Risks occur in every project and as a project manager, it is your responsibility to manage them as they occur. These risks can be identified or unidentified. If these risks are identified, you will implement the contingency plan; otherwise, you will manage them through a workaround.
To manage these risks, you will use the contingency reserve and management reserve. These reserves are defined during the risk management planning process. The contingency reserve and management reserve provide you with a cushion against the risks and are part of your project budget.
Many professionals assume these reserves are the same since they serve the same purpose. Generally, small and medium-sized organizations do not differentiate between them and take them as a percentage of the project cost to keep things simple. Therefore, professionals that have experience with these organizations may not know the difference between contingency and management reserves.
You manage identified risks with the contingency reserve. This reserve can be in either cost or time.
The contingency reserve is not random; it is an estimated reserve based on various risk management techniques.
Project managers control this reserve; they have full authority to use it whenever an identified risk occurs. They can also delegate this authority to a risk owner. The risk owner will manage it and update the project manager in later stages.
How to Calculate the Contingency Reserve
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 will discuss each technique in detail.
Percentage of the Project’s Cost
Small and medium-sized organizations use this technique for small projects; it helps save money and resources.
Basically, you take a percentage of the cost of the project to calculate the contingency reserve, which usually lies between 3% and 10%. This number is based mainly on the perceived risk of the project.
Expected Monetary Value
Expected monetary value is a statistical technique used to quantify risks and help calculate the contingency reserve. This technique is used in medium to high-cost projects, where the stakes are too high to risk the project failing.
To find the expected monetary value, first, you will calculate the probability and impact of each event, then multiply them together to generate the EMV of each risk.
Expected Monetary Value (EMV) = Probability * Impact
Then add the calculated EMV of all identified risks together.
Assuming you have four risks with probabilities and impact:
From the above table, you could argue that the funds needed to manage all identified risks is 4,500 USD, but this would be incorrect.
Not all possible risks are guaranteed; some may happen and some may not. All risks will add their EMV to the pool. The risks that do occur will use money from the pool, but the risks that do not occur will help cover the cost of those that did.
In the above scenario, 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 many risks because the more you can identify, the better the spread of the reserve. If you have identified fewer risks, there will not be enough spread, and the reserve may dry up.
The EMV technique has a few drawbacks, which include:
- You assume that all risks are independent, which is not always 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 a false result.
Decision Tree Analysis
Decision tree analysis is a quantitative risk analysis technique. This technique helps you select the best choice. This is a graphical technique that looks like a tree, hence its name.
Here, you determine the expected monetary value of each event and select the best choice.
Calculate the expected monetary value of the best choice.
In this example, you have three choices: Choice A, Choice B, and Choice C.
As seen from the figure above, all three choices represent opportunities. Therefore, you will find the expected monetary value of the three events and go with the most favorable. You are trying to get the maximum profit.
Now, let us calculate the EMV of all three events.
In the diagram, you were given the probability of one event, while the probability of the other event is not provided. To find the other probability, you have to subtract the probability of the first event from 100, because the sum of all possible outcomes for one event is 100%.
EMV of Choice A = 0.30*200 + 0.70*400
= 60 + 280
= 340 USD
EMV of Choice B = 0.40*300 + 0.60*200
= 120 + 120
= 240 USD
EMV of Choice C = 0.2*500 + 0.80*200
= 100 + 160
= 260 USD
You have to choose the one with the highest EMV, which is Choice A.
Note that if all risks are negative, you select the least negative option. This is because you want to spend the least amount of money on managing risks.
Monte Carlo Simulation
In 1940, an atomic nuclear scientist named Stanislaw Ulam invented this technique and named it Monte Carlo after the city in Monaco, which is famous for its casinos.
This technique gives several possibilities of 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 use this technique, you must have duration estimates for each activity.
You have three activities with the following estimates (in months):
According to the PERT estimate, these three activities will end in 18.3 months.
Best case, it will take 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:
(The above information is only for illustration purposes and is not from an actual Monte Carlo simulation test result.)
After reviewing the results, you can determine that 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 gives 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, it’s clear that with the use of this technique you can get valuable information that will help you make better-informed decisions.
As you proceed, you will become more familiar with the situation and you can review this contingency reserve again. If required, this reserve can be reduced and you can release the funds.
The management reserve is defined as the cost or time reserve that is used to manage the unidentified risks or “unknown-unknown”.
The management reserve is a part of the project budget but not the cost baseline. It is not an estimated reserve; it is a figure that is fashioned according to the organization’s policies.
It can be 5% of the total project cost or duration of the project or it may be as high as 10%. The management reserve is usually estimated based on the uncertainty of the project.
For example, if you are doing a project in which your organization has the expertise and experience, the management reserve will be less. In this case, there is less uncertainty.
However, if you are doing a kind of project new to your organization, the management reserve will be high, because, in this situation, the uncertainty is greater.
The project manager does not control management reserve, the management does. Therefore, the project manager must receive approval to use this reserve whenever any unidentified risk occurs.
Many organizations try to avoid using the management reserve. They think if the project manager has to come to them every time to get approval, then why keep it separate? The project manager can come any time they need extra money; so why have a management reserve?
On the PMP exam, you will see many questions on contingency reserve, management reserve, cost estimate, and the project budget. These are crucial concepts; without these reserves, you cannot estimate the cost baseline and project budget. Therefore, for your easy reference, I am explaining these topics here as well.
The cost estimate is the cost of all work packages and is “rolled up” to the top level; this is the total cost of the project.
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 and serve different purposes.
Below are a few cases where you should not use the management reserve.
When You Are Over Budget
You have to estimate the new budget and try to get it approved. You should never use the management reserve to compensate for cost overrun.
The management reserve is for unidentified risks, not to cover the cost overrun.
While Using Schedule Compression Techniques
There are two schedule compression techniques: fast tracking and crashing.
Schedule compression may lead to new risks. Identify those risks, prepare a response plan, and calculate the new contingency reserve. You will need to get it approved.
You can revisit your management reserve for a review as well.
However, in crashing, you use extra resources. After you complete the planning for crashing, you have to revisit your risk management planning.
You should avoid gold plating and you should not use the management reserve for it, this increases the risk and changes the scope.
I often receive emails from my visitors asking me why we cannot use the management reserve for the fallback plan.
By definition, the management reserve is used for unknown risks.
A fallback plan is not used for unknown risks; it is a plan for known risks when the primary response plan fails. Therefore, you will use the contingency reserve for this plan, not the management reserve.
Since residual risks are identified risks, you will use contingency reserve to manage these risks.
The Difference Between Contingency Reserve and Management Reserve
The following are a few differences between the contingency reserve and management reserve:
- The contingency reserve is used to manage identified risks, while the management reserve is used for unidentified risks.
- The contingency reserve is an estimated figure, while the management reserve is a percentage of the cost or duration of the project.
- The project manager has authority over the contingency reserve, while for the management reserve, they need management’s permission.
- The contingency reserve is a part of the performance measurement baseline, while the management reserve is not.
To complete your project successfully, you will have to be proactive in risk management. The contingency reserve and management reserve are the backbones of your risk management, as they provide you with the means to manage risks. The contingency reserve and management reserve are not the same; they are calculated with different techniques and serve different purposes. The contingency reserve is for identified risks and is a part of your cost baseline while the management reserve is for unidentified risks and is a part of your budget.
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 exam.
How do you calculate the management reserve and contingency reserve on your projects? Please share your thoughts in the comments section.