a key to managing cost risks
John W. Murray William F. Ramsaur,
Arthur Andersen & Co.
Historically, cost estimates for specific long-term projects have included a contingency amount to cover — hopefully — the cost of uncertain risks or “unknowns.” The amount of this contingency varies by project, depending on such variables as the “state of the art,” firmness of project design scope, and other “undocumented” reasons.
We will describe procedures that have proven to provide a basis to aid the control of cost risks. Our approach differs from the historical approach by establishing project cost reserves in the project cost estimate for specific cost risks. Project reserves provide the opportunity for management to focus attention and resources on the major risks. The use of project reserves should be a key factor in a project cost control program.
Project reserves are special provisions for uncertainties which may affect the cost of the project. A variety of reserves should be included in the total planned cost for a long-term project as contingencies against inaccurate preliminary estimates, schedule slippage, technical problems, potential minor changes in project scope, specific events which may or may not occur, etc., and as an overall hedge against problems not anticipated at the time when the preliminary project costs were approved.
The use of the term “reserve,” as defined in this project management sense, is not the same as and should not be equated with that same term as it is often defined and used in a financial accounting and reporting sense. In addition, the project reserve should not be considered as part of the original legal requirements of any specific contract (i.e., anticipating formal change orders, informal changes, delays, suspensions of work, etc.).
It is imperative that reserves be given proper visibility and that their establishment, use, and rate of consumption be monitored closely at the proper level in the project organization. The sections that follow describe procedures to create, utilize, and monitor project reserves. These procedures are being used by the project management department of a utility firm on a project to design and construct two large electric generating units.
The following are definitions of specific terms which are used to describe the project reserve procedures:
• Planned Costs — The approved budgeted costs for the project. Project reserves are included in the total planned cost.
• Committed Costs — The planned costs for project segments which have been committed to contractors and vendors based on awarded contracts and purchase orders.
• Forecasted Costs — The current best estimate of costs at completion. The use of forecasted costs in the project cost control reports does not require the formal approval associated with the planned costs.
• Contract Reserves — Two types of contract reserves are used — specific and general. Specific contract reserves are established for specific cost risks for project segments or contracts. In some cases there will be multiple specific reserves associated with a contract. General contract reserves are established for minor changes which may occur during the contract.
• Management Reserve — A reserve for the project not associated with specific project segments or contracts.
Major Principles of Project Reserves
There are four major principles associated with project reserves. These principles, which are described below, are: (1) Assess risks; (2) Establish reserves which are as specific as possible; (3) Develop project cost estimates; and (4) Assign specific reserve responsibility to individuals.
1. Assess Risks — The project must be reviewed to determine the risks associated with each segment or contract. The level of detail for risk identification should reflect the magnitude of the risk and the phase of the project. On many projects, this risk assessment merely formalizes an informal project procedure.
A major factor in assessing risk is determining the degree to which the design, manufacture, construction, or installation of a certain segment of the project represents an advance in the state of the art. In our experience, these risks are typically understated to a significant degree. A second factor in risk assessment is to identify materials or equipment which are in short supply or which are particularly susceptible to inflationary pressures. Closely related is the identification of long lead time materials and equipment which, by their extended procurement cycles, may represent a high degree of cost uncertainty. These procurement uncertainties can often be minimized through effective purchasing policies and practices, including obtaining quotes and finalizing contracts for long lead or short supply items at the earliest practical point in the project. However, a key to material and equipment control in the early planning and budgeting phase of a project is to identify potentially sensitive items so that the requirement for reserves can be determined.
The nature of the contracts anticipated for each segment of a project must also be considered when evaluating reserve requirements. From an owner’s standpoint, for example, any segments of the project which may be performed on a cost-plus-fixed-fee (CPFF) basis or under a price subject to escalation would generally involve greater cost uncertainty than those segments performed on a firm price, lump-sum basis. The CPFF and escalation contracts, therefore, would normally require larger reserves to cover the increased cost uncertainty.
2. Establish Reserves Which Are As Specific As Possible — The more specific the reserve can be defined, the greater will be management’s ability to monitor the use and evaluate the adequacy of the reserve as the project progresses. For example, a specific contract reserve could be established for extra backfill charges to cover the risk that the fill material shrinkage allowance would be exceeded in an earthwork contract.
When specific reserve requirements are combined with other contingency amounts, it is far more difficult to monitor the reserve usage as the work progresses.
If the reserve is not required for its intended use, it is automatically returned to the overall management reserve for the project. Conversely, if problems develop, the specific reserve would provide the visibility necessary to evaluate the additional cost requirements.
