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Your new project was approved for funding. That in itself is a huge step. You wouldn’t believe the number of project managers I speak to on mentoring calls who struggle to get their budget approved.
You can’t do much on a project without some funding behind you.
However, before you start the celebration too soon, there are always details to check first.
What exactly got approved? How much do you have and what boundaries and constraints come with it? You will likely have lots of questions. Not least: is it enough? Does the funding include contingency? (Because you put some in the request, right?)
If you’re wondering what budget contingency is, then you have come to the right place. This article will explain project contingency, how to calculate contingency and how to manage it within the scope of your projects.
In this article:
- What is project contingency?
- Why is contingency important?
- How to calculate contingency
- How to manage contingency funds
- How to access contingency funds
- What is a contingency plan?
- Quick questions
- Your next steps
What is project contingency?
Contingency can be defined as additional resources put aside to address potential risk and uncertainty in a project.
There are two types of contingency typically used on projects:
- Budget contingency: Additional funding to deal with problems, realized risks relating to a specific event
- Schedule contingency: A buffer of extra time in case of schedule delays (not that you would ever pad your estimates?)
Why is contingency important?
Only 62% of projects complete within their original budget, according to PMI’s 2021 figures. No organization wants a cost overrun to scupper their budget. However hard you try, you simply can’t predict the future and anticipate every problem.
Contingency allows us to present final budget estimates as a range, as you can see in the Figure below.
Take the cost baseline, add in the mitigation costs for dealing with ‘general’ risks and residual risks, and that will give you the final cost of the project – the IPA Guidance is specifically for construction budgets but the general premise is useful as best practice for all kinds of projects.
So risk is critical to understanding contingency: that’s the first step.
Read next: 14 Common Project Risks – perhaps some of these will contribute to your contingency position?
Why risk matters
It is not practical to document the infinite number of things that could go ‘wrong’ on a project. As a project manager, our reality is that we expect the unexpected to happen.
From your previous experience, you may have a general idea of what is most likely to happen. Even if you do, you still need a plan and potential options to address things when they do happen.
That’s where project contingency comes in. Think of it as the promise of additional resources (typically time and/or money) allocated in a project to address possible risks and uncertainty. The reason we do this is to help increase the likelihood that the project will be completed at or below the approved amount for funding.
Schedule contingency might take the form of additional time or a buffer in a project schedule. For example, on a project, we might factor in an additional several days or even weeks to accommodate unforeseen delays.
Project scope and complexity can also be a factor. For example, a high complexity project using a new technology may require additional time to complete and funding to address any unexpected challenges.
How to calculate contingency
The basic process for calculating project contingency is:
- Determine the level of risk/uncertainty in the work (at work package level if you are using work packages).
- Work out how much money to put aside based on the risk.
- Ringfence that amount until it is needed
- Contengency reserves are available at Work Package and Activity levels (see image below).
4 Common methods for calculating contingency
The UK Government’s Infrastructure and Projects Authority launched Cost Estimating Guidance for infrastructure (construction) projects in 2021 which covers the whole process for creating a budget from estimates, of which contingency calculations are a part.
The guidance says:
“Projects should reserve funding to address the impact of risks materializing. This funding should be proportional to the impact of the risk and adjusted to the probability of the risk materializing. The project contingency is therefore cost estimated at a probability value. The project team must evaluate an optimistic, median and pessimistic spend to face risks.”
Let’s look at 4 common methods for calculating those costs for your contingency plan – don’t worry, there are some easy wins here as well as more complicated calculations.
1. Easy method: Use established contingency levels
Some businesses have established contingency levels that are acceptable for projects. For example, some might simply add 5% to 10% to the base cost of a project. For a $1 million project, this would be an additional $50,000 to $100,000.
This is what I use. If in doubt, stick 10% on your budget. Make sure it is called out transparently in a line on its own so it is clear that it is contingency funding.
Advantages: Quick! You end up with some contingency funds instead of none.
