Project Financial Management: Contingency

Posted by Elizabeth

CoinsOne way to cope with uncertainty in your project budget – for example, if you don’t know exactly how much things will cost – is to use contingency.

A contingency fund is money set aside at the start of a project to be used in case of need, for example to offset unforeseen increases in costs.  The amount of this ring-fenced budget depends on the level of risk the project faces and also on the overall project budget itself.

Effectively, this is building in probability to your cost estimates.

As we’ve seen in my previous articles about financial management on projects, at the beginning of your project you calculate the expected budget required in order to deliver the work.  This budget figure is the first step to being able to work out a reasonable contingency.  The project risk register will also be important, as your knowledge of the risks inherent in the delivery will inform your decision about how much contingency is required:  the riskier the project, the higher the amount of contingency budget.

If you have done this type of project lots of times before you’ll have a pretty good idea of the costs.  If it is a brand new project, with lots of new technology, really innovative, it is likely to come with a higher risk factor and greater uncertainty, so you would want to include more contingency to address that.

Calculating contingency is not really a science.  Your company might use a formula for calculating contingency but as it depends so inherently on the risk factors for each individual project it is hard to give a one-size-fits-all equation.   You can use risk analysis or history from similar projects to help determine contingency costs.

Because calculating contingency requires a bit of thought, some project managers don’t do it at all.  It might be hard to figure out what the amount should be, but that’s no excuse for not setting a contingency budget at all.  If you are really stuck, add a contingency line to your budget of 10%.  This at least gives you a starting figure to begin negotiations with your sponsor and it will give you some leeway if it does turn out that your estimating has been a little wayward.  The more experience you have with budgeting, and with projects, the easier it will be to predict what amount would make a reasonable contingency fund.

Ideally, you should calculate contingency at major task level.  This makes it easier to work out how much your contingency budget should be.  If you can’t do it at task level, with more money allocated to the riskier tasks, calculate the amount of contingency budget for each short phase or unit of work, not at a project level.

The contingency fund should be held separately to your main budget.  If something happens – a risk materialises, you then ask for approval to spend the money from the contingency fund.  It’s not there as a line in your day-to-day budget spreadsheet, and you can’t just dip into it whenever you feel like.

Once management have approved the spending, increase your budget appropriately so you have an accurate idea of how much you have spent or are predicting to spend.  This gives you a greater degree of transparency.  You have added the contingency into your budget tracking mechanism, and it’s OK to spend.

Finally, if contingency is not required, give it ‘back’ to the company so it is not included in any profit calculations at the end of the project.  Contingency is not free money!  It’s not there because you were too lazy to work out the costs properly at the beginning, it is there to offset risks and unforeseen circumstances.  If you get to the end of the project and you haven’t spent it, you can’t increase the scope or buy some more equipment to use it up.

The important point here is to make sure that you report the use of any contingency funds transparently.  It will give your sponsor more confidence that you are acting in an accountable way and should also dissuade you from overspending irresponsibly, which I’m sure you would never do.

In summary, a contingency budget allows you to react more quickly to any unforeseen events that impact your project.  The contingency budget is set based on project risk and you should ensure you have a mechanism by which to authorise and monitor the use of the funds.

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2 Comments to “Project Financial Management: Contingency”

  • its a very useful article.thanx

  • Rao, you are welcome!

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