A Study on Calculating the Optimal Contingency and Management Reserves for Project Budget

( 프로젝트 예산 편성을 위한 적정 예비비 산정에 관한 연구 )

Kwon, HyukChun CPA / PMP

November 27th,2009

The Project’s Success leads to Business Success.

2

Problem Background

Experiences Theory

KnowledgeSkills

TechniquesTools

Application

Business

The Application of Knowledge, Skills, Tools and Techniques to Project Activities to meet Requirement.

UAA MSPM

Background

Personal

Project Management?

3

Project Management

Project Triple Constraints

Scope, Time, Cost

Background

Project Cost Management

Plan Do Check Act

Budget Expense Variance Cost

Estimate,Predict Spend fund Budget – Actual

Expense Sum of Expense

Project

Temporary, Unique

4

BudgetBackground

Why Accurate Budget ?

• Budget > Cost

Surplus Fund

Loss Business Opportunities

• Budget < Cost

Lack of Fund

• Stop Project • Add more

Fund

Impact Financing Plan

Estimate, Predict the Budget What a Project will Cost.

5

Budget / Cost

Project

Scope

Work Package

Activity

Specification(Quality)

ResourcesQuantities/

Time

˟ Unit Price = Budget

Budget : The Sum of Resources Monetary Value

• Budget : Plan, Estimate, Predict• Cost : Sum of Expenses, Result

∑

Background

WBS

6

The Factors to Change the Budget

ItemsRisk/

Opportu-nity

CausesTo change Risk Type Type of

Budget

Scope(WBS)

Work Pack-age

(Activities)

Increase/Decrease

Uncertainty(Risk)

NotIdentified

Manage-ment Re-

serve

IdentifiedContin-

gency Re-serve

Resource

Specifica-tion

(Quality)Low/High Error/

Mistake Known

Point Esti-mate

(Allowance)Quantities Lack/Surplus Error/Mistake Known

Unit Price High/Low Inflation/Deflation Known

Background

7

The Study Approach

Theory Literature Review Survey Study

Net Cost ○ ○ ○ ●

Point Esti-mate

(Allowance)○ ○ ○ ●

Contingency Reserve ○

○ ○

●

Management Reserve ○ ●

MSPM,PMBOK Case Study

NASA Cost Hand-bookDr. Stephen BookOthers

59 Respondents in Korea

Apply the theory thru Case Study

Background

8

Theory

UAA, MSPM

PMBOK Guide, Text Book, Case Study

Theory

9

The Factors to affect Project Risk

Stakeholders

Team Members

* InternalProject Boundary

* ExternalUncertainty (Known, Unknown, Identified, Not Identified)

Project

Environment

Human Resources

Theory

10

Internal Factors – Human Resource

* Stakeholder’s Risk Tolerance

* Team Member’s

• Experience Level

• Required Skill (Tech, Leadership, Communication …)

• Knowledge, Competency, Ability

→ Refer to NASA Cost Estimating Hand Book Volume 4

High

Median

Low

Low Median High

Probability

Impact

Risk Tolerance Line

Theory

11

Resources

Time

Budget with Risk

Time Management

Scope(WBS)

Resource Management

Cost Management

Budget without Risk

Scope without Risk(Scope Management)

Risk Management

Scope with Risk

TheoryCost /Time / Scope / Risk

12

Risk / Budget

 

Outcomes ($)

Knowns Unknowns

Process

(%)

KnownKnown Knowns(Experience, Education)

Known UnknownsProject Risk Management

Unknown

Unknown Knowns(Laziness, Mistakes, Errors, No Project Management)

Unknown UnknownsProject Novelty Management

PMI Global Congress North America 2007

Theory

(Net Cost) (Contingency Reserve)

(Allowance) (Management Reserve)

(Point Estimate)

13

TheoryBudget

Resources

Time

Net Cost (Known Knowns)

Budget Base Line

Total Project Budget

Point Estimate

Allowance (Unknown Knowns) Contingency Reserve (Known Unknowns)

