Project Contingency

December 11, 2009 | Author: PM Hut | Filed under: Risk Management

Project Contingency
By Clifford Ananian

It’s time to talk about one of the more controversial topics associated with Project Management: Contingency.

Once a project has been properly defined, one typically has to determine both a schedule and budget for the project scope. This stage of project scope development is the most painful: Everyone has agreed on what they want and now it is time to convince them of what it will cost in both money and time.

Everyone involved in the development of the project scope has an opinion of what the project will cost. Senior Management has an expectation for what the project will cost. It is now time to replace fiction with fact (or at least attempt to replace unsubstantiated fiction with a more grounded fiction!). It is now time to estimate the cost of the project and agree on a budget.

It should be noted that the procedure is a two step process: (1) establish an estimate, and (2) agree on a budget. One typically would expect the budget for a project to be based on the estimate but there are some managers that would prefer not to admit to this concept. In some cases, especially when the estimate far exceeds the original expectations, the budget is often simply a “wish” or “challenge” instead of a reasonable expectation.

The Estimate

There are a number of different techniques and processes that can be employed in establishing a project estimate. Every company typically has its own preferences and systems for preparing the estimate. Many have a number of different methods which they feel have differing levels of “accuracy”. Quite honestly, the purported level of accuracy of one method versus another cannot be easily substantiated, but the level of accuracy is specifically intended to “modify expectations”. If one claims that an estimate is accurate to ± 50%, then one has planted the seed for corporate executives to reasonably understand if the final costs differ substantially from the original “estimate”.

Regardless of the purported accuracy of the estimate, the budget typically does not allow for variance.

Most companies are looking for a budget that is at least within a 5 percent accuracy, or a “not to exceed” figure. Note that we are addressing company policies concerning budget versus estimate accuracy. The estimate is simply a stepping stone to establishing a budget. Regardless of the estimating accuracy used to support the budget, once the budget is agreed to and accepted, the method used to establish this budget becomes unimportant.

The distinction between a project budget, and the estimate used to establish the budget, is often conveniently forgotten. If your method of developing an estimate is only accurate within 10 percent, and your management’s expectations on budget control is “Not To Exceed”, then it seems reasonable that the budget for the project must be established ten percent higher than the estimate. Logical but not Realistic!

The purpose of this article is not to address the different methods of estimating and their anticipated accuracy – we will address this in future articles. The important principle to understand is that the estimate accuracy must be accounted for when establishing a budget.

The Budget

The budget is, in many respects, an agreement between the company and the project manager. It quantifies expectations. Each company has different policies and expectations concerning the project budget. Most expect that the budget will not be exceeded and have procedures in place that require senior management approval for expenditures beyond budgeted amounts.

The budget is a primary tool for controlling the project. The project manager must constantly compare expenditures and forecasts against the budget to control the project.

Because the budget is the primary tool for controlling a project, it should be broken down into sufficient detail to allow the manager to measure the project against the budget on a regular basis. The writer strongly suggests that this budget breakdown structure be flexible to allow for proper project control. Its structure will reflect the intended execution strategy. It should not be dictated by the structure of the estimate nor the business accounting structure.

For instance, if the project is to be executed by awarding four subcontracts for construction, the estimate should be reapportioned to reflect these subcontracts, and the budget broken down in this same fashion. Hence, when a subcontract is awarded, the budget and the bid align, and the project manager can reasonably forecast the project regularly without having to constantly manipulate figures.

Similarly, the budget should have a line item, or multiple line items, for “contingency”.

Contingency

Contingency is a nebulous concept that lacks an agreed-upon definition. The dictionary defines contingency as “an event that might occur in the future, especially a problem, emergency, or expense that might arise unexpectedly and therefore must be prepared for” or “provision made against future unforeseen events, e.g. an allocation of funds in a budget”. The key word is “unforeseen”.

  • Estimate Contingency

    An estimate is developed based on a project scope. If the project has reasonable definition, there is a basis for developing reasonably detailed capital cost estimates. For instance, with the use of P&ID’s and Equipment Arrangements, the size, material and quantity of pipe can be quantified. This quantity of pipe is “reasonably accurate”. It is a known. In order for this quantity to become a line item on an estimate, however, a cost must be assigned to it.

