Stop reacting, it's too late! Start to anticipate!
use a proper budget structure as an early warning system integrating cost, scope and risks
Olivier Lazar, Msc, MBA, PMI-ACP, PMI-RMP, PMI-SP, PMP
Project management is definitely an activity of anticipation, not reaction. If you ever have to react, it means that the problem has already occurred, that you're already out of budget, timeline, and scope. This reactive situation leads to conducting actions in a panic mode which, most of the time, introduces a bias in the decision making process. This leads to conflicts, stress, and the harming of the overall value creation expected from the project outcomes.
Very often, when analyzing these situations, we have seen that the budget structure of the projects was inappropriate and led to a loss in visibility and predictability of deviations. Even if, sometimes, a sort of risk analysis is performed, a properly structured risk budget is missing or can be blended within a contingency reserve, if one exists.
Clarification About the Estimation Processes: Taking Proper Account of Risk and Contingencies
Everything starts with the common introduction of a bias in the initial estimation process. When defining the amount of resources required to perform the different activities of a project, these parameters should be taken into account:
- - The fundamental resource, which quantity will determine the budget at completion, representing as such, the ideal execution scenario.
- - The additional resources aimed to deal with unexpected events occurring during the activity execution process.
Mostly, these elements are estimated as one single amount that constitutes the project budget.
Often, budget elements are required to cope with any event that occurs, such as issues, risk occurrences, and sometimes even scope changes, which are usually taken from this budget.
If the organization where the project takes place is mature enough to apply, to a certain extent, the budget structuration as described in A Guide to the Project Management Body of Knowledge (PMBOK® Guide) – Fifth Edition (PMI, 2013, p.213), then the unexpected event's occurrence should be covered by a specific and defined contingency reserve, eventually completed by a management reserve.
This structuration very often leads to the following issues and biases:
- - Unpredictability of budget override
- - Mix between budget allocations for risks, issues, and scoped activities
- - Lack of predictability of the evolution of the project costs evolution
In this sense, a proper estimation process should separate the different components according to the different factors defining a project life cycle:
- - The regular activities of the project as defined in the scope
- - The risks which have been identified along with their defined strategies
- - The unexpected events potentially happening
In the process of estimating the activity resources, it will lead to having to separate the estimation of committed resources, potential risks, and unexpectancies—essentially, three different budget envelopes.
Defining a Project Budget Structure
Following the above statement, we will define the components of a project budget as such:
- - The Budget At Completion (BAC)
The BAC represents the amount of resources estimated as necessary to complete the work described in the scope statement, nothing less, nothing more. This first envelope constitutes the budget reference of the project, the ideal scenario of project execution.
- - The Contingency Reserve (CR)
As slightly different from the PMBOK® Guide definition, here the CR is defined to cover the deviations caused by the occurrence of an unexpected event, and that only. We define these events as issues. The difference between an issue and a risk lies in the predictability factor of a risk. We can identify, anticipate, and adopt a strategy toward a risk, but we can't anticipate an issue. The CR is defined by deciding upon a certain percentage of the BAC, based on the level of predictability of the project's risk exposure. Usually, an average starting point to define the CR starts around 10 percent of the BAC.
- - The Risk Response Budget (RB)
As defined in the PMBOK® Guide – Fifth Edition a risk is “… an uncertain event or condition that, if it occurs, has a positive or negative effect on one or more project objectives…” (PMI, 2013, p.310). A risk has to be identified, quantified, analyzed, and a strategy has to be decided upon to either reduce a threat or maximize an opportunity.
Doing so, the project team will define a certain set of activities, which have to either preventively treat the risk, or curatively absorb the impact of the risk occurring.
Indeed, these activities have to be planned and then budgeted to ensure a proper, realistic project forecast.
- - Finally, a fourth envelope can be constituted within a Management Reserve (MR).
The MR has to be defined to covert the impact of specific organizational level decisions, which might be caused by the additional activities they trigger or their impact on the expected profit margin and return on investment. These decisions are not usually within the authority and decision perimeter of the project manager and the project management team. That's why we'll keep the MR under the authority of the project sponsor.
The MR is constructed either based on the estimated impact on the profit margin of the project, or based on the estimation process applied to concrete and tangible activities implied by the scope of the specific decisions concerned within the MR perimeter.
These four envelopes of the project budget are connected and interdependently related. When the project team has to face an issue (unpredicted event), they covert the counter measures by transferring the necessary budget from the CR into the BAC, then updating the cost baseline. The same principles apply when facing the occurrence of a risk (predicted event) by taking the corresponding budget from the RB and updating the BAC.
This is what we consider as being the project budget.
Exhibit 1: Project budget structure.
The Fixed and Variables Within the Budget Structure
When we look at the so-defined budget structure, it defines the perimeter of responsibility of the project management team and the project manager.
