The 10% Contingency Myth: The Hidden Source of Many Projects’ Cost Overruns
Contingency has become synonymous with 10 percent, 15 percent, or even 20 percent in some cases. Arguably, many project and procurement professionals have accepted this norm and have reinforced its veracity and legitimacy.
Many instances of cost overruns on projects could be avoided if painstaking, scientifically proven risk identification, assessment, analysis, prioritization, and mitigation are employed.
During the process of planning cost, the estimated cost of individual items including resources (salaries and benefits for team members, equipment, machinery, tools, etc.), logistics, permits, etc., are individually estimated using the Work Breakdown Structure (WBS). The hierarchical presentation of the total project scope provides greater flexibility for estimating cost, resources, schedule, and to avoid scope-creeping. The efficient decomposition of the project into the individual control accounts, work packages, and activities offers the project manager and the team total control over the estimation and the other processes of the project, going into executing, monitoring and controlling, and the closing stages of the project. Based on preference, the WBS can be developed by using the:
- Project phases – Initiation, Planning, Execution, Monitoring & Controlling, and Closure;
- Deliverables – Site Clearing, Foundation, Sub-structure, Superstructure, etc.;
- Subcontractor-based – Civil works, Mechanical, Plumbing, HVAC, Electrical & Instrumentation, etc.
These first-level work packages are further decomposed into their respective minutest activity level.
With the full details of the entire scope represented on the WBS, a similar pictorial representation – Risk Breakdown Structure (RBS) is utilized to bring the risks associated with each activity to a better perspective for identification, bearing in mind, the two levels of risks on every project – individual risks and overall risks.
During the process of risk identification, the various known, unknown, knowable, unknowable, and other forms of risks that might affect the fortunes of the project are identified and classified as such based on their characteristics. Having concluded the process of risk identification, the risks identified are analyzed quantitatively and qualitatively. While the quantitative risk analysis involves the use of numbers (usually in the form of cost, schedule, etc.), the qualitative analysis involves the interplay between probability and impact of the various risk items.
Contingency reserves are set aside for known-unknowns, which are risks that have been identified but whose probability and impact cannot be precisely determined. These reserves are calculated based on the risk analysis and are included in the project budget to cover potential cost overruns due to these identified risks.
Management reserves, on the other hand, are set aside for unknown-unknowns, which are unforeseen risks that could impact the project. These reserves are typically a percentage of the project cost and are controlled by senior management. They are not included in the project budget but are available to address unexpected issues that arise during the project lifecycle.
The Project Management Institute defines contingency as an estimate of costs associated with identified uncertainties and risks, the sum of which is added to the base estimate to complete the project cost estimate. – PMBOK Seventh edition.
The expectation is that contingency will be expended during the project development and construction process. It is however not the case! The individual costs of Identified risks that get to manifest themselves during the lifecycle of the project are expended to address the impact of the said risks. The Contractor or Sub contractor who is the spending officer, writes to the Project Manager or on larger scale and more complex projects, to the Procurement team, with details of the risk/ occurrence to formally request for the release of the amount or a portion of the amount associated with the particular risk that has manifested. If none of the known-unknown risks gets to manifest itself, no request is made for the release of the contingency amount. The contingency reserve funds therefore remain the property of the buying organization or Sponsor. As a Project Manager, you are a steward of resources belonging to shareholders and or the State.
In conclusion, the practice of arbitrarily slapping a 10% or 15% contingency on project sums is inadequate and can lead to significant cost overruns. A more rigorous approach involves the proper computation of contingency amounts based on detailed risk identification, assessment, and analysis. By utilizing contingency reserves for known-unknowns and management reserves for unknown-unknowns, project managers can develop more accurate Project Budgets and better manage project risks, ultimately leading to more successful project outcomes.
The writer is a certified Project management Professional with over 18 years’ experience in leading complex projects in diverse industries.
Frank is the current President & CEO of Project Management Institute, Ghana Chapter and the Managing Consultant for Certified Projects Avenue, a Project Management Advisory and Consultancy firm based in Accra, providing world class Project Management Services to its valued clients. He is also an adjunct Lecturer at the Gold Coast University.
