Cost contingency
Encyclopedia
When estimating the cost for a project
, product or other item or investment, there is always uncertainty
as to the precise content of all items in the estimate, how work will be performed, what work conditions will be like when the project is executed and so on. These uncertainties are risks to the project
. Some refer to these risks as "known-unknowns" because the estimator is aware of them, and based on past experience, can even estimate their probable costs. The estimated costs of the known-unknowns is referred to by cost estimators as cost contingency.
AACE International
, the Association for the Advancement of Cost engineering
, has defined contingency as "An amount added to an estimate to allow for items, conditions, or events for which the state, occurrence, or effect is uncertain and that experience shows will likely result, in aggregate, in additional costs. Typically estimated using statistical analysis or judgment based on past asset or project experience. Contingency usually excludes:
Some of the items, conditions, or events for which the state, occurrence, and/or effect is uncertain include, but are not limited to, planning and estimating errors and omissions, minor price fluctuations other than general escalation), design developments and changes within the scope, and variations in market and environmental conditions. Contingency is generally included in most estimates, and is expected to be expended".
A key phrase above is that it is "expected to be expended". In other words, it is an item in an estimate like any other, and should be estimated and included in every estimate and every budget. Because management often thinks contingency money is "fat" that is not needed if a project team does its job well, it is a controversial topic.
In general, there are four classes of methods used to estimate contingency. ." These include the following:
A fifth method, called Reference Class Forecasting
, was recently developed, based on prospect theory
and theories of the planning fallacy
, that won the Nobel Prize in economics 2002.
While all are valid methods, the method chosen should be consistent with the first principles of risk management
in that the method must start with risk identification, and only then are the probable cost of those risks quantified. In best practice, the quantification will be probabilistic in nature (Monte-Carlo is a common method used for quantification).
Typically, the method results in a distribution of possible cost outcomes for the project, product, or other investment. From this distribution, a cost value can be selected that has the desired probability of having a cost underrun or cost overrun
. Usually a value is selected with equal chance of over or underrunning. The difference between the cost estimate without contingency, and the selected cost from the distribution is contingency. For more information, AACE International has catalogued many professional papers on this complex topic.
Contingency is included in budgets as a control account. As risks occur on a project, and money is needed to pay for them, the contingency can be transferred to the appropriate accounts that need it. The transfer and its reason is recorded. In risk management
, risks are continually reassessed during the course of a project, as are the needs for cost contingency.
Project
A project in business and science is typically defined as a collaborative enterprise, frequently involving research or design, that is carefully planned to achieve a particular aim. Projects can be further defined as temporary rather than permanent social systems that are constituted by teams...
, product or other item or investment, there is always uncertainty
Uncertainty
Uncertainty is a term used in subtly different ways in a number of fields, including physics, philosophy, statistics, economics, finance, insurance, psychology, sociology, engineering, and information science...
as to the precise content of all items in the estimate, how work will be performed, what work conditions will be like when the project is executed and so on. These uncertainties are risks to the project
Project
A project in business and science is typically defined as a collaborative enterprise, frequently involving research or design, that is carefully planned to achieve a particular aim. Projects can be further defined as temporary rather than permanent social systems that are constituted by teams...
. Some refer to these risks as "known-unknowns" because the estimator is aware of them, and based on past experience, can even estimate their probable costs. The estimated costs of the known-unknowns is referred to by cost estimators as cost contingency.
AACE International
AACE International
AACE International was founded in 1956 by 59 cost estimators and cost engineers during the organizational meeting of the American Association of Cost Engineering at the University of New Hampshire in Durham, New Hampshire. AACE International Headquarters is located in Morgantown, West Virginia, USA...
, the Association for the Advancement of Cost engineering
Cost engineering
Cost engineering is an area of engineering practice concerned with the "application of scientific principles and techniques to problems of cost estimating, cost control, business planning and management science, profitability analysis, project management, and planning and scheduling."- Overview...
, has defined contingency as "An amount added to an estimate to allow for items, conditions, or events for which the state, occurrence, or effect is uncertain and that experience shows will likely result, in aggregate, in additional costs. Typically estimated using statistical analysis or judgment based on past asset or project experience. Contingency usually excludes:
- Major scope changes such as changes in end product specification, capacities, building sizes, and location of the asset or project;
- Extraordinary events such as major strikes and natural disasters;
- Management reserves; and
- Escalation and currency effects.
Some of the items, conditions, or events for which the state, occurrence, and/or effect is uncertain include, but are not limited to, planning and estimating errors and omissions, minor price fluctuations other than general escalation), design developments and changes within the scope, and variations in market and environmental conditions. Contingency is generally included in most estimates, and is expected to be expended".
A key phrase above is that it is "expected to be expended". In other words, it is an item in an estimate like any other, and should be estimated and included in every estimate and every budget. Because management often thinks contingency money is "fat" that is not needed if a project team does its job well, it is a controversial topic.
In general, there are four classes of methods used to estimate contingency. ." These include the following:
- Expert judgment
- Predetermined guidelines (with varying degrees of judgment and empiricism used)
- Simulation analysis (primarily risk analysis judgment incorporated in a simulation such as Monte-CarloMonte Carlo option modelIn mathematical finance, a Monte Carlo option model uses Monte Carlo methods to calculate the value of an option with multiple sources of uncertainty or with complicated features....
) - Parametric Modeling (empirically-based algorithm, usually derived through regression analysis, with varying degrees of judgment used).
A fifth method, called Reference Class Forecasting
Reference class forecasting
Reference class forecasting is the method of predicting the future, through looking at similar past situations and their outcomes.Reference class forcasting predicts the outcome of a planned action based on actual outcomes in a reference class of similar actions to that being forecast. The theories...
, was recently developed, based on prospect theory
Prospect theory
Prospect theory is a theory that describes decisions between alternatives that involve risk i.e. where the probabilities of outcomes are known. The model is descriptive: it tries to model real-life choices, rather than optimal decisions.-Model:...
and theories of the planning fallacy
Planning fallacy
The planning fallacy is a tendency for people and organizations to underestimate how long they will need to complete a task, even when they have experience of similar tasks over-running. The term was first proposed in a 1979 paper by Daniel Kahneman and Amos Tversky...
, that won the Nobel Prize in economics 2002.
While all are valid methods, the method chosen should be consistent with the first principles of risk management
Risk management
Risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities...
in that the method must start with risk identification, and only then are the probable cost of those risks quantified. In best practice, the quantification will be probabilistic in nature (Monte-Carlo is a common method used for quantification).
Typically, the method results in a distribution of possible cost outcomes for the project, product, or other investment. From this distribution, a cost value can be selected that has the desired probability of having a cost underrun or cost overrun
Cost overrun
A cost overrun, also known as a cost increase or budget overrun, is an unexpected cost incurred in excess of a budgeted amount due to an under-estimation of the actual cost during budgeting...
. Usually a value is selected with equal chance of over or underrunning. The difference between the cost estimate without contingency, and the selected cost from the distribution is contingency. For more information, AACE International has catalogued many professional papers on this complex topic.
Contingency is included in budgets as a control account. As risks occur on a project, and money is needed to pay for them, the contingency can be transferred to the appropriate accounts that need it. The transfer and its reason is recorded. In risk management
Risk management
Risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities...
, risks are continually reassessed during the course of a project, as are the needs for cost contingency.