How to Calculate Contingency Reserves Using Expected Value Method

There's an old saying that no battle plan survives first contact with the enemy. The same is true for project management: No matter how carefully you plan the project, surprises that cost you money or time are inevitable. Having a contingency reserve is a backup plan to prevent surprises from derailing you.

Tip

There are several ways to calculate contingency reserves. With the expected value method, you look at potential problems and multiply the probability they'll happen by their potential financial cost. Add together the results for each risk, and you'll see how much of a reserve you need.

Project management is easier when you know what you're dealing with, but sometimes, you don't know what to expect. You can divide information or the lack of it into four classes.

1. Known knowns. This is stuff that you know for sure: for example, your web designer will be absent for two weeks for a vacation he booked 6 months ago. You can factor these into your project planning and take steps to mitigate the effects.
   
   
2. Known unknowns. If you're in road construction, for example, you know bad weather can delay the work. What's unknown is how bad the weather will be over the next four months and how much time you'll lose.
   
   
3. Unknown knowns. These are things you could have known but haven't learned. For example, if your team knows the IT response to outages is notoriously slow but nobody shares this information, you may underestimate the time repairs will take. The problem is known to some people but not to you.
   
   
4. Unknown unknowns. These are complete surprises, such as a key staffer quitting abruptly or a meteor hitting your headquarters. There's no way to know that these unknown risks even exist.
   

Breaking down potential problems in this way can help distinguish between certainties and assumptions. Identifying assumptions that haven't been confirmed goes a long way toward preventing problems.

To protect against risk, you need a contingency reserve and a management reserve. If you're a small firm with a small budget, one reserve may be enough. A contingency reserve of either money or time protects you against known knowns and known unknowns.

For example, suppose you're managing a software project. You know the software will have to be debugged before you release it, but you don't know how many bugs it will have or how long the fix will take. You calculate a contingency reserve of two months and work that into the timeline.

A management reserve deals with unknown knowns and unknown unknowns. If your software project budget is $120,000, you might add a $6,000 reserve for when unknown costs surface. Unlike a contingency reserve, you don't build a management reserve into the project baseline.

There are several methods for setting a contingency budget in project management.

• EMV. Using expected monetary value, also known as the expected value method, you multiply the potential loss in time or money by the probability of a known-known risk or known-unknown risk occurring. If you have several known unknowns, you combine them for a total contingency.
  
  
• Decision tree. You show the different paths your project could take and adopt the one with the lowest risk. You build your contingency budget on that.
  
  
• Monte Carlo. You crunch probabilities to give you the best-case, worst-case and most-likely case. If you know there's a 90% chance the project will be done ahead of schedule, your contingency planning will be different than if there's only a 40% chance.
  

The Monte Carlo uses enough data to get excellent results. However, it also takes time and more effort than EMV, which is one reason the expected value method is popular.

For an estimated monetary value contingency reserve example, suppose you're designing and building a high-rise condo for a real estate developer. You have a tight deadline, so you sit down and draw up a list of known unknowns. Construction contingency examples could include:

• The city may request changes to the plans. There's an 80% chance the changes could add up to $1,000 in added labor and tougher standards for the project.
  
  
• Weather may force delays. Your best guess is that there's a 75% chance that could cost up to $4,000.
  
  
• If area construction picks up, materials and labor might be in short supply. To compete, you might need up to $5,000. However, you estimate that there's only a 15% chance of this.

Using this information, you can set your contingency budget:

• 80% times $1,000 equals $800.
  
  
• 75% times $4,000 equals $3,000.
  
  
• 15% times $5,000 equals $750.
  
  
• Add the three figures together, and you get a contingency budget of $4,550. You build that into your cost estimate for the project.
  

Using EMV to calculate contingency reserves has its good and bad sides. The good side includes:

• Using statistics helps make your estimates more rational.
  
  
• You can see which risks are serious threats and take steps to minimize them.
  
  
• It's a cost-effective approach to managing risk.

The bad side includes:

• EMV assumes all the risks are independent of each other. That's not always true, as delays from design changes might push you into the rainy season, for instance.
  
  
• It works best when you're measuring large numbers of risks. With a low number of risks, there's a greater chance of underestimating how much you'll need.
  
  
• EMV works better for large, complex projects than small-scale ones.
  
  
• It's possible you'll underestimate the chance of a given risk happening. Personal assumptions and bias can skew the result.
  
  
• If you don't identify all the known knowns and known unknowns, you won't have a big enough reserve.
  
  
• With some risks, setting a monetary impact may be difficult.
  

The management reserve covers the problems you don't see coming. For example, your construction project strikes an old water pipe that isn't on the city's utilities map, and suddenly the site is flooded, or you discover there's a forgotten cemetery on the site and have to relocate all the coffins and grave markers.

Because the management reserve deals with unknown unknowns, you can't apply EMV or calculate the chance of the unknowns happening. The usual approach is to set the reserve based on the budget, such as 5% or 8% of the total budget. Unlike a contingency reserve, you may have to seek approval from people higher up in the hierarchy to authorize tapping the money.

One problem with which you may have to deal for large projects is that they have many more ways that things can go wrong. Even if most of the risks are low probability, a list of 10 to 15 risks could create a very large EMV-based contingency. You may have to tailor your contingency reserve to what your company can afford.

Another budgetary issue is that "low probability" isn't the same as "won't happen". It's conceivable that if you get a run of bad luck, a lot of the risks in your list could actually come to pass. A reserve based on EMV won't have enough to cover everything going wrong.

One way to deal with this is to focus on preventing or mitigating risk rather than just budgeting for it. If you can find ways to prevent the worst and most-expensive risks from coming to pass, this will benefit your bottom line better than the contingency reserve,