided by the development team.

Contingency Management Process

 

Exhibit 3: Contingency Management Process

Determine Estimate Uncertainty

In talking further with the development lead, you learn that some initial design work had been done in support of the estimate and that a portion of the labor, materials, and equipment were based on prior projects and/or vendor quotes. According to the development lead the estimate is a ‘class 3 estimate” and has a range of plus $2 million and minus $1 million, for a base cost estimate range of $9 million to $12 million. You further learn that the class of estimate is based on an industry best practice put forth by the Association for Advancement of Cost Engineers (AACE®), there being five classes of estimate. The most accurate estimate being a class 1 estimate and least accurate a class 5 estimate. Finding the AACE® estimate classification system a good way to talk about estimate accuracy you decide to include a copy of it, as shown in Exhibit 4, in your presentation to sponsors (AACE®, 2011, p. 2).

Estimate Class (adopted from AACE<sup>®</sup> Estimate Classification System)

 

Exhibit 4: Estimate Class (adopted from AACE® Estimate Classification System)

From experience, and consistent with the range of uncertainty for a class 3 estimate, you know that adding contingency of 10 percent, to cover estimate uncertainty, for this type of project is a reasonable request. However, the project controls support personnel assigned to your project have indicated that they have expertise with Monte Carlo multi–variable sensitivity analysis. The project controls personnel go on to explain that the Monte Carlo analysis is performed using specialized software that takes the three–point estimates (min, most likely, max) for each scope item provided by the development team and calculates the cumulative probability of achieving the project at or below any give cost within a range of cost.

The Monte Carlo analysis indicates that there is a 40 percent probability that the project will not exceed the base estimate of $10 million. Conversely, the addition of $1 million to the base cost estimate increases the likelihood of not exceeding the cost, now estimated at $11 million, to 80 percent. When you share this with the development lead they tell you “this level of confidence is consistent within the risk tolerance of our management, they really dislike it when projects go over cost.” Your new funding request, excluding contingency to cover risk events, is now $11 million with a range of $9 million to $12 million.

To further justify the addition of contingency to your funding request, and ensure a common understanding of using contingency to offset overspend due to estimate uncertainty, you add the following points to your presentation;

  • Estimate Contingency can be defined as: amount of funds included in an estimate to purchase additional materials, labor, equipment and escalation for the scope provided, due these:
    • – Uncertainties that are inherent in the estimating process
    • – Minor errors and omission that occur when the estimate is put together
  • Estimate Contingency is not intended to cover major changes in scope

Having determined the estimate uncertainty and formulated a desired level of contingency to cover the potential need to purchase additional materials, labor, etc., you now proceed with the next step in the contingency management process, determination of risk exposure and associated level contingency desired to cover the risk of exceeding your cost estimate.

Determine Risk Exposure

In reviewing the package of materials you were provided on the first day of the job, you realize that no structured project risk review has been performed. The development team documentation is thorough, including a moderately detailed description of project requirements, scope, schedule, resources, major stakeholders, lessons learned from similar projects, and list of major assumptions and constraints. You feel that you have enough information to pull together a good risk register, so you schedule a risk workshop with your team and ask the company project management center of excellence (PMCoE) team to facilitate the meeting. The PMCoE representative talks over the workshop agenda with you in advance and provides you with the process, shown in Exhibit 5, they use to facilitate:

  • Creation of the initial risk register and risk matrix; and
  • Quantification of risk exposure using expected monetary value (EMV) (Project Management Institute, 2009, p. 94).
Formulating Total Risk Exposure

 

Exhibit 5: Formulating Total Risk Exposure

The PMCoE representative stresses that the process of managing risk is a continuous one, and that the quantification of risk and summation of risk EMVs requires:

  • Good risk statements provided in an IF event, THEN consequence format;
  • Quantification of impact, including the monetization of schedule and quality impacts (turning of changes in schedule and quality into a dollar impact);
  • Determination of probability of occurrence of each risk event;
  • Calculation of EMV for each risk (probability * impact);
  • Determination of which risks are correlated and in what way; and
  • Summation of risk EMVs (simple approach to aggregation of risk).

