What’s the Price of Contingency?
Contingency budgets are a common and necessary aspect of construction project budgets. These are not “slush funds” that should be, or generally are, arbitrarily created by overly cautious project managers. On the contrary, a well thought out contingency budget is the direct result of a risk assessment by the project manager and team, to cover those known and unknown risks that are thought to be likely to occur, during the course of the construction project. Nonetheless, this direct correlation between existence and size of contingency budgets to project risks, are not always well understood, nor articulated clearly to either clients or company management. This article begins the discussion of how to use established Risk Management techniques, to both define and defend a project contingency.
Contingency budgets are widely used within construction projects, both in the US and worldwide. The most common percentage of the base costs reserved for Contingency is between 5 and 10%, but can range from 0% to upwards of 20%. (See the graph to the right.) Nonetheless, questions will continue to arise on how, you, as Project Manager, have chosen the Contingency Budget for your particular project:
- Clients may push back on the extra costs in your budget; OR
- Your management may question whether you have budgeted enough contingency, to be sure your project delivers on time, and on budget.
Ultimately, you want to have confidence that your choice of Contingency Budget is sufficient to reasonably assure your project is successful — on-time and on-budget! But reserving too much, can cause real problems for your client, in that money just sitting unused, could have been used to fund other vital business objectives for them. So, just pulling a number “out of the hat”, say 10%, may end up not being the best option.
Wouldn’t it be great to have a real basis for your estimate of contingency, rather than just “what everybody else does”? Luckily, there are many proven methods for coming up with Contingency Budgets, ranging from very simple to very complex. I’ve outlined two broad methods in this article.
Risk Management and Contingency Budget
Contingency Planning (and contingency budgets) is just one facet of the general Project Management discipline of Risk Management. There are many great sources of detailed thinking on this discipline, e.g. the Project Management Institute web pages (PMI.org.) (I actually feel like Risk Analysis & Management is the most important planning tool for project managers, but that is the topic of another blog.)
But, you don’t necessarily have to spend a huge amount of time, in order to ground your Contingency Budget, and provide yourself, and your clients, with some reassurance, that these reserve funds are both sufficient and reasonable.
Level 0 Contingency Budgeting:
For many smaller or more straightforward construction projects, it is frankly, just not worth spending days or weeks, in risk assessment meetings, or running Monte Carlo simulations of possible scenarios, etc., to achieve a “95% Confidence Level contingency budget.” It is just overkill! But, you can likely justify spending an hour or maybe two, doing what I call a Level 0 Contingency Budget. It is as simple as choosing a Base Contingency Rate, and then adjusting this based upon a quick Risk Analysis:
- Choose a Base Rate, based upon the type of project, and you and your company’s past experience. (There is a great discussion of this in this video.)
- Identify the main Risk Types for your project, say Regulatory Challenges, Shortage of qualified labor, Weather, Lack of sufficient detail in the designs, etc.
- Assign a factor to each risk area, which moves the Contingency Rate up or down, depending upon the assessed risk.
Now, for an example….
Here’s an example of Level 0 Contingency Budgeting:
- Start with a Base Contingency Rate of 5% (for new build.) (The video link above presents a good discussion of some standard contingency rates for various types of construction projects.)
- To the right are the results of a quick Risk Assessment, ranking 5 risks from 0.5 (low risk) to 1.5 (high risk).
- Now, just multiply all the Risk Factors together, and then times the Base Rate, and you come up, in this case, with 5% X 1.2 X 0.8 X 0.9 X 1.5 X 1.2 = 7.8%
If you couple this quick analysis, with a few statements for each Risk Area justifying your Risk Factor, then not only do you have much better confidence in your Contingency Budget, but you also have a great one-page Risk Managed Contingency Budget deliverable that you can show to your client (and to your boss!)
Risk Management: Diving Deep
Okay, so what if there is a real need to fully assess risks, and come up with a high confidence Contingency Budget. Perhaps, this is a critical project for your company, and it is vital to get it right. Or, your client expects a detailed Risk Analysis. In any case, the methods are basically the same as what I presented for Level 0, but with more detail and more effort — but the steps are very similar:
- Identify the Risks: Same as Risk Areas above, but in more detail.
- Assign the Probability of Occurrence: How likely is this risk to materialize?
- Quantify the Impact: What is the cost (in dollars) if the risk happens?
There are lots of great tools available for each of these steps, and good discussions abound. (Here are a couple great references, from PMI and ProjectAcademy.) But, an in-depth discussion is beyond the scope of this blog. In a subsequent posting, I may dive very deep into this topic. But for now, I’ll just show you an example of the output of this exercise.
In this simple exercise (borrowed from the ProjectAcademy reference), you would then add $1700 to your base budget, as a Contingency Budget.
I hope that you found this article of interest, and of value. There is a lot of value in performing, even a relatively quick and easy risk analysis, in order to define your construction project’s contingency budget. You can provide yourself and your team some assurance that it is adequate and sufficient, to make your project a success. And, you can provide great documentation to your clients and company management, that your contingency funds are well thought through.