Budgeting a Contingency Fund

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When planning your construction project or even in your household, establishing a budget is one of the first steps in planning a successful project. Setting a plan for where to spend the money, and budgeting for all the work takes both attention to detail and a complete scope of the project.

However, there is oftentimes unforeseen issues or items that come up where additional work will be needed. This is where a contingency budget becomes critical.

So, what is a contingency fund and how can you budget for it? This article will provide more insight into this topic of budgeting a contingency fund.

What Is a Contingency Fund?
What is Contingency Budgeting?
What are Some Pros and Cons of Contingency Budgeting?
How much Should a Contingency Fund be?
How do you Calculate Budget Contingency?
What is Contingency Cost in Construction?
What is an Example of Contingency?
What are the Benefits to the use of Contingency Funds?
How do you Write a Contingency Plan?
What are Key Components of a Contingency Plan?
What Budget Items Could be Addressed in The Contingency Plan?
What Does Contingent Mean in a Budget?
What Are The Three Benefits to The Use of Contingency Funds?
Contingency Budget Example
Contingency Fund Formula
Contingency Budget in Project Management
Importance of Contingency Fund
How to Calculate Contingency Cost
What is Included in The Contingency of an Estimate?

What Is a Contingency Fund?

A contingency fund is cash or other assets reserved to address unforeseen circumstances or losses in a business. The role of the contingency fund is to improve a company’s financial stability by developing a safety net that the firm can use to fill emergency needs. It can also be used to reduce the need to take out high-interest loans, such as credit cards, to cover unexpected expenses.

Major Emergencies

A contingency fund lets a small business owner react to emergency funding needs while continuing with at least some normal operations. The contingency fund gives the company the flexibility to address emergencies that require large cash outlays with little to no disruption of its ability to pay routine expenses.

Read Also: Budgeting on a Fluctuating Income

Without a contingency fund, events such as natural disasters, mechanical failures or medical issues can drain much-needed resources and cripple a firm’s ability to conduct business.

Large Expenditures

The uses of a contingency fund are not limited to emergencies. A contingency fund can also be used to cover major business expenditures. These expenditures can include replacing old equipment, upgrading technology or acquiring other assets.

However, monies from the contingency fund should be used to improve the business and take advantage of opportunities that require immediate cash outlays — not as a means to pay for routine expenses or extravagant items.

Credit Protection

Another purpose the contingency fund serves is to protect businesses from having to use credit to finance unexpected expenses. When a company takes out a loan or uses a high-interest credit card to cover emergency needs, it can wind up paying back the loan and the interest for months or years to come.

High debt can hamper a company’s ability to acquire assets, hire new workers and expand its capabilities. A contingency fund reduces the company’s reliance on debt.

Each company must develop its contingency fund budgeting based on its individual needs. An early-stage startup often will experience more variance than a more established firm, so these companies often require a higher percentage of their budgets dedicated to contingency funds.

Depending on the industry, a startup can require 10 percent to 20 percent of its budget set aside as a contingency fund. These monies protect the company as it encounters unforeseen expenses and ramps up its cash flow in the early stages of business development.

What is Contingency Budgeting?

Contingency budget, in the context of project management, is an amount of money that is included to cover potential events that are not specifically accounted for in a cost estimate. The purpose is to compensate for the uncertainty inherent in cost and time estimates, as well as unpredictable risk exposure.

A contingency is something that may or may not occur but that must be dealt with if it does. The word contingency implies that the potential of an event is foreseeable. In business, contingency plans are drawn up to specify foreseeable potential events, the actions to be taken to address them and the resources that will be required to do that, including money.

Events that are known possibilities are sometimes referred to as known unknowns. Additional funding may be included in contingency for unforeseeable events, which are sometimes referred to as unknown unknowns.

The amount allotted for contingency and details of what it is intended to cover may be laid out in documents shared with the clients or maybe only specified within the project management organization. In some cases, contingency is not specified but is ensured through mechanisms like adding to the number of days allotted for a segment of the project, in which case it is sometimes referred to as padding.

What are Some Pros and Cons of Contingency Budgeting?

Many businesses use budgeting as a management tool to plan for future activities, allocate competing resources and evaluate team performance. Budgets mostly deal with estimates and projections that management makes based on what is known, as well as projected future uncertainties.

