Saturday, October 20, 2018

Contingency vs Management Reserve

During the risk management planning process, you first identify and qualify the risk. The next step is to calculate the contingency and management reserve.
These reserves provide you with a cushion against known and unknown risks. Without contingency and management reserves, you cannot estimate your project cost and budget. These reserves are an inseparable part of your budget and help you manage risks.
Since both reserves serve the same purpose, managing risks, many professionals assume they are the same.
Some also think that they are just a percentage of the project cost because in many small to medium-sized organizations project managers take a percentage of the project cost for all kinds of risks, often because of a lack of resources or the simplicity of the project.
Keep in mind that contingency reserve and management reserve are not the same. They are different, calculated with different techniques, and serve different purposes.
Contingency Reserve
You manage identified risks, or “known-unknown” (known = identified, unknown = risks), with the Contingency Reserve. This reserve can be measured in either cost or time.
Contingency reserve is not a random reserve; it is an estimated reserve based on various risk management techniques.
This reserve is controlled by the project manager. The project manager has full authority to use it whenever any identified risk occurs. They can also delegate this authority to the risk owner, who, in turn, will use this reserve at the time of the risk occurrence. The risk owner can update the project manager at later stages.

How to Calculate the Contingency Reserve

There are various techniques to calculate the contingency reserve. Some of them include:
  • Percentage of the Project’s Cost
  • Expected Monetary Value
  • Decision Tree Analysis
  • Monte Carlo Simulation
Percentage of the Project’s Cost
Many small and medium-sized organizations use this technique. You can also use this technique when the project is small and not complex. This can help you save money and resources.
In this technique, you take a percentage of the cost of the project and calculate the contingency reserve. Usually, this percentage lies between 3% and 10% and is largely based on the perceived risk of the project.

Expected Monetary Value

Expected monetary value is a statistical technique used to quantify the risks, which helps you calculate the contingency reserve. This technique is used in medium to high-cost projects where you have enough resources and cannot risk the failure of the project because the stakes are high.
To find the expected monetary value, you calculate the probability and impact of each event. Once you calculate this data, you multiply probability and impact together to generate the EMV of each risk.
Expected Monetary Value (EMV) = Probability * Impact
Once you have calculated the EMV of all identified risks you add them together.
Please note that you should calculate the EMV of all risks, regardless of whether they are positive or negative.
Example
Let us say you have four risks with probabilities and impacts as follows:
contingency reserve management reserve expected monetary value
From the above table, you could argue that you may need 4,500 USD to manage all the negative risks, but this would not be correct.
Not all possible risks are going to happen. Some of them may happen and some may not. All risks will add their EMV to the pool. The risks that do occur will use the money from the pool, but the risks that do not occur will not use money from the pool. Their unrealized risk will help cover the cost of those risks that did occur.
In the above case you may need to add 1,100 USD to your budget to cover all identified risks.
The expected monetary value concept works well when you have a lot of risks, because the more risks you identify, the better the spread of the reserve will be among all risks. If you have identified fewer risks, you will not get enough spread and your reserve may dry up too soon.
The expected monetary value technique has a few drawbacks, including:
  • In the calculation, you assume that all risks are independent, though in reality this is many times not the case.
  • If the number of risks is small, the spread will be less and the reserve may be insufficient.
  • There is a chance of avoiding positive risks, which may lead to you a false result.

Decision Tree Analysis

Decision tree analysis is a quantitative risk analysis technique. This technique helps you select the best choice from many available options. This is a graphical technical which looks like a tree. Hence, it is known as decision tree analysis.
In a decision tree calculation, you determine multiple choices and the probability of each occurring as well as the impact. You will also need to find the expected monetary value of each event and select the best choice.
Example:
contingency reserve management reserve decision tree.png
Calculate the expected monetary value of the best choice.
In the given example, you have three choices: Choice A, Choice B, and Choice C.
As you can see from the figure, all three choices are representing opportunities. Therefore, you will find the expected monetary value of three events and go with the most favorable. Normally you are trying to get the maximum profit.
Okay, let us find out the EMV of all three events.
In the diagram, you have been given the probability of one event. The probability of the other event is not given. To find the other, you will have to subtract the percentage of the first event from 100%.
This is because the sum of all possible choices for one event is 100%.
EMV of Choice A = 0.25*200 + 0.75*350
= 50 + 262.5
= 312.50 USD
EMV of Choice B = 0.45*300 + 0.55*400
= 135 + 220
= 355 USD
EMV of Choice C = 0.2*450 + 0.8*200
= 90 + 160
= 250 USD
You can see that the EMV of Choice B is the highest, so you should choose that one.
Keep in mind that if all risks are negative, you select the least negative option. This is because you want to spend the least on managing the risks.