Management Reserve(Unknown Unknowns)

Uncertainty(Risk)

14

From PMBOK Guide, page 170

Management Reserve

TheoryContingency & Management Reserve

ContingencyReserve included

15

Plan Risk Management

Identify Risks

Perform Qualitative Risk Analysis

Perform Quantitative Risk Analysis

Plan Risk Responses

Monitor & Control Risks

Risk Management Plan

Risk List / Description

Risk Description / Probability / Impact Matrix

Risk Description / Probability / Impact / Amount

Risk Resister(Updates)• Budget & Schedule activity for Responses• Contingency Reserve

Planning Process

Estimate Costs

Contingency Reserve ProcessTheory

• PMBOK Guide, Risk Management Process

16

Management Reserve Process

Estimate Costs

Determine Budget

Control Costs

Risk Resister• Budget & Schedule

activity for Responses• Contingency Reserve

EVM(Earned Value Management)

Basis of Estimates

Cost Performance BaselineProject Funding Requirement• Management Reserve

Planning Process

Scope Baseline

Project Schedule

Human Resource Plan

Theory

• PMBOK Guide, Cost Management Process

17

Literature Review

• NASA Cost Handbook 2008

• Dr. Stephen Book

- Allocating “Risk Dollars” back to Individual Cost Elements

• Paul Garvey

- Cost Risk Analysis without Statistics

• Michael W. Newell, Marina N. Grashina

- The Project Management Question and Answer Book

• Dr. Prasanta Kumar Dey

- A Combined Analytic Hierarchy Process and Decision Tree Approach

• Others

LiteratureReview

18

Decision Making Tools

Solution Approach/Methods/Techniques LiteratureReview

■ Three Points Estimate

AHP(Analytic Hierarchy Process) / Ph. D Thomas L. Saaty HDP (Hierarchical Decision Process) Ph. D Jang W. Ra

■ Normal Distribution @risk, Crystal Ball

■ Decision Tree Analysis

■ Confident Level

19

Three Points Estimate

Base Estimate or Point Estimate Cost.*

The total cost of a project, where Cost (BE) is the sum of the cost element costs summed across the system’s Work Breakdown Structure(WBS) without any adjustment for Risk/Uncertainty ;

Probability

Cost

Three Point Estimate

Cost Account(Work-package)

Point Estimate(Most likely)

Low High

Budget

* Cost Risk Analysis Without Statistics. - Paul R. Garvey

LiteratureReview

Reserves ?

20

AHP(Analytic Hierarchy Process) / HDP (Hierarchical Decision Process)

Three basic principles of the AHP/HDP

• Hierarchical Representation and Decomposition

• Priority Discrimination and Synthesis

(Pair-wise comparison)

• Logical Consistency

LiteratureReview

21

AHP/HDP

ExampleHigh-Volume Coil Winding ma-

chine

Net present worth

Safety Future ca-pability

Manage-ment Re-quirement

Upgrade existingMachine

New semiauto-matic

Machine

Fully automaticMachine

Goal

Criterion/ Factors

Alternatives

LiteratureReview

22

Net : Safety = 3:1Net : future = 6:1Net : Mgmt = 7:1Safety: Fut = 5:1Safety:Mgmt = 2:1Fut : Mgmt = 1:3

Coil Winding machine

Net Safety Future Mgmt

Upgrade New Fully automatic

AHP/HDP LiteratureReview

23

Normal Distribution @risk, Crystal Ball

Monte Carlo Simulation

LiteratureReview

24

• Incorporate the cost of each choice, the probabilities of each

possible scenario , and rewards of each alternative logical path.