A normal procedure is to identify general contract reserves as well as specific reserves. For example, most long-term contracts on a project which overlap engineering and construction work will incur changes. Thus, a general contract reserve for change orders would be established for the other contract cost risks that are not provided for in a specific reserve. Figure 1 illustrates types of contract reserves.
The establishment of contract reserves does not, however, preclude the need for a management reserve for the project. The management reserve is needed to cover events which invariably occur during long-term projects, but cannot be specifically anticipated when project costs are approved. The management reserve should be established, however, only after the reserves for specific segments and contracts have been defined, evaluated, and approved.
3. Develop Project Cost Estimates — It is critical that the major assumptions used to develop the reserve estimates be thoroughly documented and retained for reference. This documentation of the estimating logic provides management with a basis for review and approval of the estimates, allows for subsequent reassessment of the estimates as the project progresses, and provides a historical data base for developing estimates on similar projects in the future. The level of detail may vary substantially by project segment. Estimation of a reserve requirement for a state-of-the-art task, for example, may be less refined than those developed for more conventional construction work. In any event, the estimating logic should be returned for subsequent analysis.
The project reserve procedures must be integrated with the cost estimating function. To be effective, cost estimates must be organized the way that the work will be constructed and managed. In addition, cost estimators and project management must work closely together to identify the risks associated with special project segments and their respective cost estimates.
It is essential that the format for presenting the project cost estimate identify the reserves associated with each project segment contract. A summary cost estimate report is shown in Table 1.
It is very important that the management reserve be independently analyzed and approved at periodic project cost estimate reviews. The state of drawings, commitments, actual expenditures, and physical construction completion percentage are key factors in this management reserve analysis.
aThe details of reserves for each contract are shown in a separate cost estimate report.
4. Assign Specific Reserve Responsibility To Individuals — Each reserve must be assigned to an individual. At the lowest level, reserves should be assigned to individuals having line responsibility for a specific segment or contract for the project. Higher level reserves should be assigned to higher levels of mangement.
Each individual having responsibility for a project reserve should perform the following functions:
a. Review and approve the reserve estimates and their underlying assumptions.
b. Approve the transfer of reserve amounts.
c. Monitor the status of the reserves and their rate of usage; develop project cost control reports to aid in this analysis.
d. Participate in estimating the amount of additional reserves which may be required to complete the total project or a specific segment of the project.
In most cases, the actual transfer of reserve amounts results from the completion of a prior event, such as the awarding of a contract or the approval of a change order. An integral part of the contract or change control approval process is a determination of its impact on reserves, including the need to utilize part of the management reserve. Therefore, responsibility for the control of reserves should rest with those who have line responsibility for project decisions in the segment involved. In all areas of a project, periodic and independent analyses of reserve usage should be performed to help ensure maximum control and prudent use of project funds. In addition, all transfers are evaluated in relation to budget availability and constraints.
Assigning specific responsibilities for the control of project reserves is a prerequisite to the control of cost risks. Affixing specific responsibility for each reserve, including the management reserve and separately identifying each at the appropriate level in the project control reports, will provide the visibility necessary to monitor their adequacy and control their rate of use. An example of reserves assigned to project personnel is shown in Figure 2.
Reserves and the Contract Life Cycle
Table 2 describes the project reserve procedures over the life of a planned, open, and finally completed contract.
The present reserve procedures can also be applied in the project planning phases that precede design. As would be expected, their application in the project planning phase may be at a higher level because of the lack of detailed information.
Table 2 suggests the importance of reserves in the cost management process. The reserve transfer process should be as tightly controlled and based on actual events (e.g., design changes, contract awards) as possible. Frequent and unnecessary reallocation of reserves can cloud the cost visibility on a project.
Table 2 also reflects the necessity for periodically reassessing reserve requirements. Generally, it is preferable to establish specific guidelines when these reviews must be made. Examples of guidelines for a contract would be:
• When a contract is 70 percent physically complete.
• If percent usage of a contract general reserve exceeds the physical percent complete by more than 20 percentage points.
• At least once a year.
Finally, an important element of reserve control is that reserves can only be used for the purposes for which they were established. Reserves that are not used should be eliminated from the planned cost estimate.
A comprehensive reporting system is necessary for the effective monitoring of planned costs and reserves. It can provide an early warning of potential problems and identify reserve transfers and uses. These reports would also be used to evaluate the rate at which reserves are being consumed over the course of contracts and the project. An example of a summary project cost status report for executive management is shown in Table 3.
In this report, the forecasted cost is compared to the planned cost for each contract to determine the potential impact on the management reserve.
The Monthly Project Cost Summary is presented in more detail for each lower level of management. For example, the project manager would have a line item for each “High Risk” Open Contract. In addition, the columns of the project manager’s report would separate Planned Cost into the Committed Cost, General Contract Reserve, and Specific Contract Reserve for each line item.
aPlanned Cost includes Committed Cost and Reserves.
