After publishing my article entitled Evaluating Risks Using Qualitative Risk Analysis, I received questions on how to determine project budget reserves. Here are the questions and my answers. I welcome your comments and insights.
Project Budget Reserve Questions
Question: After evaluating risks qualitatively, do you set aside some dollars for a contingency reserve?
Answer: The short answer is yes. Contingency reserves are for “known risks” identified in risk management. The contingency reserves cover residual risks in the project and account for cost uncertainty such as rework.
Imagine a project budget with no reserves. The project manager is basically saying there will be little to no problems. The project manager expects to deliver every task with no negative impacts to the budget. A wise project manager will identify risks, assess risks, and recognize the potential impacts by adding appropriate reserves to the budget.
Question: How do we estimate a contingency reserve?
Answer: The Project Management Body of Knowledge (PMBOK) says that contingency reserves may be a percentage of the estimated cost, such as 5% – 10% of the estimated cost.
For example, a project manager may estimate the project cost to be $100,000. Assuming a 10% contingency reserve, the project manager would estimate the contingency reserve to be $10,000 (i.e., $100,000 x 10%). The project manager would add the contingency reserve to the project estimate resulting in a cost baseline of $110,000.
Question: How can I perform a quantitative risk analysis? Why do this?
Answer: The PM may perform a quantitative risk analysis using a technique such as the Expected Monetary Value (EMV). EMV = Probability x Cost Impact. Notice in the example below, we add the positive risks (i.e., opportunities) and the negative risks (i.e., threats) together resulting in an EMV of $21,000.
The project manager would add the $21,000 to the $100,000 project estimate resulting in a cost baseline of $121,000.
Why do we perform quantitative risk analysis? Quantitative risk analysis takes more time than the qualitative risk analysis. However, the quantitative risk analysis provides greater detail for decision making. The project manager also has a better basis for justifying the reserves.
Question: What is the management reserve? How do we estimate the management reserve?
Answer: Management reserves are for “unknown risks” or risks that were not identified in risk management. A common method for estimating the management reserve is to add 5-10% of the cost baseline for the management reserve.
Assuming a cost baseline of $121,000 and a 5% management reserve, the project manager would calculate the management reserve as $6,050 (i.e., $121,000 x 5%). The $6,050 management reserve would be added to the $121,000 resulting in a total project budget of $127,050.
Things to keep in mind:
- The PMBOK says that reserves may be used, reduced, or eliminated over time. Not everyone agrees with reducing unused reserves. Project managers should determine if reserves will be reduced or eliminated during the project, how this will occur, and when. Include this information in your Cost Management Plan.
- The range of reserves and confidence levels change over time. As project managers progressively elaborate the project, confidence in the budget estimates should increase. During the Initiating Process, a Rough Order of Magnitude Estimate could be +/- 50% from actual. During the Planning Process, a Budget Estimate might decrease to a range of –10 to +25% from actual. Later in the project, the Definitive Estimate might be a range of +/- 10% from actual.
- If you track contingency and management reserves in your organization for multiple projects, you will discover what makes sense. Adjust the reserve estimates accordingly for future projects.
- Reserves should be used when risks occur (e.g., threats occur resulting in issues). Reserves should not be used for gold plating a project. Use change control where appropriate.
Question: How do you establish your project reserves? What do you find most difficult about this process?
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