Of course, the entire budget to be properly overlooked requires considering additional layers.
- - The Overheads
Any initiative in the organization has to integrate a certain part of overheads, usually covering the infrastructure to be shared by the different parts of the organization. Often, the overheads are included in the BAC of the project, due to their integration into the calculation of the individual cost of each resource to be allocated on the project activities.
- - Project Margin/Profit/Return on Investment (ROI)
Each initiative in the organization is supposed to generate a certain profit for this organization. Even if not resulting in an outcome being directly sold to a client, but internally exploited, a project is supposed to generate a ROI committed to that project.
The sum of these layers defines the selling price for a fixed-price project.
One can easily realize that, considering this structure, the project budget, as such, is fixed (if the scope of the project is fixed, it is also fixed). Often, the overheads are also fixed. The only variable part lies within the profit layer. If the project budget has been properly estimated and constructed, the only place where the organization can take the necessary resources to cover the overspending will come from reducing that layer, and then reducing the organization's profit and performance.
Construction of the Risk Response Budget: A Matter of Perception
As the definition of the BAC and CR are quite straightforward in their principle, the construction of the Risk Response Budget (RB) needs to be somehow clarified.
This being a key aspect of the presented model, we'll review it in detail.
When a risk is identified, analyzed and quantified, the outcome of the process defines the applicable strategy and the evaluation of a certain level of probability and impact of that risk.
Consider a threat meaning a negative risk), as having a percentage (X) as a possibility of happening. Imagine the project management team has chosen to apply a mitigation strategy to that threat, meaning taking anticipative actions to reduce as much as possible probability or impact of that to happen, leading to a certain residual risk (Y). If (Y) can then be considered as still significant, the project management team decides to define a risk response plan. This risk response plan is a certain set of actions to be activated and conducted if, and only if, the threat occurs. This plan would have a certain duration and a certain cost estimated by applying common and usual estimation techniques. This risk response plan constitutes a reactive set of actions.
This plan then needs to have a budget allocated to it, just as the mitigation plan (preventive actions) needs to have a budget allocation.
The mitigation plan (activities performed as related to the concerned threat), has to be budgeted for, taking into account the full cost within the BAC. Then it becomes part of the project scope.
The risk response plan, as being only activated in case the threat occurs, has to be budgeted considering its estimated cost weighted by the residual probability of occurrence, meaning its expected monetary value. This amount of budget has to be added to the risk response budget, from which the budget will be taken to cover the cost of the risk response plan if it ever needs to be activated.
The risk response plan is then constructed based on the sum of all the different budget allocations corresponding to all of the different response plans defined toward the risks which have been identified and for which the relevance of such a response plan has been decided by the project management team.
The size and nature of the risk response budget will then be dependent on two major factors:
- - The ability of the project team to identify risks
- - The tolerance and sensitivity of the project team toward risks and their risk appetite (Hillson & Murray-Webster, 2012).
Once this risk response budget has been constructed, based on the Expected Monetary Value (EMV) of each individual response plan for the different threats, it appears that when utilizing this budget, the cost of the plans to be activated and then transferred into the BAC to update the cost baseline, which will have to cover the full cost of such activities. That raises an obvious problem: there's a big gap between the budget allocated to each plan and the budget effectively used by these plans.
Exhibit 2: Usage of contingency and risk budgets.
Exploiting the Opportunities
How reliable and sufficient will that risk response budget be? How can you help ensure its reliability and sufficiency?
Actually, if the risk analysis is reliable, not all of the threats will occur, so not all of the response plans will have to be activated.
In fact, the reliability of the project budget lies within the ability of the project team to identify opportunities, or, in other words, their realistic consideration of the potential occurrence of threats.
The identification of opportunities is one of the most difficult parts of risk identification. The human mind is naturally oriented toward threats when talking about risks. That leads us to face situations where, in a willingness to sometimes minimize the effective exposure to risk and help ensure that a project budget will not inflate, project teams have a tendency to identify threats with a high level of probability to occur. Obviously, such a high level of probability will generate a consequent amount of the risk response budget, but, often leads to budget overruns (as a threat with a high probability, will often have an annoying tendency to happen).
In addition to these mechanical factors, this situation also has an effect on the soft aspects of project leadership in its negative impact on a project team's motivation and thus, performance.
When addressing a threat that has a very high probability to occur, knowing (consciously or not) that the chances to avoid the occurrence of the event are very low, the team will be less motivated to counter the concerned threat.
Exhibit 3: What is the probability of not being crushed by the elephant?
The relevant strategies consist, then, in the risk analysis process to help take all threats with a high probability, integrate them as a parameter of the project instead of an uncertain event, and consider the reverse probability of this event, meaning the reverse opportunity. The risk strategy will then consist to enhance or exploit this opportunity, leading to having a more realistic BAC and a more relevant RB addressing only threats with an acceptable probability to occur.