Disadvantages: Barely any probability-related thought has gone into this at all. It’s just guessing.
2. Robust method: Risk analysis
Use the risk management process to carry out a risk assessment. Then work out the risk budget required to adequately address each risk.
Tip: Use subject matter experts at this point to establish what cost contingencies might be needed to deal with the risk. They can give you an estimated amount for key items on the risk register. They can also give you an indication of the degree of uncertainty associated with their estimate. Previous projects are a good source of information.
Project managers create and maintain a risk register throughout a project’s lifecycle. The risk register is a summary of all potential risks that might occur during a project’s lifecycle, and that could have undesirable consequences on a project’s cost, schedule, etc.
In this model for contingency planning, the total value of those identified risks match the total contingency allocated to the project. This helps provides justification for keeping those contingency funds in reserve. An example is shown in the table below.
|Resources lack training||Training||Additional cost and time for training||Provide training after kick-off||$5,000|
|Misalignment on scope – customer requests changes||Scope||Additional hours for re-work||– Discuss at kick-off |
– Get sign off for intermediate deliverables
|Scope unclear for 1 deliverable due to incomplete design – rework required||Scope||Additional hours for re-work||Get customer feedback on prototype||$10,000|
Here’s how to assess the potential cost impact of a risk:
- Work out the full potential cost you would incur if the risk happened.
- Calculate the expected cost or expected value based on how likely it is to happen (value = probability x loss). This is your risk exposure.
- Calculate the cost of management actions required if the risk occurred.
- Add the figures together for all risks to create your contingency budget.
In other words, this way of calculating contingency uses the risk exposure as a way of working out the additional costs that may be required to meet the project objectives if the worst happens.
Advantages: Logical. Easy to explain to the project sponsor and team members.
Disadvantages: Time-consuming to do that level of analysis on every risk.
Tip: If your project doesn’t warrant doing that level of analysis on every risk (because over here in real life, we have barely any time to dedicate to full risk management while trying to juggle multiple projects and not burnout), then do it for the major risks and use the % of project base estimate for everything else.
3. Advanced method A: Monte Carlo analysis
An advanced method for calculating project contingency is to quantify risk using a method like Monte Carlo simulations. To use this method, you need to understand and estimate the best, worst, and most likely effort needed to complete each task in a project.
Monte Carlo-based software randomly combines those different estimates to determine the overall probability that the entire project will be completed within a specific budget.
Advantages: You can select the desired probability or confidence in the final budget that is consistent with your desired risk tolerance. Your contingency is likely to be accurate for your needs.
Disadvantages: Creating those estimates and running the Monte Carlo simulation takes time and vetting the estimates is also critical. This option needs a lot of thought, time investment, and someone skilled at using the software. It’s overkill for small, low-risk projects.
4. Advanced method B: Class of estimate
Another advanced method for working out your contingency reserve amount is to define the class of estimate for your project budget (the level of certainty).
This is typically based on guidelines for different classes of cost estimates, as explained by the Association for the Advancement of Cost Engineering (AACE) and their classification of estimates.
The classifications are based on specific criteria for the level of project information available (data used as the basis of the estimate). More detail means a tighter tolerance or increased likelihood that the project cost will fall without the desired range.
This method can be used with factored estimates that combine high-level or rough estimates, vendor quotes, and even previous costs from similar projects.
Advantages: You can perform the minimum level of work, engineering, or effort needed to meet the desired estimate range. For example, a Class 3 estimate might have a cost estimate range of -10%/+30%, while a Class 5 estimate has a range of -3%/+15% but Class 5 does require additional work and time to better define the project and achieve the tighter estimate tolerance.
Disadvantages: If you had to read that section twice, you are not alone! This is a specific and complex way of working that will suit certain projects but if you don’t already know your project falls into that category then skip this method.
Note: A management reserve is different from the amount of contingency you have. Management reserves have a different call-off process and might be used for unforeseen changes.
