This is the third article of a 3-part series on the money aspects for project risk management, including a discussion on estimating, budgeting, contingency and management reserve. In this article we discuss the response cost.

Response cost

We have to split the response cost into two time segments, the cost required during the planning processes, and the cost required during implementation.

Response strategies

Before we discuss cost and funding, let us refresh our understanding of the type of response strategies, per the PMI framework and standard.

1. We have strategies for high priority risks, which must be planned and actioned during the planning processes of a given phase; before approving the phase management plan and moving into the executing processes. These include avoid, transfer, and mitigate for high priority threats, and exploit, enhance, or share for the high priority opportunities.
2. We have strategies thatare shared such as active acceptance and passive acceptance
   1. Active acceptance is where we plan the response during the planning processes but we do not implement the response until the risk is triggered, normally in the executing processes part.
   2. Passive acceptance is where we do nothing and deal with the risk, when it occurs.

Cost during planning

Based on the above, response strategies, for high priority risks, the essential differentiator, is that the response planning and implementation of the response plan must be done during the general planning processes. Let us consider them one by one.

1. Avoid: to avoid a risk, one must change the plan. The team cost should be already covered with management cost, and nothing to add here. However, if there are any cost related to implementing the response strategy, those costs would be added as part of the base budget[1].
2. Transfer: same as avoid, the management cost cover the team costs and the cost of insurance will be included in the base budget. This include the cost to pay the insurance company and the deductible amounts if required.
3. Mitigate: same as before – management costs will cover the team costs. The cost of mitigationwill be included in the base budget. However, here is something else to consider. In mitigating a risk, we do things to lower the priority of the risk and make smaller but the risk remain (residual). The expected monetary value (EMV) of the residual riskwill be included in the contingency amount. In other words, we have three types of cost here per the following:
   1. Management cost; with the team cost (project indirect cost à base budget)
   2. Mitigation cost; part of the plan, i.e. the base budget
   3. EMV; part of the contingency amount.
4. Exploit: same as avoid.
5. Enhance: same as mitigate; except the EMV in this case will reduce the base budget.
6. Active Acceptance: the planning part will be part of the plan. However, since we do not implement prior to the risk occurring in executing – the EMV will be in the contingency.
7. Passive Acceptance: no cost in planning; only contingency.
8. What happen if during planning we recognize the strategy is not working? We will need an alternate strategy and we treat its costs per the above guidelines.
9. On large projects, organizations do not typically quantify the low and medium priority risks. If the organization have good historical data, they probably have a way to decide on what percent to allow for the contingency reserve, or at least for the low and medium priority risks. This is a common practice.

Special situations on the above

Cost during executing

What happen during the executing processes?

1. For the risks we already assessed in planning, some of these risks could occur. If they occur, they would either increase the project actual cost (if they are threats) or reduce the project actual cost (if they are opportunities). In theory, these are covered by the contingency amount.
2. If the things happen that we did not identify as risks before, we can these issues and since they were not covered in the risk assessment, in theory we fund them from management reserve. We say in theory here because in practice this does not happen. If these issues were due to mistakes, errors, or normal variations, in practice contingency covers these things. Management reserve cover major unexpected events, or if the project goes over the baseline.
3. New risks: it is possible that during executing we identify new risks (before they occur). We will have to assess and develop response actions for them – the team cost is part of the management cost. Other costs, will have to come from contingency, or management reserve, depending on the risk and its severity.

Alternate approach

If one follows the letter of the information we present here, it could become quite complicated, and time consuming. Well, the required effort might be required and necessary if the project is of high importance to the organization. The alternate is a general approach that approximate the use of contingency on projects.

Estimating contingency reserve

1. Based on the above approach, the contingency amount is calculated based on the cumulative EMV of all risks (threats and opportunities); assuming we can calculate the EMV for all risks.
2. Over numerous years of experience, what we have observed, as the most common practice, is to estimate contingency as an allowance of the base budget. For example, for conceptual estimates the contingency could be 25% or more, budgetary estimates may include 15% or more, definitive (funding) estimates would typically has 10%. These numbers come from the author background in petroleum industry but not set in stone. Basically, any organization with good historical data can determine the proper percent.

Estimating management reserve

Most often this is a just a percent, as we mentioned earlier in this document.

Using contingency reserve

One approach is to block the contingency reserve amount, as a control account. Then based on actual performance we deduct or add to this account.
 
[1]Refer to the discussion on the components of the budget