“Sounds like a lot of work” you say to the PMCoE representation. “Glad you're facilitating the risk workshop for us.”

During the risk workshop you and the project team review the documentation provided by the development lead and compile a list of 10 risks, none of which are significantly correlated. The sum of risk EMV's is $1.5 million (with the sum of total risk impacts, not weighted by probability, of $5 million). In preparation for your discussion with project sponsors, you decide to include a description of one of the major project risks in your presentation, as shown in Exhibit 6.

Example of a Major Project Risk and Calculation of EMV

 

Exhibit 6: Example of a Major Project Risk and Calculation of EMV

In addition to the risk calculations shown in Exhibit 6, you plan to note the following in your presentation:

  • Risk Contingency is:
    • Amount of funds included to cover risk exposure as measured by the cumulative, and potentially correlated, expected monetary value (EMV) of project risks; and
    • Not intended to be a blank check to hide mistakes made in the execution of the project.

Having formulated a desired level of contingency to cover estimate uncertainty ($1 million) and risk exposure ($1.5 million) you are now ready to proceed to next the next step in the contingency management process, setting of the desired contingency funding request.

Set Desired Contingency Funding

Upon finishing the work with your project team, the development team, and the PMCoE to determine the estimate uncertainty and risk exposure of the project, you now feel confident that you are prepared to request, and defend, the total project contingency funding. A brief look at your notes and supporting documents, mainly the project cost estimate, Monte Carlo analysis, and risk register, allow you to quickly formulate your total contingency request as follows:

  • Estimate contingency = $1.0 million
  • Risk contingency = $1.5 million
  • Total requested contingency = $2.5 million

To further increase transparency, and facilitate an understanding of the reasonableness of your request, you decide to include the figure shown in Exhibit 7 in your presentation to the project sponsors. Your goal at this point to provide solid justification for your contingency request of $2.5 million and affirm that your intent is to improve sponsor confidence and certainty in your ability to the deliver the project scope and functionality on time, on budget, in a safe and sound manner.

Formulating Total Project Contingency Request

 

Exhibit 7: Formulating Total Project Contingency Request

Now that you've formulated your total project contingency request, you finalize the sponsor presentation and flag on the request for approval page that you are seeking authorization of $12.5 million (including $2.5 million in contingency). You also note that your request is based on a class 3 estimate and the range of the estimate between $9 million and $17 million, as follows:

  • Low end of $9 million
    • Minimal cost for known scope
    • No risk exposure
  • High end of $17 million
    • Maximum cost estimate for known scope of $12 million, plus
    • Maximum impact from all known risks being triggered of $5 million

Recalling your conversation with the project sponsor regarding the inclusion of contingency and impact on the business the case, you reassess the project based on the total project cost including contingency and find that the project still has a healthy benefit–to-cost ratio and positive net present value. In addition, you find that the breakeven point on cost is close to $16 million, just below the high end of your cost range. Finding this information useful, you decide to include the results of your analysis into the presentation, which is scheduled for tomorrow afternoon.

Check Adequacy of Contingency as Project Progresses

Your presentation to the sponsors goes well and your request for contingency is approved. The project sponsors thank you for the level of rigor, transparency, and professionalism that you have brought to the project. So the question facing your sponsors is—how do they gauge the reasonableness of the project contingency as the project progresses? Sponsors and project managers, have an interest in keeping an eye on contingency level:

  • Too much contingency leads to sub–optimal allocation of project funds
  • Too little contingency can result in the need to go back to stakeholders for more money
    • Drives perception of project failure
    • Hinders cost budgeting and forecasting