How to manage contingency funds
Ongoing review and validation of project risks and associated contingency should occur throughout a project.
In the example in the table above, the 3 main risks listed have a total impact of $65,000. If one of the risks no longer applies, let’s say resources do not need training, then the contingency can either be reassigned or released from the project.
If released, the contingency would become $65,000 – $5,000 (less the proposed training budget) = $60,000.
Experience shows that it is easier to release contingency than to add it back, so be sure to keep that in mind. Don’t hand back funding unless you are sure you won’t need it later!
Considerations for managing contingency
In addition to cost and schedule impact, the timing of potential risks should also be considered. You might assume that as a project nears completion that all contingency could be released.
The IPA Cost Estimating Guidance says that as a project:
“becomes more defined and scope and risks are further identified, the size and allocation of contingency must be revised.”
However, pay close attention as some projects have risk that is heavily weighted towards the end of the project. For example, if there are deliverables to review and acceptance does not occur until the end, there is a chance that some updates or rework may occur towards the end of a project.
Be sure to understand the timing of risk on a project and communicate that so that everyone is aligned on expectations.
How to access contingency funds
On one project early in my career, I wanted to use some contingency funding. I had a specific reason, and I knew the money was there. At least, I’d been told that it was.
But I couldn’t get it.
It seemed like no one knew the process for accessing the funding. Where were my contingency funds?
I learned to check the process for accessing the contingency budget (and ideally, to be in charge of it).
Your organization might have or require separate documentation for contingency release. There may be a formal process for requesting and allocating contingency funds if you do not manage them. This may be noted in the project risk register, or via a separate document or process.
Regardless of the process, you want to provide traceability that explains how and why the contingency funds were spent. That traceability is important to ensure transparency, in the event of a project audit, for potential stakeholder questions, etc.
What is a contingency plan?
What happens when a risk does occur? Technically, at this point, it becomes an issue. Before that ever happens, a good project manager, along with the support of their team, will have developed what is called contingency plans.
A contingency plan is the specific action (or actions) one takes if an identified risk occurs. It’s your Plan B. At least one or more contingency plans should be identified for each known risk.
For example, in the table above, resources lacking adequate training were identified as a risk. The impact of that risk could be that people will spend additional time due to inefficiency or perhaps they will need to do some rework.
The contingency plan for that is to provide training (at a cost of $5,000) to ensure technical alignment and higher efficiency. If the team does need training, the risk becomes an issue, and the contingency plan swings into action to provide that training at a cost of $5,000.
Project schedules can also make use of contingency plans. This is typically in the form of additional days incorporated in scheduled activities.
For example, for a project phase that takes 12 weeks, we might add roughly 10% (let’s say 5-7 additional working days) of contingency in the schedule. This is time to cover unknown technical issues that need to be addressed and might otherwise cause some delays. By building that time into the schedule, we can reduce potential schedule exposure.
What contingency should a project have?
There is no single answer to how much contingency a project should have. The level of contingency funding or schedule contingency is determined by how risky the project is.
How is project contingency calculated?
There are a few ways to calculate project contingency. A common and reliable method is to assess the mitigation costs for all known risks and use that as the basis for putting a value on risk exposure. That then becomes your contingency allowance figure.
What is an example of contingency?
Here’s an example of contingency: If there is a risk that the cost of a component part will increase, we could use past increases to forecast potential cost increases and include that in the contingency budget.
Your next steps
We have defined contingency, reviewed ways to calculate it, explained where to document it, and how to provide a contingency plan for when things do occur. Now it’s time to put that into action.
Your next steps are:
- Review the specific nuances of your project that are dependent on the project scope so you understand where the risk is.
- Make sure you have an existing cost estimate.
- Review your company’s financial guidelines for contingency (be sure to ask your financial contact).
However, this should give you enough information to get started and give you a better idea of what to expect through project completion. Now you can go out and celebrate securing your funding!