Development and Use of Project Contingency (Borneo Post 16th april 2010)

It is common practice for practitioners tendering for lump sum contracts to apply a contingency to the estimated sum prior to client submittal however, the development and use of contingencies is often misunderstood.
It is not unusual for a company to simply apply 10 or 15 percent of the estimated sum as a contingency value to be used at the discretion of the Project Manager (PM) throughout the project life cycle.
The typical uses of the contingency fund by the PM vary with justifications ranging from additional scope of work, design changes, additional resources, scope creep or even that end of project party. In addition to how contingency is used the PM also usually determines when it is used and in most cases will ensure that it is in fact used before the end of the project, instead of returning any unused portion to the company coffers.
This misuse of contingency is a very common practice both in the development and use of contingency costs and if you are telling yourself ‘well that’s how we have always done it’ then consider the following reasons for not doing it.
Allocating subjective contingencies to projects could deprive the funding of budgets to other company projects resulting in those projects not being allowed to proceed. Conversely, the allocated contingency could be inadequate and the project has to be abandoned at the cost of the company. The reality is that contingency funds are an essential budgetary item that requires objective development and strict governance in the use thereof.
So first let’s look at the real reason for applying contingencies by looking at a simple example. You save all year for that holiday during Chinese New Year and a week before the time actually comes to fly off to that exotic island or back to your homeland to see long lost relatives, you look at the money you have saved and think to yourself “Maybe I should take a little extra, just in case something goes wrong like an accident, illness, robbery or loss of personal possessions or money”. Now that’s contingency!
Note I didn’t say “Maybe I should take a little extra, in case I run out of money” or “… in case I decide to stay a little longer”, because that’s not contingency.
Contingency is an allocation of funds to be used in the event of identified risks eventuating, remembering that risks are potential events that cannot be forseen.
If the holiday went as planned, then one should return home with the contingency fund in the pocket. It should not be exchanged at the duty free store for goods that you never knew existed prior to walking into the store, it should be returned to your bank account for the next holiday.
So contingency is used for use during the eventuation of identified risks and therefore it requires some objective method of determining both how much money to allocate in total and when to spend that allocation. If the amount allocated is a lump sum determined subjectively then it is expected the spending of that allocation can only be subjective also.
When we talk of ‘risk’ we think of harmful or damaging results but there are also positive risks that if eventuate are opportunities for a project to capitalize on. As such, contingency allocations should be made available to seize opportunities as well as remove hazards. This can only be executed effectively if each individual potential risk is identified and allocated a contingency budget.
Before determining the contingency value thought must be given to the probability of the individual risk occurring and the consequence should it occur, then estimate what impact in terms of time and cost that risk will have on the project.
Each identified risk should, if possible, be associated with certain activities in the project schedule, however certain risks may only be applicable to activities in a particular timeframe like cyclones. If these activities are delayed then they could move outside the cyclonic weather window and the potential risk may reduce or increase as the case may be.
The next step is to develop strategies to be implemented should the potential risk occur or to mitigate the risk from occurring and it is these strategies that need to be costed for the contingency allocation. In the event that the potential risk does occur then the mitigation strategy can be implemented utilising the allocated contingency.
After totaling all the individual values the PM has a total contingency budget determined objectively that can be justified to senior management. In addition, senior management can monitor the spending of the contingency and forecast any unspent money for allocation to other projects upon its return.
There are other methods of determining the contingency funds, one being a quantitative method using ‘Monte Carlo’ analysis. This use of standard deviation to calculate the contingency is very popular with the larger organisations or enterprises but requires the use of sophisticated software for a full analysis of the data outputs.
Whatever method is employed the bottom line is, anything is better than a subjective assessment of adding 10 to 15 percent to the estimated value.
On May 29, 2006, an Indonesian company drilled a well into pressurized rocks in an East Java oil field but something went wrong when the well breached rocks somewhere around 3,000 meters underground, depressurizing the fluid in the rocks below.
Since the rupture, more than 90 million cubic meters (approx 14 football fields) per day of 80 degree Celsius clay and water have percolated to the surface displacing 30,000 people and causing roughly USD1 billion in damages.
I can guarantee you that every future risk management workshop held in that company will be identifying that risk as maybe a medium possibility with an extremely high consequence resulting in the allocation of well defined contingencies.