• EMV(Expected Monetary Value)

Decision Tree Analysis LiteratureReview

25

Confidence Level

• Appropriate level of Confidence

• Cover Unidentified Risk, Residual Risks, and Secondary Risks

• Consider Risk Dollar amount beyond Budget Baseline

• Executable within the Level of Confidence

• Lessons learned : Historical Data, Performance

LiteratureReview

26

2008 NASA Cost Estimating Handbook LiteratureReview

Table of Contents

Volume 1 Cost Estimating Volume 2 Cost Risk

Volume 3 Economic and Supporting Analysis Volume 4 NASA Cost Estimator Career Development Guide

Volume 5 Knowledge Management

Volume 6 Reference

27

Cost Risk Approaches

Step 1. Generate / Obtain Point Estimate

Step 2. Quantify Cost Estimating Uncertainty

Step 3. Quantify Technical Risk

Step 4. Quantify Correlation

Step 5. Run Simulation

Step 6. Assess Risk Dollars/ Unallocated Future Expense

Step 7. Allocate Risk Dollars to the WBS

• Analytic Approach

• Simulation Approach

• Hybrid Scenario Based Approach

• Integrated Risk Management

LiteratureReview

28

Unallocated Future Expense(UFE)

• Held by the Project to be allocated to WBS

• Held by the Program(Mission Directorate):

Probability

CostPoint Estimate or Sum of Most likely WBS Element Costs

Confident level 70%

Unallocated Future Expense(UFE)

Unallocated Future Expense (UFE):

The Difference between the Confidence Level Amount and the Funded Amount.

LiteratureReview

Contingency Reserve

Management Reserve

Budget Baseline Estimated total Budget

29

Allocating “Risk Dollars” Back to Individual Cost Elements – Stephen A. Book

Merge WBS-Element Cost DistributionWBS-Element Triangular

Cost Distribution

+

+

+

Most likely

Most Likely Total CostProbability

CostPoint Estimate or Sum of Most likely WBS Element Costs

Confident Level (70%)

UFE

A.

B.

C.

To be allocated in proportion to their Riskiness.

LiteratureReview

30

Summary of Literature ReviewLiteratureReview

WBS Elements

Tree Point Estimate

Define Point Estimate

Calculate Needs

Define Confident Level

Allocate Risk Dollars

• More Cost Risk, More Risk Dollar

• More Uncertainty, Wider Range of Cost

Distribution

• Allocation method

- Confident level

- Standard Deviation

- Risk Response Plan

To be allocated in proportion to their Riskiness.

31

ContingencyReserve

ManagementReserve

Risks Identified Not Identified

Budget Base line Included Not Included

Approval to use From Project Manager From Program Man-ager

When used No Change the Budget Baseline

Change the Budget Baseline

LiteratureReview

Summary of Literature Review

32

NASA Cost Estimator Career Development Guide.

Responsible : The NASA Office of Human Capital Management

Table of Contents

Cost Estimator Career Development Philosophy Leadership Development Philosophy Minimum Actions to Ensure Effective Career Development Career Directions and General Career paths General and Technical Competencies Attitude Training and Development Experiences Certification and Continuing Professional Education Individual Development Planning

LiteratureReview

33

Survey Result

10 Questionnaires

• What Reserves they use?

- Contingency Reserve or Management Reserve or both

• How to Calculate the Reserves Amount ? Open Survey (Thru PMPCafe)

59 Respondents

Survey

34

건설 , 중공업 , Plant (19)

IT, SI 등 Software 구축(29)

연구 개발 , 신제품 개발 (5)

업무 개선 (BPR, 조직개편 ,

업무 개선 )(6)

Total 59

Survey Result

Q1. Which Project Category do you handle ?

32%

49%

9%

10%

Survey

35

Survey Result Survey

Q 2. Do you estimate the Contingency Reserve and Management Reserve in your project budget?

별도로 각각 존재함 (0)

Contingency, Management Reserve 구분 없이 예비비 (Reserve) 있음 (40)

예비비 (Reserve) 없음 (19)

Total 59

68 %

32 %

36

Q 3. How to calculate the reserve amount in project budget?

