Many are familiar with the concept of project contingency, but may not know how the value is initially calculated, when it is drawn from, and how to effectively generate an appropriate draw down curve. First let’s review the general concept of project contingency and its purpose.
When estimating the cost of a project, there exists a level of uncertainty ranging from cost of equipment, execution strategy, unspecified scope of work, or even local work conditions. “Cost Contingency” is defined as the amount added to an estimate to allow for items, conditions, or events that are uncertain but will likely result in cost increase. However, there are some key items that contingency is not typically intended to cover (although sometimes is):
- Major scope changes: contingency exists to cover growth in original scope, and sometimes minor scope growth. It is not intended to fund growth as a result of items such as a change in capacities, building sizes, or production specifications.
- Major force majeure or catastrophic events such as a flood or wild fire.
- Management reserves
- Escalation or currency exposure
Another key note is that when a contingency budget is established, it is anticipated that it will be spent. It is not until it is near certain or even project completion that a project team would recognize unused contingency as savings.
It may sound like contingency is a random number pulled from a hat to cover future cost, but there are multiple methods used to determine contingency budget values.
- Estimator experience and judgment.
- Monte Carlo Simulation using probability analysis (preferred)
- Parametric modeling using regression analysis
- Percentage allocation of TIC
No matter the method chosen to establish the projects initial contingency position, the outcome will only be as good as the defined risks. The better the project team can define respective risk, the better you can risk range your events and run your simulation accordingly.
Once you have established your contingency budget (contingency template to follow), you must then develop a drawdown plan that reflects the means in which you believe the money will be re-allocated to a specific budget. This is done in order to be able to evaluate the health of your contingency position each month, and determine if you have enough contingency for the duration of the project. You should note that the contingency budget is not a direct spending account, but rather a fund of money that is drawn from to increase specified budget accounts established by the estimate. In other words you will always decrease your contingency budget by the same value you increase the budgets you are allocating the money to. This means there will always be a $0 impact to the total indicated cost.
As is seen with many projects, often times the original contingency budget is not enough to complete the project. When this situation presents itself, the project team must re-evaluate the active project risks, and re-run a simulation to establish a new contingency budget. Due to the nature of this practice, it remains very important that the project team maintain an active risk register and change management log.
In order to be able to support the actual contingency drawdown, it is common practice to keep a change management log that represents the specific events that have impacted the contingency position. Each month this change management log should be reconciled to the contingency position and should be reflected in the corresponding cost reports. The more detailed and accurate your change management log, the easier it is to both manage your contingency budget, but recognize potential future impacts that may jeopardize the health of your contingency.