A contingency is a portion of your budget which is set aside for “known unknowns”; that is, for unexpected additional expenses that come up during project execution that, based on your past experience, you believe will happen. This can include things like underground pipes that weren’t on the drawings, faulty wiring that needs to be replaced, or even something like increased labor cost because of a worker shortage.
No matter how well you plan or estimate your project, you should always have a contingency. Having one is critical to the success of your project.
Setting the Contingency on your Project
There are a lot of ways to set the contingency on your project and a lot of variables that must be taken into account.
The first requirement is an accurate estimate. This is where communication with the customer is critical: the more information they give you about the project and the conditions around its execution, the better your estimate is going to be.
Having accurate historical information is also important and this is where keeping accurate records of prior projects can be of tremendous assistance.
Some questions to keep in mind as you develop your contingency estimate:
- How long do your vendors take to do the work or provide the goods? How much rework are they typically required to do and what are the contract provisions for rework?
- How complicated is installation? Installing a new heat exchanger during a time-limited shutdown is much more complicated than replacing a roof.
- What is the state of the project’s location? A new building at an old manufacturing plant is going to have many more–and different–unknowns than a subdivision built on a greenfield.
Are you familiar with the job site? Has the customer provided accurate drawings or have they allowed you to visit the job site to make your own assessments?
On a project to install an additional tank for a chemical process, the people who controlled access to the location would allow the designers to make measurements. They were instead given drawings that did not properly reflect the space. Based on the incorrect drawings and the limited accessibility, the tank ended up being placed in front of a doorway–which then leads to significant cost overruns as the tank needed to be re-sited.
- What time of year is the project scheduled? Is there the possibility of a hurricane or other extreme weather that could increase project costs? After Hurricane Katrina, the price of copper and of construction labor jumped significantly across the U.S. and as Houston rebuilds after Harvey, the same escalations should be taken into account for projects in the region.
- Is there the potential for currency fluctuations? This is something which is wholly out of your control, but it’s certainly something to keep in mind if your project spending will be in multiple currencies and there is a history of wide fluctuations in exchange rates.
Answering these questions means your estimate will be more accurate and a smaller contingency. If your estimate is nothing more than a guess, you’re going to have to set a higher contingency.
Contingencies are often set as a percentage of the estimate and they can range from ten percent all the way up to fifty percent if the estimate is really rough. If you have a process by which you refine estimates as you develop the project and before you start executing it, you will also be reducing your contingency as you go.
Sometimes you’ll be pressured by the customer to include a smaller contingency–if at all possible, do not allow this to happen. A contingency protects both you and the customer from cost overruns.
There are dangers to having too large a contingency as well as too small a one. If you consistently come in well under your estimates, your customer will notice and they may come to believe that you’re sandbagging your estimates or forecasting in an overly optimistic manner.
Finding the contingency sweet spot is something that will take time, experience and reliable data from past projects.
Using the Contingency on your Project
So you’ve done the best estimate you can and have determined what the contingency should be and the customer’s onboard. And now you’re executing the project–how do you use the contingency to cover your known unknowns?
One of the best ways to think about your contingency is that it’s like a checking account–as you use funds, the total amount available decreases. If you use a detailed work breakdown structure for your project and if you’re keeping your planned spending up to date, you will transfer funds from the contingency to the appropriate cost elements and you should document this through a change order process.
During the execution phase, the customer may pressure you around the contingency. They may ask that you release the contingency earlier than you’re comfortable with–this means they’re asking you to reduce your overall project forecast.
They may be asking you to do this for a variety of reasons:
- They have budget constraints or a budget shortfall
- Your project is going more smoothly than anticipated and they don’t believe you’ll run into any additional unknown expenses.
- You’re nearing the end of the project and they’d like an idea of what you think the final cost is going to be.
Contingency should only be used for unknowns that are part of the original project scope and not for additions or expansions to the project. There can be a significant amount of tension on this front, particularly when there are multiple stakeholders with competing interests.
For example, if you’re installing a new HVAC system in a building, you may find that the building manager doesn’t like the thermostats that the building owner approved and that they want different, more expensive thermostats–and they’re in your face about it, while the owner is located off-site. This isn’t a known unknown but is instead scope creep; you would need to go to the building’s owner and let them know that the manager would like more expensive thermostats–but even if the owner approves the change, this should not come out of contingency if at all possible.
There are times when this is unavoidable and you do end up using contingency to cover scope creep, but as a principle, you should hold the contingency separate because you are expecting to spend it on unknowns that are within the project scope.
As you move through project execution, monitoring your contingency and reassessing project risks is critical to success. A poorly planned contingency–one which is too small or too large–can hurt your credibility with the customer and hurt the overall quality of the project.
Taking the time in the beginning to develop an accurate estimate and contingency will help ensure that your project is funded appropriately. You’ll be able to execute with the security of knowing that if you do run into something unexpected–like asbestos insulation or lead pipes–you’ll have the funds to cover it without having to ask for a budget supplemental.