Contingency reserve and management reserve are essential in managing risks regardless of how an organization takes a project management approach. Contingency reserves and management reserves mainly guard against inflation, production delays, labor disputes, or unforeseen circumstances.
The two reserves differ in their concept and purpose, but both can save a business from financial loss. But what are these reserves? And how are they used? In this article, we’ll be taking a look at the difference between contingency reserve and management reserves and breaking down how to set them up for your next project.
Contingency reserve refers to the funds set aside to guard an organization against possible defined risks. They help an organization to manage the risks they have already identified. It’s an estimated reserve that concentrates on various risk management techniques. Project managers have the right to control the contingency reserve anytime a known risk occurs. Risk owners fully manage it and only inform the project manager in later stages.
Techniques Used in Calculation of Contingency Reserve
An organization can calculate contingency reserve using the following techniques:
1. Expected monetary value
Expected monetary value refers to a statistical technique that determines risks and aids in calculating contingency reserve. This technique is appropriate for large or medium organizations where the capital involved is enormous, hence losing the project is a nightmare to them.
In calculating the expected monetary value of a particular risk, an organization first determines the probability and impact of a project, thereby multiplying the two.
Expected monetary value EMV=impact x probability
From the solution of each risk, an organization will add the calculated value of each EMV
A company producing sugar had four risks with probabilities and impact as shown in the table below:
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|Risk||probability||Impact (USD)||EMV(Probability x Impact)|
According to this table, an organization could conclude that the total money required to handle all identified risks is 5500 USD, which isn’t the case. Some risks may occur, and others may not. Therefore, an organization can’t be sure which risks will occur. However, those risks that occur will add their EMV to the pool. And those that won’t happen will help cover up for those that did.
The sugar company will have to add 2175 to their budget to cover all the identified risks from the table above. The expected monetary value technique best fits an organization that has many risks. A lot of risks promote a better spread of the reserve. In fewer risks, the spread won’t be enough, forcing the fund to dry up. The disadvantages of EMV are:
- High chances of missing out on the positive risks, hence false results
- Insufficient reserve in case of fewer risks which cause less spread
- High probability of assuming all risks are independent, which isn’t always the case
2. Percentage of the Project’s Cost
Percentage of the project’s cost is a reliable technique for small and medium-sized organizations. The method is cost-efficient and helps organizations save money and resources.
To calculate contingency reserve using this technique, an organization only takes the percentage of the project’s cost. The value usually lies between 3% and 10%. This figure is a result of the perceived risk of the projects.
3. Decision Tree Analysis
Decision tree analysis entails the quantitative risk analysis technique. The name tree is because the method is graphical, and the graph resembles a tree. In this technique, an organization only determines the expected value of each event and select the best choice.
Three farmers wanted to determine the best choice that will increase their productivity, and each farmer had a different option, as shown below:
|Choice A||40%||$200 & $300|
|Choice B||50%||$400 &$200|
|Choice C||30%||$600& $200|
From this example, the farmers had three choices A, B, and C. All these choices represent opportunities. To get the maximum profits, the farmers will have to calculate the three choices’ expected monetary value and then settle on the most favorable one.
The table gives the probability of one event and the other one doesn’t have. To find the second value’s probability, the farmers will take the percentage allocated to the first and subtract from 100%. Below are calculations of EMV of each event:
EMV of choice A=0.40 x200+0.60 x300
EMV of choice B=0.50 x400+0.50 x200
EMV of choice C=0.30 x 600+0.40 x200
The calculation now gives the values of the three choices, with choice A having the highest EMV.In the scenario where all the risks are adverse, the farmers only select the one with the least negative option. The choice is when they aim at spending the least amount of money on managing the risks.
4. Monte Carlo simulation
An atomic nuclear scientist called Stanislaw Ulam formulated the Monte Carlo Simulation technique in 1940. This technique offers a variety of possible outcomes and the probabilities of any choice of action.
An organization needs to have duration estimates for each activity to use the Monte Carlo simulation technique.
A company with three activities used the Monte Carlo simulation technique to calculate its contingency reserves as follows:
|Activity||Optimistic||Most likely||Pessimistic||Pert Estimate|
The company has three activities with the above estimates in months. The activities are most likely to end in 16.7 months, according to the pert estimate. If the company works well, the activities will end in 13 months, but it will take 16 months in the worst circumstances.
Management reserve refers to the cost or time reserve that is applied to manage the undefined risks. It’s a section of the project budget, however, not the cost baseline. It entails a figure that concerns the organization’s policies. Management reserve mainly estimates the uncertainty of a project. The percentage varies and can be 5% of the project’s costs or duration and can go as high as 10%.