The budget contingencies method purposely incorporates certain risk factors into the budgeting process to help a business better prepare for potential contingencies. Management may also use the budget contingencies method to its own advantage for meeting performance goals. However, unduly relying on budget contingencies may overstretch a business’s resources and result in unrealistic projections.

Risk Management

Compared to non-contingency budget methods that do not plan for potential unknowns, the budget contingency method sets aside additional resources that can be drawn on if the unexpected happens in future business activities. Using the budget contingency method, a business has the advantage of carrying out better risk management.

Business risks are perceived future uncertainties based on management past experiences, such as price fluctuations, changes in cost structure due to product or service modifications, or other projection errors and omissions. Management often is aware of these risk factors, and not including them as part of the estimates could render a budget potentially unreliable.

Budget Performance

Management may also have the incentive to adopt the budget contingencies method when its performance rewards are based on meeting budget goals. In a contingency budget, management tends to provide lower sales goals but higher cost targets. Contingency planning provides a safety precaution or buffer zone, but management does not have to resort to it if business conditions turn out to be normal.

The budget contingencies method provides management a better chance to outperform a budget when in comparison, actual sales can more easily surpass budgeted sales goals and true costs stay below-budgeted cost targets. In a worst-business scenario, management may still be able to meet the conservative goals set in a contingent budget.

Budgetary Slack

The budget contingencies method has its drawbacks. Allowing to plan for contingencies may unintentionally cause management to unreasonably underestimate sales and overestimate costs, effectively padding a budget with the so-called budgetary slack. A budgetary slack is the difference between what management believes about a budget and what it actually gives as projections.

A budgetary slack does not necessarily reflect genuine risk considerations used in contingency planning, but rather is the result of likely unethical management behaviors. By padding a budget, management hopes to make a budget easier to achieve, which could decrease business efficiency and inhibit innovation.

Straining Resources

The budget contingencies method often requires businesses to have enough resources to back up their contingency budget plans. If a business is lacking in resources, management likely would have to compete for limited resources that are allocated among different divisions. This can cause strains on a business’s resources and lead to potential budget cuts, a measure often used in the resource-allocation process.

Anticipating a budget cut, management may want to take advantage of the budget contingencies method by further inflating its budget. Faced with ever-growing budgets, a business likely will have to implement more budget cuts, creating a vicious cycle in budgeting and resource allocation.

How much Should a Contingency Fund be?

Families should allocate a percentage of their income to contingency funds. Although 10 percent is preferred, a minimum of 5 percent of Net Spendable Income should be placed in contingency funds.

Even though some financial planners recommend keeping a specific amount (like $10,000 for example) in contingency funds, most planners recommend maintaining a minimum of three to six months’ living expenses for families who have steady incomes; for those who have fluctuating or seasonal incomes, six months’ living expenses is best.

This does not mean that large amounts of money should be saved while failing to pay creditors, but a good habit to develop is to save a small amount on a regular basis.

As a thumb rule and for starters, it is advised to keep at least three to six months’ worth of basic living (and non-negotiable) expenses as emergency fund. Later on, it can be enhanced to cover six to 12 months’ worth of expenses.

So how do you find out your correct monthly living ( and non-negotiable) expenses?

Here is what you can include:

-Start with critical ones such as rent (and/or home loan EMI), food, non-food consumables, utilities, school fee, transportation (fuel) costs, healthcare expenses, other loan EMIs and salaries for support staff (if any). You may also want to include important yearly expenses such as insurance premiums.

-Other non-critical but regular expenses on entertainment, eating out, vacations, etc. aren’t exactly the categories you spend money on during emergencies. So, those can be left out for starters. The idea is to focus only on basic unavoidable and essential expenses.

How do you Calculate Budget Contingency?

In deterministic methods, contingency is estimated as a predetermined percentage of base cost depending on the project phase. In this technique, you take a percentage of the cost of the project and calculate the contingency amount.

Consequently, how is contingency calculated?

Dividing the total overruns by the total associated revenue gives you the percentage to use for your contingency reserve. Use this percentage to calculate the amount you need to reserve for current and future projects. For most companies, this percentage will be 3 percent to 5 percent of the project’s budget.

Similarly, what is the contingency amount? Most of the highly experienced cost estimators or cost engineers and quantity surveyors 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

Then, how much should I budget for contingency?

Most construction projects use a rate of 5%-10% from the total budget to determine contingency. Typically that will cover any extra costs that might come up. However, it is often a bad idea to use a rate less than that, depending on the scale of the project.