    There are a large number of assumptions that must be made to take this quantity of “known” material and assign a cost to it. One must assume (1) a price for the material, (2) a cost for the support materials to hang the pipe, (3) a labor productivity rate for installing the pipe and supports, and (4) a labor hourly rate for this labor. In addition to these assumptions, one must determine the level of accuracy of the quantity takeoff. Typically, this quantity is adjusted to allow for the accuracy of the takeoff. This adjustment is not contingency i.e. it is not addressing an unforeseen issue.

    A detailed estimate is a compilation of all of the “knowns”, assumptions and factors. The writer strongly recommends that all of these assumptions and factors are carefully reviewed and challenged as an estimate is developed. These factors and assumptions are not, however, contingency.

    Once the estimate is built up from the “knowns” as defined in the project scope, a contingency must be applied to the estimate. This contingency, the estimate contingency, is specifically applied to address the unknown or unidentified issues that are normally encountered in the execution of a project. This contingency does not account for unknowns outside the scope of the project. For instance, it does not account for adding a spare pump to a process system – the need for spares should have already been properly addressed in the project scope. The addition of a spare pump is an out-of-scope change to the project and must be addressed by a change order.

    If the estimate is built on a fairly detailed project scope, and the estimate itself is detailed, the contingency is relatively small. Although not intended as a rule, this estimate contingency should normally be in the range of 5 to 10 percent of the overall estimate.

    The sum of all the estimate parts, including the contingency, is the estimate. This estimate has a level of accuracy based on the estimating technique.

  • Budget Contingency

    Once an estimate has been developed it serves as the basis for developing a budget.

    This can be a difficult step depending on the final estimate value as compared to management expectations. It is not uncommon for the project estimate to exceed management’s expectations for the project.

    The purpose of this article is not to address the negotiations that will ensue with an estimate that exceeds expectations. One word to the wise, however: the budget must be supported by an estimate. If the estimate must be reduced, the project scope should be reduced to reflect these “savings”.

    For the most part, the budget should be identical to the estimate. However, one must take into account the company’s policies and procedures before agreeing on a budget.

    First, remember that the estimate has a degree of accuracy. If the budget policy in the company is that the budget is a “not to exceed” appropriation, than the budget must be increased, by an “insurance” contingency, to address this issue.

    Secondly, if the company is unwilling to accept “changes” to the project scope, and their policies allow this type of “scope creep”, than additional monies must be added to the budget to address this scope growth which would normally be addressed with budget change requests.

Summary

Contingency is a concept which is applied a variety of ways by different organizations. Regardless of the use of the term, there are specific, definable applications within a project for the proper application of “contingency” funds.

Project contingency must address both unforeseen and historically, predictable costs. These contingencies can be categorized as:

  1. Estimate Contingency that allows for unforeseen costs within the project scope.
  2. Budget “Insurance” Contingency that addresses a corporate budget control philosophy of “Not to Exceed”, and
  3. Scope Growth Contingency that reflects the corporate casual attitude toward “scope creep”.

Each company and project may have a need for each of these contingencies. Each contingency should be addressed during the development of a project scope and budget. Each should be identified separately in the budget and a project controls methodology put in place to monitor, control, and forecast them.

Clifford Ananian is a Project Manager experienced in both managing engineering and construction on heavy, industrial type projects in the Power Generation, Chemical, Specialty Chemical, Cogeneration, Pulp & Paper, and alternative energy fields. Clifford can be contacted through is blog, Project Management Consultants.

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1 person has left a comment

What group of management executives will let project teams have large visible line items called “contingency, management reserve or budget buffer” or similar?

Most executives will take items like that and financial risk reserves and take them out of the project budget and think they have added value to the project, rather than what they have done which is to ensure that the project will go over budget.

Project teams then respond by icnluding contingency within their estimates, thus distributing the contingency throughout the project, effecctively padding each estimate. Thus going against PM text book practices.

As I understand it, if you apply PERT estimating to a project and add up the variances to work out the total variance and total standard deviation of the project, you can’t ever get to a value of “can’t go above” because there is always some probability that the project will go above the budget estimate.

John Tailby wrote on December 15, 2009 - 8:09 pm | Visit Link

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