After publishing my article entitled Evaluating Risks Using Qualitative Risk Analysis, I received questions on how to determine project budget reserves. Here are my answers.
Project Budget Reserves: Questions and Answers
Question #1
After evaluating risks qualitatively, do you set aside some dollars for a contingency reserve?
The Answer:
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.
Consider a project budget without any reserves. In this case, the project manager is essentially declaring that they expect no or minimal issues. They plan to complete every task without affecting the budget. However, a responsible project manager will anticipate potential risks, evaluate their impact, and mitigate them by incorporating suitable reserves into the budget. This proactive approach is crucial for preventing budget overruns and ensuring project success.
Question #2
How do we estimate a contingency reserve?
The Answer:
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.
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Contingency reserves are for “known risks” identified in risk management.
Question #3
How can I perform a quantitative risk analysis? Why do this?
The Answer:
The project manager may perform 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.
Risk | Probability | Impact | EMV |
|---|---|---|---|
A (Threat) | 10% | $100,000 | $10,000 |
B (Opportunity) | 40% | ($10,000) | ($4,000) |
C (Threat) | 30% | $50,000 | $15,000 |
Total EMV | $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 #4
What is a management reserve? How do we estimate this reserve?
The 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.
Other Project Reserves Tips
- The 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 on the project, confidence in the budget estimates should increase. A Rough Order of Magnitude Estimate could be +/- 50% of the actual when initiating a project. The Budget Estimate range might decrease to –10 to +25% from the actual while planning a project. Later in the project, the Definitive Estimate might range from +/- 10% from the actual.
- By tracking contingency and management reserves in your organization for multiple projects, you will gain valuable insights. This experience will guide you in adjusting the reserve estimates for future projects, empowering you with the knowledge to make informed decisions.
- Reserves should be used when risks occur (e.g., threats arise, resulting in issues). Reserves should not be used for gold plating a project. By using change control where appropriate, you can ensure that any changes are managed effectively, providing a sense of reassurance and control.
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"Intelligent leadership, creative communication and depth of technical skill all describe Harry Hall." –John Bartuska, Director of HR–ONUG Communications