Monte Carlo Simulation

This technique was invented by an atomic nuclear scientist named Stanislaw Ulam in 1940. It was named Monte Carlo after the city in Monaco which is famous for its casinos.
This technique gives you a range of possible outcomes and the probabilities for any choice of action.
For example, we will discuss the use of the Monte Carlo simulation in analyzing a project schedule. To perform the Monte Carlo simulation to determine the schedule, you must have duration estimates for each activity.
You have three activities with the following estimates (in months):
pert
According to the PERT estimate, these three activities will be finished in 18.3 months.
In the best case, it will be finished in 15 months, and in the worst case it may take 23 months.
Now, if we run the Monte Carlo simulation for these tasks five hundred times, it will show us results like this:
contingency reserve management reserve monte carlo 2.png.jpg
(The above information is for illustration purposes only, and is not taken from an actual Monte Carlo simulation test result.)
After reviewing the results of the above Monte Carlo simulation, you can determine there is a 2% chance of completing the project in 16 months, or a 70% chance of completing the project in 19 months, or a 95% chance of completing the project in 20 months, etc.
Likewise, you can run the Monte Carlo Simulation for the budget.
For example, you can generate data like: adding 20,000 USD to the project cost produces a 70% chance that you can complete the project within the budget. If you add 40,000 USD to the project cost, there is a 95% chance that you can complete the project within the budget, etc.
So, you can see that with the use of this technique you can get valuable information which will help you make better informed decisions.
As you move forward, the situation becomes clearer and you can review this contingency reserve again. If needed, this reserve can be reduced or eliminated.
Contingency reserve is used to manage known risks including residual risks. Keep in mind that a fall back plan also uses the contingency reserve, as this is the plan used for identified risks.

Management Reserve

Management reserve is the cost or time reserve that is used to manage the unidentified risks or “unknown-unknown” (unknown = unidentified, unknown = risks).
Management reserve is not a part of the cost baseline, and the project manager needs management’s permission to use this reserve.
Management reserve is not an estimated reserve. It is a figure which is defined according to the organization’s policy.
For some organizations it is 5% of the total project cost or duration of the project, and for others it may be as high 10%. Usually, the management reserve is estimated based on the uncertainty of the project.
For example, if you are doing a project in which your organization has expertise, the management reserve will be less. In this case there will be less uncertainty. However, if you’re doing a new kind of project where your organization has less, or no, expertise, the management reserve will be high, because in this case the uncertainty will be more.
Management reserve is not controlled by the project manager; it is managed by the management of an organization. Whenever any unidentified risk occurs, the project manager should receive approval from management to use this reserve.
Many organizations try to avoid using this kind of reserve. The opinion is that if the project manager has to come to them every time to get approval, then why keep it separate? The thinking is that the project manager can come any time they need extra money, so there is no need for any management reserve.

Project Budget

You must understand the relationship between contingency reserve, management reserve, and the project budget. These are important concepts. Without these reserves, you cannot estimate the cost baseline and project budget.
Let us discuss it in detail.

Cost Estimate

The cost estimate is the cost of all work packages and is “rolled up” to the top level. This is the total cost of your project.

Cost Baseline

When you add the contingency reserve to the cost estimate, you get the cost baseline.
Cost Baseline = Cost Estimate + Contingency Reserve
Note that the project’s performance will be measured against the cost baseline.
If you add the management reserve to the cost baseline, you will get the project budget.
Project Budget = Cost Baseline + Management Reserve

When You Cannot Use the Management Reserve

Management reserve and contingency reserve are different reserves and serve different purposes. You should be able to differentiate between the situations and use the correct type of reserve.
Below are a few cases where you should not use the management reserve.

When You Are Over Budget

If you are over budget, estimate the new budget and try to get it approved. When you are over budget, you should never use the management reserve to compensate for cost overrun.
The management reserve is for unidentified risks, not to cover cost overrun.

While Using Schedule Compression Techniques

You have two schedule compression techniques: fast tracking and crashing.
Usually, in fast tracking you may encounter some risks. The first step is to identify those risks, prepare a response plan, and update the contingency reserve, though you may need to get it approved.
You can also revisit your management reserve for a review.
The situation will become familiar after following all these steps. For identified risks you will use the contingency reserve and for unidentified risks you will use the management reserve.
However, in crashing you are authorized to use extra resources. After you complete the planning for crashing you must revisit your plan for any new risk.

Gold Plating

Gold plating should be avoided and you should not use the management reserve for it. Gold plating increases the risk and changes the scope.

Fall Back Plan

I have mentioned it earlier and am reminding you again about this point. I often receive emails from my visitors asking why we cannot use the management reserve for the fall back plan.
By definition, the management reserve is used for unknown risks.
A fall back plan is not a plan for unknown risks, it is a plan for known risks when the primary risk response plan fails. Therefore, you will use the contingency reserve for this plan, not the management reserve.

The Difference between Contingency Reserve and Management Reserve

The following are a few differences between contingency reserve and management reserve:
  • Contingency reserve is used to manage identified risks, while management reserve is used to manage unidentified risks.
  • Contingency reserve is an estimated figure. Management reserve is a percentage of the cost or duration of the project.
  • The project manager has authority over the contingency reserve. For management reserve, they need management’s permission.
  • Contingency reserve is a part of the performance measurement baseline while management reserve is not.

Summary

To successfully complete your project, you will have to manage all risks proactively. If you fail to do so, your project may not be able to be completed successfully. Try to identify as many risks as you can and calculate the contingency and management reserve. Once you get approval, the next job is to use them wisely in your project.
Do not spend these reserves on gold plating, crashing or any other technique. Avoid gold plating and request a budget revision for crashing. Many times, project managers try to use contingency or management reserves for gold plating and crashing. They do so to avoid going to the management for more funds. This is a poor practice and you should refrain from doing it.

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