전체 예산의 일정 비율 (%) (19)

Risk Response Plan( 리스크 대응 계획 ) 에 의한 방법 (14)

예비비 없음 (18)

상기 이외의 방법 (3)

무응답 (5)

5 %

Total 59

32 %

24 %

31 %

8 % • Under 5% : 7• 10 ~15% : 9• 16~30% : 3

Survey Result Survey

37

Survey Result

Q 4. Have you done your project within the budget including reserves?

항상 전체 예산 ( 예비비포함 ) 초과 함 (14)

예비비를 사용하나 전체 예산 범위내에서 완료 함(26)

예비비를 사용하지 않고 완료함 (19)

Total 59

24 %

44 %

32 %

Survey

38

Survey Summary

No Cases to use both Contingency and Management Reserve.

Use Management Reserve only

Use Three Point Estimate ? - Never Use 63% (37/59) - Occasionally use 37% (22/59)

Use Monte Carlos Simulation (Crystal Ball or @Risk) ? - Never use 86% (51/59) - Occasionally use 14% (8/59)

Survey

39

Case Study

“ Construction Project for Production Base in Vietnam”

Case Study

Developed by D Construction Co. Ltd.

40

WBS

Project

PM

Civil Works

Architecture Works

Mechanical Works

ElectricalWorks

# 1. On-Shore

Works

# 2. Off-Shore

Works

# 3.Power Plant

# 4.Utilities

House

# 5. Main Office

# 6. Facilities

# 7. Machines

# 8. Electric

Equipments

# 9 Cabling

Omit PM for easy calculation of the budget

Case Study

PM

41

Work Package L M H MEAN Weighted avg

#1 191 380 1151 574 477

#2 96 192 582 290 241

#3 33 76 143 84 80

#4 9 18 27 18 18

#5 77 154 465 232 193

#6 30 58 86 58 58

#7 11 22 66 33 27.5

#8 58 120 182 120 120

#9 120 230 691 347 288.5

Sum 1,250 1,756 1,503

• Assumption : Base Estimate Cost 1,250 does not include contingency (but include technical/commercial allowances)• MEAN = (L+M+H)/3, Weighted avg= (L+4*M+H)/6

Example : “Case Study” Project

Case Study - Select Base Estimated Cost Case Study

42

@RiskStatistics

Output value

Trial 1,000

MEAN 1,756(52.5%)

Median 1,741(50.0%)

Base Esti-mate

1,250(2.22%)

Weight avg 1,503(19.0%)

Minimum 1,089

Maximum 2,694

Select Base Estimated Cost Case Study

43

Risk Register Case Study

44

Risk category

Pri-or-ity

(Weight

)

RisksLo-cal%

Global

%

Techni-cal

47

Scope change

36 17

Materi-als

12 6

. . .

Fi-nance& eco-nomic

23

Inflation 38 9

Fund 15 3

. . .

Organi-zation

15

Capa. 44 7

Vendor capabil-ity

23 3

. . .

Market 6Market share

57 3

. . . .

Total 100 100

Pro. %

Cri-terion

Al-ter-na-

tives

Cost/Im-pact

EMV

25

a A450

-

b B380

-

c C320

80

37

a

D220

-b

E190

70c

9

a H670

60

b I740

c J690

100% 1,352

% WP

Con-tin-

gencyre-

serve

# 1

28.0

# 2

32.4

# 3

16.8

# 4

12.0

# 5

59.8

# 6

26.6

# 7

14.7

# 8

15.0

# 9

54.7

29

a

F250

b

G172

50c

260 260.0

#1

#2

#3

#4

19.2%

Allocation of the Contingency Reserve Case Study

45

Calculate total amount of identified Risk dollars required.

