During the risk management planning process, first of all you identify and qualify the risk. Then the next step is to calculate the contingency and management reserve.
Calculating these reserves is an important part of your project management planning. 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 that they are the same.
Some people think that they are just a percentage of the project cost. This is because in many small to medium sized organizations project managers take a percentage of the project cost for all kinds of risks. They do so 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, they are calculated with different techniques, and they serve different purposes.
Anyway, in this blog post I’m going to discuss these two kinds of reserves in detail.
Okay, let’s get started.
You manage identified risks or “known-unknown” (known=identified, unknown=risks) with the contingency reserve. This reserve can be 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 will use this reserve at the time of risks occurring. The risk owner can update the project manager at later stages.
How to Calculate the Contingency Reserve
As I have said earlier, there are various techniques to calculate the contingency reserve. Some of them are as follows:
- Percentage of the Project’s Cost
- Expected Monetary Value
- Decision Tree Analysis
- Monte Carlo Simulation
Now we are going to discuss them in detail.
Percentage of the Project’s Cost
Many small and medium sized organizations use this technique. You can also use this technique when the project size is small and not complex. This helps you save money and resources.
Here you take a percentage of the cost of the project and calculate the contingency reserve. Usually this percentage lies between 3% to 10%.
Expected Monetary Value
Expected monetary value is a statistical technique. It is 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 or the stakes are high.
To find the expected monetary value, you calculate the probability and impact of each event. Once you get these data, you multiply them together.
Expected Monetary Value (EMV) = Probability * Impact
Likewise you will calculate the EMV of all identified risks and add them together.
Please note that you will calculate the EMV of all risks, regardless of whether they are positive or negative.
Let’s say you have four risks with probabilities and impacts as follows:
From the above table you can say that you may need 4,500 USD to manage all negative risks, but this is not so.
Because not all risks are going to happen at the same time. Some of them may happen and some of them may not. The risks that do not occur will add their EMV to the pool and the risks that do occur will use the money from the pool.
So, 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 spread of the reserve will be better among all risks.
If you have identified fewer risks, you will not get enough spread and your reserve may dry up sooner.
The expected monetary value technique has a few drawbacks, and some of them are as follows:
- In the calculation you assume that all risks are independent, though in reality many times this is not the case.
- If the amount of risks is less, the spread will be less and the reserve will 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 will be given many choices with their probability of occurring and their impact.
You will have to find the expected monetary value of each event and select the best choice.
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 highest one. Here you are trying to get the maximum profit.
Okay, let’s find out the EMV of all three events.
In the graph you can see that you have been given the probability of one event. The probability of 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 every event has only two choices and the sum of both choices 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 will choose that one.
Keep in mind that if all risks are negative, you select the lowest option. This is because you want to spend less 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, let’s discuss the use of the Monte Carlo simulation in analyzing the project schedule.
To perform the Monte Carlo simulation to determine the schedule, you must have duration estimates for each activity.
Let’s say that you have three activities with the following estimates (in months):
According to the PERT estimate, these three activities will be finished in 17.5 months.
In the best case it will be finished in 16 months, and in the worst case it may take 21 months.
Now, if we run the Monte Carlo simulation for these tasks five hundred times, it will show us results like this:
(The above information is for illustration purposes only, and is not taken from an actual Monte Carlo simulation test result.)
After reviewing the result of the above Monte Carlo simulation you can say that there is a 2% chance of completing the roject 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 also.
For example, here you can get data like: if you add 20,000 USD to the project cost there is a 70% chance that you can complete the project within budget, if you add 40,000 USD to the project cost there is a 95% chance that you can complete the project within budget, etc.
So, you can see that with the help of this technique you can get valuable information which will help you make a better informed decision.
As you move forward, the situation becomes clearer and then 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 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 random 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 is 10%. Usually the management reserve is guessed based on the uncertainty of the project.
If you are doing a project in which your organization has expertise, the management reserve will be less, because 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 has to get approval from management to use this reserve.
Many organizations try to avoid using this kind of reserve. They think that if the project manager has to come to them every time to get approval, then why keep it separate? According to them, the project manager can come any time they need extra money, so there is no need for any management reserve.
You may be wondering why I have brought up this cost management concept here.
This is important: You must understand the relationship between contingency reserve, management reserve and the project budget.
Without these reserves, you cannot estimate the cost baseline and project budget.
Let’s discuss it in detail.
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.
When you add the contingency reserve to the cost estimate, you get the cost baseline.
Cost Baseline = Cost Estimate + Contingency Reserve
Please note that your 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 the situation to use the correct type of reserve.
Here I am going to list a few cases where you should not use the management reserve in any case.
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.
After following all these steps, the situation will become familiar. 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 must 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.
- Usually contingency reserve is a calculated reserve and management reserve is a percentage of the project cost.
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.
Usually project managers try using contingency or management reserves for gold plating and crashing. They do so to avoid going to the management for more funds.
This is an incorrect practice and you must refrain from doing it.
Here is where the discussion about contingency reserve and management reserve ends. If you have any comments, you are free to post them in the comments section.
This topic is important from a PMP and PMI-RMP exam point of view. You may see a few questions on this topic in your test.