Developing and Using Risk Contingency Reserve

NK Shrivastava and Phillip George RefineM Project Management Consulting

An important part of project risk management is developing the contingency reserve. A contingency reserve is cost or time set aside to respond to a known risk. As opposed to management reserve, which is allocated at a high-level for the unknown unknowns,1 contingency reserve is allocated to respond to the known unknowns. These known unknowns are risks that have been added to the risk register and that have responses planned for them should they occur. Many quantitative analysis tools exist to calculate contingency reserve, including Monte Carlo analysis. One simple method is Expected Monetary Value (EMV) which is the product of a risks probability of occurrence and the impact of its occurrence. Once the contingency reserve has been developed, it is useful for communicating risks, addressing them, and improving the predictability of a projects outcome. In this article, we will further explain how to develop and use the contingency reserve and what limitations exist with them. Developing the Contingency Reserve The main inputs in developing the contingency reserve are the risk register and a quantitative analysis technique used to calculate the cost of each risk. Monte Carlo analysis is a powerful tool that can be used to determine expected costs associated with risks in simulations of project schedules. We will use a more simple method, Expected Monetary Value (EMV), to illustrate the following examples.
1

Project Management Institute (2013). A Guide to the Project Management Body of Knowledge (PMBOK Guide), Fifth Edition. Newtown Square, PA: Project Management Institute, Inc.

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Despite its name, EMV is not restricted to just monetary costs; it can be used with other units of measure, such as time in workdays or, less commonly, units of a specific resource or material. Calculating EMV is simple once you have obtained the probability in percentage of an event occurring and the impact it is likely to have. The EMV is the product of these two; just multiply the impact by the percentage and you have your EMV. For example, a risk that has a 60 percent probability of occurring would cost $10,000. The EMV for this risk event is (0.6 * -10000), or -$6,000. Because the outcome is negative, this risk is a threat, not an opportunity. The final set of inputs to developing the total contingency reserve are the sum of total contingency reserves for each risk and the organizations practices for cost and time management. It is important to get signoff on the contingency reserve, and following set standards for allocating budget and schedule increase the chances of getting the contingency reserve approved2.

Communicating the Contingency Reserve Once calculated, the contingency reserves are added to either budget or schedule depending on the unit calculated. The project finish date adjusted for contingency reserve becomes the No Later Than date, while the budget adjusted for contingency reserve becomes the Not To Exceed budget. It is important that the contingency reserve is communicated in this way and not as the new finish date or project budget. While some contingency reserve will almost certainly be used, it is based off the EMV and will not adequately cover all project risks should they occur. In the above example, the EMV of the risk event is $6,000, but if it occurs, it will still cost $10,000, not $6,000. Plotting contingency reserve against the schedule or budget is a good way to keep track of both. The charts below show contingency reserve and project budget over time. As contingency reserve is used, the amount available decreases, while the project budget simultaneously increases.

Project Management Institute (2009). Practice Standard for Project Risk Management. Newtown Square, PA: Project Management Institute, Inc.

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Risk Exposure Over Time

$50,000 $40,000 $30,000 $20,000 $10,000 $0 Jan-14 Feb-14 Mar-14 Contingency Reserve
Figure 1.1. Risk Exposure Over Time

Apr-14

May-14

Project Budget Over Time

100,000.00 90,000.00 80,000.00 70,000.00 60,000.00 50,000.00 40,000.00 30,000.00 20,000.00 10,000.00 0.00 Jan-14 Feb-14 Mar-14 Apr-14 May-14

Figure 1.2. Project Budget Over Time

Using Contingency Reserve Contingency reserve is used when the risk occurs. Notice that the contingency reserve is higher near the beginning of the project and is lower near the end. This effect is consistent with project risk, which tends to be greater at the beginning of the project and less near the end. The main reason for this effect is that there are more unknowns at the start of the project than at the end. Also, as the project proceeds and risks either happen or do not happen, the reserves associated with those risks either are spent or not spent, lowering the overall reserve. As risks are reassessed, reserve analysis can also be performed again to reallocate some reserve to a risk or take some away based on the new risk probability and impact.

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One limitation of contingency reserve is that it is not as useful when there are only a few defined risks or all the risks have a high probability of occurring. If all the risks occurred, then the contingency reserve would be overrun because it is based off EMV, not impact. Conclusion The contingency reserve is a critical component of quantitative risk analysis. Developing a risk contingency reserve, using it on known risks, and tracking its use as the project progresses will help increase the predictability of project outcomes. Using EMV to calculate contingency reserve is a simple way to get started with harnessing the benefits of this powerful tool.

www.refineM.com contact@refineM.com 405 N. Jefferson Ave, Springfield, MO 65806 417.414.9886