Optimation Blog

The Battle Over Contingency

Posted by Wendy Smith on Sep 29, 2016 3:08:36 PM

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What is contingency?  What is it used for? Who controls it and dictates how it gets allocated?

In a recent project there was a discussion with the customer about contingency vs. change. The customer saw the contingency as a “fund” that was set aside to handle surprises that came up during the project.  These would include those unforeseen activities or issues that affect our estimate, but are not actual changes in scope. The customer thought that we should have a much higher tolerance for these types of changes. Our project manager described our approach to contingency, and noted that changes in direction or the addition of new features or scope changes are covered by change notices; contingency is for “our” estimating errors. In hindsight, these expectations should have been discussed earlier on in the process.

It is often a fine line to walk when you tell a customer that you have built contingency into the budget for a project. Questions arise, such as when do you use the contingency, and what should it be used for?  Also, who is responsible for the contingency? Each party involved in the project should have their own bucket of contingency, but all should have the common goal: to complete the project on budget. Each type of contingency will address different aspects of the whole project.

DEFINITION

The dictionary definition of contingency is as follows:

Contingency (1): the condition that something may or may not occur: the condition of being subject to chance (2): the happening of anything by chance: fortuitousness…

a: something that is contingent: an event or condition occurring by chance and without intent, viewed as possible or eventually probable, or depending on uncertain occurrences or coincidences …  b: a possible future event or condition or an unforeseen occurrence that may necessitate special measures <a reserve fund for contingencies>…c: something liable to happen as a chance feature or accompaniment of something else. (Webster’s Third New International Dictionary)

In the context of projects: Contingency is an amount, or percentage, included in the project budget to cover some element of risk or uncertainty. The main purpose is to account for errors and omissions in the design, but it can also be used to pay for unknown circumstances that come up during the project.  Contingency is not a random allowance; it is “a planned amount of money or time which is added to an estimate to address a specific risk.”

Owners establish contingency levels for each project based on acceptable risk, degree of uncertainty,
and the desired confidence levels for meeting baseline requirements. However, contingency should not be a first alternative and should be used only as part of a complete risk mitigation effort.

Contingency funds are to be used, first, to complete the scope or deal with unknown conditions. Many owners make the mistake of adding scope with their contingency. Engineers and Designers should make sure the documents are as complete as possible and understand that the contingency is not a method for addressing late design decisions.

Things that are NOT usually covered in the contingency are:

  • Major scope changes such as changes in end product specification, capacities, capabilities,
    equipment, and location of the asset or project
  • Extraordinary events such as major strikes and natural disasters
  • Escalation and currency effects

Also note that contingency is different than a Management Reserve.

A management reserve is “a planned amount of money or time which is added to an estimate to address unforeseeable situations.” It is withheld for management control purposes rather than being designated  for the accomplishment of a specific task or set of tasks.

Presumably, by these definitions, contingency, if there is any, would be included in the allocated budget for the project and are expected or intended to be spent. Management reserve, by contrast, is not included in the budget and therefore presumably is not expected or intended to be expended.

The problem is that some project personnel expect that they are entitled to the contingency because they put it in the budget and they intend to use it all up, whereas others, who believe it is allocated to cover random error or chance, expect that contingency funds will be left over and ought to be returned to the project sponsor. Not surprisingly, those who expect to expend all contingency funds tend to be project managers, and those who expect to see at least some of the contingency allowance returned tend to be the customers or owners.

In practice, relatively few projects return leftover contingency funds to the client. In general, project managers regard contingency funds as theirs to use; if the risks fail to materialize, the funds are expended on something else, such as project improvements.

Of course, issues like scope creep can make the contingency well dry up, eliminating any opportunities for project improvements, and even eating into a firm’s bottom line. So protect your contingency with good scope management and project management best practices. If the customer wants to make the changes that is what the management reserve is for.

 Contact Wendy Smith

Topics: Project Management, Business

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