An example is in an organization with the proper knowledge and experience in a particular project. The management reserve will be less and also the uncertainty since the company can only face less or no risk in the project due to their expertise. However, if another organization engages in the same project that is new to them and has less expertise, the management reserve will be high due to high chances of uncertainties.
The management of an organization is responsible for conducting the management reserve. Thus, the project manager must get approval to use the management reserve if a particular undefined risk happens.
Significant Principles Of Management Reserve
There are four main principles related to management reserve:
- Assess risk
The management team reviews the risks related to each segment before the start of a project. The information on the risk identification should match the risk level and the phase of the project.
A primary factor in determining the risk is assessing how the manufacture, installation, design, or construction of a particular stage of the project would benefit the organization.
- Establishing specific reserves
Specific reserves make it easy for the management to oversee the use and assess the reserve’s relevance as the project continues. The management reserve primarily covers events that occur during long-term projects when the project funds are approved.
- Establishing project cost estimates
An organization should document significant assumptions to create reserve estimates and keep them safe for reference. The written estimates provide the management with a basis for review as the project progresses. It additionally offers a historical database for establishing estimates on similar projects in the future.
- Assigning specific reserve responsibility to individuals
An organization has to assign each reserve to an individual. The transferring of the funds should base on responsibilities an individual can perform concerning the project. Each individual that has been given an obligation on the reserve project should engage in the following activities.
- Review the reserve estimates together with their underlying assumptions and approve
- Give the go-ahead to the transfer of the reserve funds
- Oversee the reserve status and the level of usage
- Take part in estimating the funds for extra reserves that are necessary for the completion of the overall project.
Occasions to Use Management Reserve
Below are some scenarios when it’s appropriate to use management reserve:
- An organization identifies new work which the management accepts. The new task may arise when an organization forgot a particular stage when it began and now needs to arrange for the appropriate resources. The work the organization identifies can be due to internal replanning.
- When there is a need to redo some work, the redo can result from an unanticipated redesign, retest, or remake. The extra work requires the management to recognize the potential risks accompanied by the actual task and prepare the management for the realized risks.
- When the project requires the organization to adjust the labor or overhead costs for incomplete work, this can cause management to reserve credit or debit.
- Transfers of relevant personnel from one organization to another can result in managing credit or debit.
- When there is a significant need to purchase more equipment or funds, it is causes management to reserve debit and credit.
Occasions When You Cannot Use the Management Reserve
- Exceeded budget
Management reserve only serves for unidentified risks. When an organization exceeds its budget, it should sort out other means to compensate it but not use the management reserve. To prevent this challenge, an organization should ensure they conduct a thorough estimate of the new budget and provide its approval before taking any step.
- When applying schedule compression techniques
Schedule compression techniques have two categories: crashing and fast-tracking. Schedule compression may result in new risks. It’s vital to identify these risks, schedule a response plan and estimate the new contingency reserve, which the company will require to approve. Crashing uses extra resources, and after the organization is through with the scheduling for crashing, they have to recheck with the risk management planning.
- Fallback plan
The management reserve only applies to unknown risks, while the fallback plan doesn’t. It’s a plan set for identified risks the moment the main response plan fails. Therefore, only contingency reserve applies for this plan and not the management plan.
- Residual risks
Residual risks refer to the number of risks or dangers resulting from an event or action remaining after inherent or natural risks have been taken care of by risk controls. The contingency reserve is appropriate for this risk and not the management reserve.
The Differences Between Contingency Reserve And Management Reserve
- Contingency reserve takes care of identified risks while management reserve deals with unidentified risks
- The contingency reserve gives estimated figures, while the management reserve gives the project’s total percentage of duration and cost.
- Contingency reserve gives managers the rights and authority to handle the risks, while in management reserve, the management has to permit them.
- Contingency reserve measures the performance baseline while management reserve doesn’t.
Examples of Contingency Reserve and Management Reserve
An example of a contingency reserve is a ferry transporting tourists and encounters a vast sea storm that demolished some parts of the ferry. The project manager has the authority to repair the demolished parts since the risk management reserve states this risk plan and allocated funds for it.
The organization’s project doesn’t give room for the risks that result from lighting. However, the ferry was struck by lightning and destroyed some parts of the ferry. The project manager reported the management issue and asked them to guarantee permission to use management reserves to repair the destroyed parts.
For most organizations, the exact cost of labor, materials and the actual amount of each required for a project is usually uncertain. To help mitigate the cost’s risks being higher than expected, delaying the project, an organization should incorporate contingency reserve to avoid unfavorable budget variances. Management reserve is also important in the case of unidentified risks. It is essential for management control purposes. Why allow your project to stop due to an unplanned budget? Take the step and incorporate both management and contingency reserves to eliminate all the project delays you may be facing.