Analysis the Risk Probability and Impact

Risk Risk Response EMVAssigned

WP

Risk #1, 4,,5

Response #1 80

# 1

# 4

# 5

Risk #2,6,7 Response #2 70

# 2

# 3

# 6

# 7

Risk #3,8 Response # 3 50# 2

# 9

Risk #9,10 Response #4 60

# 5

# 8

# 9

Total 260

WP : Work Package

Calculate Cost by Decision tree and HDP method

Case Study

46

Risk Response CostAssigned

WPWeight

Allocated AmountOf Cost

Response #1 80

# 1 35% 28

# 4 15% 12

# 5 50% 40

Response #2 70

# 2 17% 11.9

# 3 24% 16.8

# 6 38% 26.6

# 7 21% 14.7

Response # 3 50# 2 41% 20.5

# 9 59% 29.5

Response #4 60

# 5 33% 19.8

# 8 25% 15

# 9 42% 25.2

Total 260 260

Define a WBS-elements “Need”

Calculate allocated amount by Decision tree and HDP method

Case Study

47

Allocate Risk dollars to WBS-Elements

WP #1

WP#2

WP #3

WP #4

WP #5

WP #6

WP #7

WP #8

WP #9 Total

28 32.4 16.8 12 59.8 26.6 14.7 15 54.7 260

Allocated Risk dollars amount to Work-Packages

Budget Base Line

Base Estimate 1,250 (2.22%)

Contingence Reserve + 260

Budget Base Line 1,510 ( 19.6%)

Case Study

48

WPBase Esti-mate

Contin-gency Re-

serveTotal

# 1 380 28 408

# 2 192 32.4 224.4

# 3 76 16.8 92.8

# 4 18 12 30

# 5 154 59.8 213.8

# 6 58 26.6 84.6

# 7 22 14.7 36.7

# 8 120 15 135

# 9 230 54.7 284.7

sums 1,250 260 1,51

0

Percentile(Confidence

level)

Cost Value

5% 1,362

10% 1,405

20% 1,512

30% 1,600

40% 1,672

50% 1,741

60% 1,817

70% 1,899

80% 1,979

90% 2,114

Contingency Reserve of WBS-Element

(19.6%)

Allocate Risk dollars to WBS-Elements

WP : Work Package

Case Study

49

Define Management Reserve At Confidence level.

Percentile(Confidence level)

Cost Value

5% 1,362

10% 1,405

20% 1,512

30% 1,600

40% 1,672

50% 1,741

60% 1,817

70% 1,899

80% 1,979

90% 2,114

50% is the Confidence level of this project.

Case Study

50

Management Reserve

Risk dollar amount at Confidence level – (Base Estimate + Contingence Reserve)

Determine Management Reserve

50% is the Confidence level : $ 1,741

$ 1,741 - $ 1,510 = $ 231 (15.3 % of the Budget Base line)

Case Study

51

@RiskStatistics

Output value

Trial 1,000

MEAN 1,756(52.5%)

Median 1,741(50.0%)

Base Estimate 1,250(2.22%)

Budget Baseline(incl. Contin-

gency reserve)1,510(19.6%)

Total budget(incl. Manage-ment reserve)

1,741(50.0%)

Weight avg 1,503(19.0%)

Minimum 1,089

Maximum 2,694Base Estimate Budget Baseline Total budget

Contingency Reserve

Management Reserve

Summary Case Study

52

C/A Base Estimate Contingency Reserve Total

# 1 380 28 408

# 2 192 32.4 224.4

# 3 76 16.8 92.8

# 4 18 12 30

# 5 154 59.8 213.8

# 6 58 26.6 84.6

# 7 22 14.7 36.7

# 8 120 15 135

# 9 230 54.7 284.7

Budget Base-line

1,250 260 1,510

Management Reserve (15.3%)

231

Total Esti-mated Budget

1,741

Case Study Summary

53

Conclusions / Recommendations

Move from Deterministic Point Estimates to Probabilistic Estimates.

Generate a Point Estimate

Budget based upon a Quantification of all the Risks.

Define Confidence Level

Allocate Risk Dollars as Reserves

Develop Human Resource Management

Conclusion

54

Thank You!

Q & A

UAA MSPM Hyukchun Kwon, CPA/PMP