Part 1: Definitions. The Essential Guide to Understanding Risk Exposure, Contingency, and Management Reserve

Introduction

Have you ever been in a discussion where different people have different understandings of risk exposure, contingency reserves, and management reserves? Or have you been in a debate about who controls the risk mitigation cost and contingency cost?

If so, don’t worry; you are not alone. The concept of risk and contingency reserves is often debated, and few people have a common and complete understanding. This article aims to change that.

This guide is divided into two parts. Part 1 focuses on concepts and definitions, while Part 2 presents a scenario for applying these concepts and definitions.

Contractual Mechanism

Before diving into details, let’s clarify some concepts. International bodies like PMI and AACE have tried to establish universal definitions for risks and contingencies. However, the definitions, categorizations, and sometimes the calculations of risk and contingencies heavily depend on the project’s contractual mechanism. For example, the categorization and division of risks and contingencies in a lump-sum contract differ from those in a cost-plus or target-price contract, whereas in the latter, additional efforts are made for better cost transparency. This article will focus on risks and contingencies in lump-sum contracts.

Clarifying the Definitions and Concepts

Unless you are a quantity surveyor, professional cost engineer, or have long experience in commercial and finance, you might not be familiar with the several synonyms that refer to the same thing in budget and risk. Let’s start on the right foot by getting the definitions correct:

• Project Budget: Also known as project funds, project financial plan, project price or project expenditure. This is the total financial plan for a project, encompassing all costs necessary to complete it. It includes direct costs, indirect costs, contingencies, and management reserves.
• Cost Baseline: Also known as the estimated baseline, initial budget or authorized budget. It is a subset of the project budget, representing the approved project budget, excluding management reserves.
• Risk Exposure: Also known as risk probability cost and risk potential cost, risk liability or vulnerability cost. It is the potential financial impact of identified risks, calculated as the product of the probability of occurrence and the potential loss (Expected Monetary Value, EMV).
• Risk Mitigation: Also known as mitigation actions or responses. These are actions taken to reduce the likelihood or impact of risks, including strategies like avoidance, transfer, reduction, and acceptance.
• Contingencies: Also known as contingency reserves, risk allowances or risk set-aside funds. These are funds set aside to cover identified (known-unknown) risks that may occur during the project. They can be categorized as financial, technical, quality-related, etc.
• Management Reserve: Also known as white funds, executive reserve or crisis funds. This additional fund is set aside to cover unforeseen risks (unknowns), separate from the cost baseline but part of the overall project budget.

Getting the Costing Right

To get the project cost right, the project manager must account for risks and uncertainties in addition to the project’s direct cost. For this reason, risk assessment is essential. Some organizations have typical risks because their business is repetitive or more predictable over time, like manufacturing. However, in construction, especially infrastructure, risks evolve and change over time, requiring a strong risk management process not only at the project level but also at the program and enterprise level.

Types of Risks

Risk Type	Definition	Examples
External Risks	Originating outside the project or organization; beyond control.	Economic changes, political instability, natural disasters, market competition.
Internal Risks	Originating within the project or organization; within control.	Resource availability, technical challenges, management changes, project scope.

Categories of Risk

Risk Category	Definition	Examples
Known-Knowns	Well understood and expected risks; known probability and impact.	Regulatory compliance, scheduled maintenance.
Known-Unknowns	Recognized risks with uncertain impact and occurrence.	Weather delays, supplier delays.
Unknown-Unknowns	Unforeseen and unexpected risks; unknown probability and impact.	Innovative disruptions, pandemics.

Risk Exposure vs. Risk Mitigation

Risk Exposure: Risk exposure refers to the extent to which a project is vulnerable to various risks that could impact its success. It is calculated by understanding the full risk exposure and multiplying it by the probability. For example, imagine a risk of losing a resource, which will lead to 3 months lost in the project progress and recruiting process with a total cost of 30,000 CAD, and the probability of that happening is 50%. Then the risk expense is 30,000 CAD x 50% = 15,000 CAD.

Risk Mitigations (Pay to Save Concept): A project manager will determine that most of the risks in her risk register are known internal risks that require a response. Responses could include avoiding, transferring, or accepting to mitigate. Risk mitigations are strategies and actions taken to reduce the likelihood or impact of risks. This includes preventive measures, contingency plans, and response strategies. Mitigation efforts can involve additional resources, revised processes, enhanced training, or backup plans to handle potential issues. For the example above, the mitigation could be to enhance the working environment, promote the resources, and provide sophisticated training, with a cost of 6000 CAD.

Contingencies

Contingencies are funds allocated in the project budget to cover known-unknown risk types. Due to uncertainties, these costs are anticipated as potential expenses and placed at different levels in the cost baseline. Contingencies are not planned to cover changes in scope, faults in design, or low performance during the execution phase but to cover the anticipated risks that have been forecasted to happen, which might relate to omissions and errors or non-conformance to quality standards.

Methods of Calculating Contingencies:

1. Monte Carlo Simulation:
   • A statistical method that uses simulations to account for variability and uncertainty in project estimates. It provides a range of possible outcomes and their probabilities.
   • Process: Multiple simulations are run with varying inputs to determine a probabilistic distribution of potential project costs.
2. Expected Monetary Value (EMV):
   • This approach calculates the contingency based on the probability and impact of identified risks.
   • Formula: EMV = Σ (Probability of Risk x Impact of Risk)
   • The sum of all EMVs provides an overall contingency amount.
3. Bottom-Up Estimating:
   • Detailed estimating where contingency amounts are calculated for each specific risk or activity and then aggregated to form the total contingency.
   • Process: Each activity or component is analyzed, and a specific contingency amount is assigned based on its risk profile.

Management Reserve

Management reserve is a budgetary provision set aside to cover unforeseen, emergent, or unanticipated risks and opportunities outside the scope of the project’s baseline budget. Unlike contingencies, which are allocated for identified risks, management reserves are used for unknown risks—risks that are not anticipated at the planning stage.

Key Characteristics:

• Controlled by Senior Management: Management reserves are typically controlled by higher levels of management rather than the project manager.
• Separate from Project Contingency: It is a separate allocation from the project contingency and is not included in the project’s cost baseline.
• Usage: Access to the management reserve usually requires approval from senior management or stakeholders, ensuring that it is used judiciously.

Calculating Management Reserve:

1. Percentage of Total Project Cost:
   • A common approach where a fixed percentage (e.g., 5-10%) of the total project cost is allocated as the management reserve.
   • Formula: Management Reserve = Total Project Cost x Percentage (e.g., 5%)
   • Process: Evaluate the potential high-impact risks and opportunities that are not included in the contingency.
2. Historical Data and Expert Judgment:
   • Use historical data from similar projects and expert judgment to estimate an appropriate management reserve.
   • Process: Analyze past project data for unexpected costs and consult with experts to determine a suitable reserve amount.

This comprehensive guide will help you understand the fundamental concepts of risk exposure, contingencies, and management reserves, enabling you to effectively manage project costs and risks.

References:

1- Contengcines are you covered

2- Contengincy, the ultimate guide