Is contingency a hard cost?

Definition of Hard Cost Contingency Hard Cost Contingency means the amount shown as such in the preliminary project budget to cover Hard Costs in excess of those shown in the Final Project Budget for the Work to be performed under the various GMP Contracts for the Project.

What is Contingency Cost in Construction?

Risk management is the name of the game in construction. Including a construction contingency in your budget is the first step to protecting yourself against any unforeseen risks. Remember: Risks equal costs, and the money needs to come from somewhere.

A construction contingency is an amount of money set aside to cover any unexpected costs that can arise throughout a construction project. This money is on reserve and is not allocated to any specific area of work. Essentially, the contingency acts as insurance against other, unforeseen costs.

Determining the amount of contingency is a balancing act. On the one hand, you want to have enough contingency funds to cover any uncertainties. On the other hand, you need enough cash on hand to keep construction going. Most projects will use a rate of around 5-10% of the total budget for contingencies.

There are two main types of construction contingency funds: contractor contingency and owner contingency.

Contractor Contingency

A contractor contingency is an amount built into the contractor’s anticipated price for the project to account for various risk factors that cannot otherwise be accounted for in a schedule of values. This money is set aside to account for any errors that occur on behalf of the contractor.

Accordingly, contractors consider these funds spent money. Building this extra funding into your estimate is the contractor accepting the fact that unpredictable costs are all part of the construction biz.

Owner Contingency

An owner’s reserve is an amount set aside for additions or modifications of the scope of the work. These types of contingencies are used mainly in guaranteed maximum price (GMP) contracts. Changes and mistakes are not always the contractor’s fault. Any changes that are not included in the initial bid will have to be paid by the owner funded contingency. Incomplete plans or owner directed changes are the leading causes of dipping into an owner contingency fund.

What is an Example of Contingency?

Use the examples below to help your organization handle a potentially risky event:

Staffing contingency plan

Your team might operate efficiently on most days. Without sufficient staff, however, your company’s productivity could suffer, which could delay your upcoming product launch.

Example of a staffing contingency plan:

Event. At least 50% of your team of programmers call in sick on a workday
Response. Begin contacting a temp agency or a list of contractors, requesting that they fill in for a day and aim to have at least 75% of programmer spots filled on every workday
Personnel. The product team manager is responsible for contacting contractors, informing the product team director about the situation and updating the programmer team
Timeline. Start calls immediately after learning about staffing issues, and aim to staff team to 75% within an hour

Supply chain contingency plan

To manufacture products, your company may need a constant supply of materials. If your suppliers experience inventory issues, your company could have production and delivery delays, which could lead to angry customers.

Example of a supply chain contingency plan:

Event. A supplier informs your company that the delivery of an essential ingredient will be delayed by a week or more
Response. Search for the ingredient at local stores and wholesalers, and purchase a sufficient amount if it costs less than 20% more than the standard supplier price
Personnel. Supply chain manager is responsible for finding alternative sources for the ingredient, informing the accounting manager and talking with the marketing manager about informing customers of delays
Timeline. Start sourcing the ingredient within the hour, and aim to procure it by the end of the day

IT contingency plan

Your company might strive to keep customer data as secure as possible. If an accidental data breach results in the loss of customer information, however, your company’s reputation and future could be at stake.

Example of an IT contingency plan:

Event. Your company learns that its customer data has been compromised in some way
Response. Find the source of the problem, stop the information leak and pursue repairs, then assess the extent of the data breach and the affected customers
Personnel. The Chief Information Officer (CIO) is responsible for overseeing security fixes, mobilizing IT staff and clarifying the issue for the public relations team, the Chief Marketing Officer (CMO) is responsible for communicating with customers and the general public
Timeline. Start repairing the security issue immediately, and contact the CMO within the hour and aim to understand the extent of the problem and share the issue with customers by the end of the day

What are the Benefits to the use of Contingency Funds?

While you might use the phrase, “Plan B” as a humorous reference in your personal life, it’s important to have backup plans in your business to prevent serious problems that could damage or ruin it. Most of the strategic plans you make are probably aimed at helping make a profit and keeping your doors open.

If they fail, you are less likely to be able to respond quickly enough if you don’t have a contingency plan. As counter-intuitive as it might seem, planning for failure can be just as important as planning for success.

