One of the hot topics frequently discussed in the creation of the budget for big projects is the appropriate contingency level and how to estimate it.
My colleague Giuseppe had found an interesting paper online that has been the starting point for this post.
So, what are contingencies?
Some far reaching definitions consider different typologies of contingencies:
- Money in the budget
- Float in the schedule
- Tolerance in the technical specifications
- Tolerance in the quality
- Tolerance in the scope of work
Possibly this is a very broad approach, so I will focus only on the first point.
Monetary contingencies are added to the estimate “to allow for items and events for which the state, occurrence or effect is uncertain” (the definition is proposed by the Association for the Advancement of Cost Engineering).
Several concepts are usually excluded from the contingency budget:
- Major changes in scope
- Extraordinary events (such as the one indicated in the Force Majeure clauses)
- Currency exchange risk (this is usually hedged or it is included in a different section of the budget)
Basically in the definition of contingencies the focus is on the “negative risks” that can create a loss if they materialize (“positive risks” is a fancy way to call the opportunities).
Identified vs unidentified risks
A key distinction should be made between identified risks and unidentified risks.
Identified risks are “known unknowns” – that is, risks you are aware of (a classic example would be the geotechnical risk.
Unidentified risks are more similar to “unknown unknowns” - risks that come from situations that are so unexpected and difficult to foreseen even to subject matter experts that they would not be considered.
Identified risks can (and should) be managed: they should be included in a risk register, with a quantification, a predefined plan if the risk materialize, an owner, etc.
Additionally, several strategies are possible for identified risk: they can be
Avoided (if a subcontractor has a poor financial status it can be removed from the bidders list)
Transferred (if the failure of the main transformer can put at risk the viability of the investment, a business continuity insurance can be purchased)
Shared (if a project is very big, possibly a Joint Venture could be a good choice)
Mitigated (if a construction technology is very complex it could be a poor choice in an emerging country, where an easier solution could be a less risky choice)
Accepted (in this case, usually a monetary reserve is created for the accepted risks).
Unidentified (“unknown”) risks are conceptually different. Even if a great effort has been made to identify all possible risks the experience show that when the project is finally built several unforeseen events will happen, impacting the budget.
The quantification of the contingency for these unknown risk is an hot topic.