You and your sponsors reach out to the PMCoE for guidance. According to the PMCoE representative supporting the project contingency reserve analysis (Project Management Institute, 2008, p. 311), which involves the comparison of contingency reserves to the remaining estimate uncertainty and risk exposure of the project, is a process that can be used to check the adequacy of contingency as the project progresses. After further consultation and discussion, your sponsors request that you include two metrics in the monthly project status report: (1) contingency to estimate–to-complete (ETC), and (2) contingency to risk exposure (EMV). With each metric calculated as follows:

  • Contingency to estimate–to-complete (ETC)
    • Formula: (Contingency $) / (ETC excluding contingency)
    • Rule of thumb: for a well developed project: greater than 3 percent and less than 15 percent is reasonable
  • Contingency to risk exposure (EMV)
    • Formula: [Contingency $] / (EMV)
    • Rule of thumb: Generally between +/- 25% is reasonable (0.75 to 1.25)

Your sponsors also request that your status report flag your contingency balance with a yellow stoplight when either metric exceed the established rule of thumb boundaries noted previously. In addition, your sponsors have requested that you present to them the status of the project in six months' time.

Six months later, you provide a brief update to your sponsors and note, among other items, the following:

  • Project is 20 percent complete, with the majority of engineering complete and primary contracts having been executed
  • Current risk exposure (pulled from the project risk register) is $1.2 million
  • Current estimate–to-complete is $8.0 million
  • $1.0 million of contingency remaining (out of its authorized initial contingency of $2.5 million)

As requested, you also supply the following contingency reserve analysis metrics:

  • Contingency to estimate–to-complete (ETC)
    • Contingency remaining = $1.0 million
    • ETC (excluding contingency) = $7.0 million
    • Contingency to ETC = 14.3% [within bounds of 3 to 15%]
  • Contingency to Risk Exposure (EMV)
    • Current risk exposure (EMV) = $1.2 million
    • Contingency remaining = $1.0 million
    • Contingency to EMV = 0.83 (within bounds of +/-25%)

In your update, you note that based on the agreed upon rules of thumb the contingency is adequate, possibly excessive even, and that the project may be able to release contingency back to the sponsors if the contingency to ETC ratio climbs and risks close without triggering. Upon conclusion of the status update, the sponsors thank you and your team for their continued work on the project and request another update in six months so that the potential release of contingency could be revisited before next year's budget is finalized.

Conclusion

Well done, you are successfully executing your project using a structured contingency management process, and find that the incorporation of contingency into authorized total project cost has delivered the following benefits to you (the project manager), the project team, and the project sponsors:

  • – Mitigation of cost overrun due to estimate inaccuracies and risk exposure;
  • – Improved transparency, trust, confidence and certainty; and
  • – More realistic business case and cash flows.

In addition, you feel that the ability to carry a reasonable amount of contingency on the project has discouraged project team members, and sponsors, from making potentially harmful tradeoffs in quality/functionality to cover differences in the cost of materials, labor, equipment, etc. and/or impacts due to triggered risk events. You also gained practice in the use of contingency management tools, techniques, metrics, and rules of thumb, each of which aid in the delivery of the project scope, on time and on budget in a safe manner.

REFERENCES

AACE® International. (2011). Cost estimate classification system – As applied in engineering, procurement and construction for the process industries - Recommended Practice No. 18R-97. Morgantown, WV: Association for Advancement of Cost Engineers (AACE®) International.

Project Management Institute. (2008). A guide to the project management body of knowledge (PMBOK® Guide) (4th ed.). Newtown Square, PA: Project Management Institute.

Project Management Institute. (2009). Practice standard for project risk management. Newtown Square, PA: Project Management Institute.

This material has been reproduced with the permission of the copyright owner. Unauthorized reproduction of this material is strictly prohibited. For permission to reproduce this material, please contact PMI or any listed author.

©2012, Kenric England & John Moreci
Originally published as a part of the 2012 PMI Global Congress Proceedings – Vancouver, British Columbia

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