Minimizes Damage

A contingency plan helps you quickly take steps to address a problem that could stop production, shut down your website, cause you to lose work and data or miss credit payments. A simple example of a contingency plan is having a backup generator in the event of a power failure.

If you lose a large customer that’s responsible for much of your sales, a contingency plan will help you quickly reduce your workforce, cut your overhead and production spending and seek other sales to replace as much of the loss as possible.

Reduces Bad Public Relations

Even if you’re a small local business and your operating problems won’t make headlines in your town’s newspapers, competitors might start spreading rumors and customers might start to worry if you run into serious trouble. A contingency plan that helps you address a problem or get back on your feet allows you to communicate your response to a problem to relieve any concerns that problem might create.

For example, if a key employee leaves, your contingency plan should include having a successor identified or a qualified substitute ready to fill in, even temporarily. This will allow you to let stakeholders know your employee’s departure will not affect your operations, that you will have a full-time replacement in position within a short time and that you have position covered until that time.

Keeps You Operating

There are many factors that can cause you to temporarily stop your operations, including a lack of working capital, machinery breakdown, office shutdown or strike. Contingency plans can help you keep operating through a crisis. A cash reserve or open line of credit can help you weather poor cash flow.

The ability to transfer your production to another location or outsource it during a machinery breakdown or weather emergency lets you keep fulfilling orders. Backing up your data offsite each day allows your staff to continue their work without losing important work or access to files.

Improves Insurance and Credit Availability

Businesses that create continuity and disaster recovery plans often have an easier time getting insurance and credit than those that don’t. Being able to show your insurers your contingency plans can help you obtain better coverage and reduced premiums, because the less money an insurer has to pay after an accident or emergency, the better risk you are.

For example, if you back up all of your data each night, you will have a smaller loss from a fire or robbery than you will if you have to re-create all of your website files, customer databases and other data. In the event you need credit to help you through slow sales because of the loss of a supplier, a lender might be more willing to help you with payroll if you show you have another supplier identified and ready to get you back up and selling.

How do you Write a Contingency Plan?

A contingency plan is a plan, and like any plan, it requires a great deal of research and brainstorming. And like any good plan, there are steps to take to make sure you’re doing it right.

Identify and Prioritize Resources: Research your company and list its crucial resources, such as teams, tools, facilities, etc., then prioritize that list from most important to least important.
What Are the Key Risks? Figure out where you’re vulnerable by meeting with teams, executives and every other department in the organization to get a full picture of what events could compromise your resources; hire an outside consultant, if necessary.
Draft a Contingency Plan: If you can, write a contingency plan for each risk that you identified in the above steps, but start with what’s most critical to the life of your organization. As time permits you can create a plan for everything on your list. Whatever the plan, the thought behind each should be the steps necessary to resume normal operation of the company, thinking about communications, people’s responsibilities, timelines, etc.
Share the Plan: When you’ve written the contingency plan and it’s been approved, the next step is to make sure everyone in the organization has a copy. A contingency plan, no matter how thorough, is not effective if it hasn’t been properly communicated.
Revisit the Plan: A contingency plan isn’t chiseled in stone. It must be revisited, revised and maintained to reflect changes to the organization. As new employees, technologies and resources enter the picture, the contingency plan must be updated to handle them.

In project management, contingency planning is often part of risk management. Any project manager knows that a plan is only an outline. Sometimes the project will extend beyond those lines. The more a manager can prepare for chance in their plan, the more effective it will be.

But risk management isn’t the same as contingency planning. Risk management is about identifying, assessing, avoiding, mitigating, transferring, sharing and accepting risk; while a contingency plan is about developing steps to take when an actual issue occurs. However, they do share the aspect of what to do when the risk happens.

So, a contingency plan is what to do if an unplanned event occurs. It can be as simple as asking, “What if…?,” and then outlining the steps to your plan as you answer that question.

Key Steps in Contingency Planning

Project managers are adept at creating contingency plans, as the structure and actions are like many of the processes already familiar to their profession. For instance, a contingency plan breaks down tasks to get more detail and, in so doing, more control.

The following are the key steps in contingency planning:

Note where there are resources that can be used in an emergency. Also, note where in your contingency plan these resources might be applied.
Identify dates that if missed will negatively impact your plan, for example getting approval from a group or committee that only meets every now and then.
Know your contingency plan. Check for any weak links and strengthen them. Identify any slack that you can find in it.
See if you can find points in your plan where alternative routes can be taken, and think through each one’s scenario to add flexibility to your plan.
Use your experience to help you see patterns in your project’s ebb and flow of activity to sharpen your plan.