It will also enhance the motivation and performance of the project team by focusing their energy on positive aspects, rather than on activities which might appear like a waste of time and energy to counter inevitable facts.
At which level of probability does a threat convert into its opposite, a possible opportunity? That depends on the project team's risk appetite.
The Impact of Ambiguity and Uncertainty on Sizing the Contingency Reserve
Another important parameter to take into consideration when defining the project budget consists in having a relevant contingency reserve.
The difficulty, of course, lies in the fact that issues are, by definition, unpredictable. How can this be addressed?
We will use the evaluation of the project team's ability to identify risks in a relevant manner. This ability is dependent upon the level of ambiguity of the project (Lazar, 2010).
Ambiguity is defined here as the lack of information on the final result of the project, its process and outcomes, and its scope. One can say that a construction project, having very detailed plans, blueprints, and specifications has a low level of ambiguity, as opposed to a feasibility study or an innovation research project where the outcome is less predictable and will have a high level of ambiguity.
The more predictable a project is and the better its process is known, the higher the ability of the project team to predict any distortion to this project from the baseline.
According to this statement, the better they can predict risks, the less the project will be exposed to unexpected events. As such, if the ability of the project team to construct a proper and accurate risk management plan increases, the size of the project risk budget will automatically inflate, but due to the lower exposure to unexpected events, the project team will be able to deflate the size of the contingency reserve.
From 10 percent of the BAC in a medium-ambiguity project, the CR can eventually be reduced to 5 percent, or even 3 percent, if the level of ambiguity is lowered.
On the other hand, if the level of ambiguity is high (meaning the outcome is less predictable and the project team has less information allowing them to properly identify risks), the risk response budget will be quite low, and then the project will be more exposed to the occurrence of unexpected events, and the project team will need to inflate the CR. From 10 percent of the BAC on a medium-ambiguity level project, the CR can go up to 20 percent, or even above 30 percent, if the ambiguity is high.
Also, as a side effect, the more risks the project team is able to identify, the more it will generate uncertainty on the project, as risk is a factor of uncertainty.
Exhibit 4: Ambiguity vs. uncertainty.
Taking into account these different factors, will allow the project team to construct a project budget which will reflect the most probable outcome in terms of the Estimate at Completion (EAC).
Monitoring the Absolute and Relative Consumption of Each Reserve to Highlight Trends, Predict Deviation, and Assess the Current Situation of a Project
Having a properly structured budget is one thing. Having the ability to use this structure as a monitoring system is more interesting for the project management team.
In order to track the current status of the project, the absolute consumption of each reserve will allow project managers to see how the project is moving and how relevant the activity estimates were.
Using a monitoring and prediction technique such as Earned Value Management (EVM), can be of high relevance, depending on the level of maturity and nature of the project.
Usually these techniques, even if EVM is supposed to highlight trends and predict deviations, reveal problems when the problem has already occurred, and push the project team into a reactive or sometimes panic mode. As stated above, project management is an activity of anticipation, if you ever have to react, it's already too late; the problem has already happened and the project is often over budget and over the timeline.
Now, consider the relative consumption of the different project budget envelopes… As an example, if the BAC is at 30 percent of consumption, and the CR is consumed to 80 percent, it means that a lot of unexpected events occurred. Meaning, most probably, the risk identification and analysis has to be revised. The project will probably be off-limits shortly, but, the project is still within the boundaries of its budget.
In another scenario, if the BAC is at 30 percent, and the RB at 80 percent, it might mean that a lot of events that the project teams considered as uncertain (as risks) have occurred, which means the project scope should be revised. And the project will also be out of limits shortly, but at the time of the measure of relative consumption, it's still within the boundaries of the project budget and there is still time to act.
The structure of the project budget according to this model (defining a separate BAC, CR, and RB), gives the ability to the project team to control the status of the project and stay in a predictive and anticipative mode. The monitoring of the relative consumption of these different reserves gives an indication of the quality of the project scope statement, of the risk analysis, and helps define which area of the project must be revised before the project goes out of its limits.
Hillson, D. & Murray-Webster, R. (2012). A short guide to risk appetite. Surrey, UK: Gower Publishing.
Lazar, O. (2010, October). The project driven strategic chain. PMI Global Congress North America, 2010, Washington, D.C.
Lazar, O. ( 2014, October). Lessons learned vs. lessons logged. PMI Global Congress North America, 2014, Phoenix, AZ.
Project Management Institute. (2013). A guide to the project management body of knowledge (PMBOK® guide) – Fifth edition. Newtown Square, PA: Author.
© 2015, Olivier Lazar, Valense Ltd.
Originally published as a part of the 2015 PMI Global Congress Proceedings – London, UK