The need to identify forecasted costs was highlighted in the Contract Life Cycle Summary (Table 2). For example, the costs of potential change orders and claims are estimated and included in the forecasted cost for the appropriate item.
Two additional key reports which support the Monthly Project Cost Summary are:
• Early Warning Report — This report shows the contracts and reserves which will potentially impact the management reserve by more than a selected amount. It allows management to direct project resources to critical areas to resolve problems and minimize costs.
The early warning report should also reflect projected balances for reserves which have potential change orders and claims identified.
• Management Reserve Usage Report — This report shows management reserve transfers over a selected amount with a description of the reason for each transfer. This report allows executive management to monitor, after the fact, the actions that have been delegated to project management.
Perhaps the most important, but difficult, aspect of reserve management, is the need to evaluate the rate at which reserves are being consumed and to assess the adequacy of the unused reserve to cover the completed portions of the project. Too often, reserves or contingencies are allowed to be virtually depleted before it is recognized that additional funding will be required to complete the project. A reserve usage graph can assist in addressing this problem. Figure 3 illustrates a simple graphic approach to management’s reporting of reserve status.
Figure 3 shows that the design and detail takeoffs are approximately 40% complete but over 60% of the reserve has been used. This could mean that the estimating variance (difference between amounts in the order of magnitude estimate and the estimates resulting from detail takeoffs) will cause the reserve to be exceeded. On the other hand, the areas for which takeoffs have been completed might represent the most complex segments and, therefore, the same variance or reserve consumption rate might not continue. In either case, specific evaluation of the reason for higher than planned reserve consumption must be made.
The reserve control concepts offered here still rely on the necessary underpinning that total planned costs before completion are the best estimate available of what it will take to do the job under circumstances as they exist.
Lessons Learned in Using Project Reserves
Effective implementation of the project reserve procedures requires good design and specific estimate documentation. It also requires that the estimating function become project segment and contract oriented, as opposed to end-product or accounting oriented. In many industries the effective implementation of contract oriented estimates will have a learning curve associated with it.
Care must be exercised that too many levels of reserves (e.g., contract, discipline, functional area) are not established. Although a several level approach may seem theoretically correct, it lessens problem visibility and can cause a large number of transfers between reserves with little meaning and more confusion.
In addition, the creation of reserves at too detailed a level can provide good information but, in reality, little control and at a high cost. For example, creating a specific reserve for (1) lump-sum, (2) unit-price, and (3) cost-plus changes, respectively, on a contract could provide good information, but little control from a reserve standpoint. In this case, a change order plan by contract term and reporting against this plan would be a better procedure for monitoring this project activity than the project reserve procedure.
Summary and Conclusions
The principal objective of the reserve control procedure is to provide management with the early and continuing visibility necessary to evaluate the total cost status of each project. This can best be accomplished by applying each of the major control tasks as follows:
1. Assess the various project risk factors.
2. Develop and document logical estimating assumptions.
3. Assign specific responsibility for reserves.
4. Emphasize the early recognition of potential changes and claims.
5. Control the use of reserves with specific approvals of transfers.
6. Report reserve changes in the project control system.
7. Analyze the rate of reserve consumption in relation to the project status.
Earliest possible visibility provides management with maximum flexibility while reacting to potential cost problems. The steps which can be taken, if potential problems are recognized early, include the following:
1. Adjust project scope.
2. Defer portions of the project.
3. Request additional funding.
4. Concentrate management resources on the most sensitive elements of the project.
Project reserves are not intended to be a vehicle for absorbing or concealing cost performance problems at any level in the project organization. This includes contractors, subcontractors, architect/engineers, construction managers, or owner personnel with project responsibilities. Reserves, developed in a logical manner, are intended to provide protection against the many uncertainties associated with complex, high-cost projects spanning long periods of time.
The major benefit derived from applying the project reserve procedures is the discipline it forces at various levels of project management. The project estimate identifies contract reserves and management reserves. These, in turn, are approved as part of the management approval process. Transfer between reserves requires management approval and post approval reporting to the next higher level of management. This visibility enables project and executive management to be informed. An informed management will be far less subject to cost problem surprises!
1984 advertising information for the “new” Project Management Quarterly will be available mid-October. Please address all inquiries to:
Dr. Terry L. Kinnear, Editor
Project Management Quarterly
School of Business
Western Carolina University
Cullowhee, NC 28723
1This article was previously published in the 1977 Proceedings of the Project Management Institute, 9th Annual Seminar/Symposium, Chicago, Illinois.