In the previous post you reviewed how we build a base estimate for your project. However, you have not made an allowance for the risks that you identified during the development of your scope document. We need to add some contingency to allow for these costs that may arise.
We will now review how we add a contingency/risk premium to our base estimate to produce an estimate for our project.
Step 1: Risk premium
Step 2: Calculate contingency premium
For each element of the project, identify and estimate:
- The risks associated with the execution of the work? (3)
- The costs should the risk materialise? (4)
- The probability that the risk might occur? (5)
- Potential cost allowance (6)= (4)*(5)
- Agreed contingency. This is the amount that you decide to allow for this particular risk. It may be zero or anything up to the potential cost allowance. This decision is made by the project manager in conjunction with subject matter experts.
The answers to the questions are often complex and require you to make your best guess. Generally, there are no exact answers to these questions. However, it is essential that you dedicate the right people and the time to building the best picture possible of all the risks and their possible impact on your budget. The grand total under (7) is then your contingency.
Step 3: Establishing your control estimate.
Your estimate is then the Base Estimate + Risk Premium/Contingency.
Base estimate – 61,200
Contingency – 2,200
Control Estimate – 63,400
The reason that we call it a CONTROL ESTIMATE is that we will be controlling the project expenditure against this estimate with the expectation that we can deliver the given scope within the given time and budget.
If our estimate is more than we have to spend on the project, then we have two choices. Firstly, we could remove scope (i.e. remove WBS elements from our project or reduce their size). This in essence means delivering less work. This has the potential to not just reduce the base estimate, but also the contingency, as you may well remove scope elements which are not well-defined or where the details have not yet been decided upon.
The second way in which we can reduce the budget is looking to the risk element of the project and reviewing the root cause of the risks. Often, spending some more time on defining the details of the work, or deciding on particular features, can remove the cost of expensive changes later in the project that we are carry a contingency allowance for. Hence, additional detail can allow us to remove risk and reduce our CONTINGENCY.
A note on Contingency
There are a number of ways of calculating the contingency amount. The most frequently used methods are:
- Simulation/Risk analysis as indicated above.
- Subject Matter Expert driven. As the name suggest, the contingency figure is based on the judgement of SMEs. This should at least be part of the method described in 1 above.
- Predetermined guidelines. Many companies have a prescribed contingency allowance for projects of particular categories. In this case, the predetermined percentage would be added to the base estimate as a contingency amount..
Contingency is then included in budgets as a control account. As risks occur on a project, and money is needed to pay for them, the contingency can be transferred to the appropriate accounts that need it. The transfer and its reason should be recorded. Your risk management must ensure that risks are continually reassessed during the course of a project, as are the needs for cost contingency that you are carrying.