What are Key Components of a Contingency Plan?

The key to building a versatile and robust contingency plan for any business is to continually plan and review collectively as a team with all levels of management in the business. It is critical to work together as a team to ensure that the developed contingency plan is not only effective but also comprehensive.

Planning for contingencies not only helps the business prepare for unforeseen disasters but also helps us to identify our vulnerabilities as a business and helps fill that gap. We, therefore, recommend the following five essential elements for building a realistic, participatory and comprehensive contingency plan for any business.

1. Scenario Plan – Anticipate the Types of Risks or Disasters you might face

A scenario planning exercise is a critical part of contingency planning as it helps the business to assess, identify and prioritise future risks to the business in different scenarios.

Developing scenarios as a team will ensure that most critical questions are covered, and realistic plans are developed, which will determine the scale of the collective team response and resource requirements. It helps us in anticipating the type of risks or disasters we might face, and to create appropriate response plans for when they strike.

2. Create an Information Manual – your ‘Go-To Document

The next requirement would be to ensure that there exists an up-to-date operational information manual for every risk scenario that is identified.

This manual would be the go-to document that will list the roles and responsibilities of all team members at the time of the contingency and the response, decision, and information dissemination protocol that will need to be followed. It will be a comprehensive document that will set the tone for business recovery and response activities and also ensure quality and accountability of operations.

3. Recovery Planning

An extensive contingency planning exercise covers all the bases regarding establishing business communication, mitigating financial risks, and creating relevant response plans.

In addition to this, a critical element of contingency planning is business recovery planning which will list out the step by the step procedures for the recovery and regular operation of all essential business functions. The recovery aspect of the plan is always going to be fluid as part of the recovery measures will have to be decided and initiated in real-time during the contingency.

4. Stress Test

Conduct stress tests as part of the contingency planning exercise, to help you and your team uncover any gaps in the planning while ensuring sufficient training has also been carried out.

We consider it as a very critical element of contingency planning as it helps to provide clarity and instills emergency preparedness within both the management and staff – and ultimately leads to team coordination; vital to ensuring any business’s continuity of operations and survival.

5. Review Regular Review

Lastly, regularly updating and evaluating the contingency plan is as important as creating one in the first place as any personnel, technological or operational changes within the business could easily make the plan ineffective and inept.

What Budget Items Could be Addressed in The Contingency Plan?

Each household’s contingency planning and budgeting is different. In general, a contingency plan should eliminate unnecessary expenses and reduce necessary ones.

For example, you may be able to identify monthly bills that you could eliminate in an emergency, such as cable television, a cleaning or lawn care service, an extra phone line or an online movie subscription. Other expenses, such as automotive expenses, can be reduced if you cut down to a single car for your family or make plans to drive less as a means of saving on the cost of gas.

What Does Contingent Mean in a Budget?

The amount allotted for contingency and details of what it is intended to cover may be laid out in documents shared with the clients or may be only specified within the project management organization. In some cases, contingency is not specified but is ensured through mechanisms like adding to the number of days allotted for a segment of the project, in which case it is sometimes referred to as padding.

What Are The Three Benefits to The Use of Contingency Funds?

A contingency fund may be used to meet the below mentioned three emergencies:

1. Contingency fund protects you from taking on additional debt
2. Contingency funds help you to finance major emergencies
3. Contingency funds help you to meet large expenses in unforeseen circumstances

Let’s expand on these points to understand them better:

Contingency fund protects you from taking on additional debt An important use of such funds is to protect you from relying on credit to meet unexpected cash requirements. In case an emergency, you don’t always have large amounts of money at hand, and are hence forced to avail of a loan or use credit card to meet such needs, it may have to service the interest and principal repayment for several years. A higher amount of debt may not have short term effects in your daily life, but even affect any savings or investment plans you might have made for the future. Therefore, a contingency fund helps you to overcome your reliance on too much debt.
Contingency funds help you to finance major emergencies Such a fund helps you to meet emergency fund requirements. Simultaneously, you may continue to your day-to-day expenses and even your long-term financial plans you’re your children’s education, easy retirement, or taking that dream vacation. A contingency fund offers you the capability to meet large cash emergency needs with very little disturbance to your abilities to continue paying your regular expenses. In the absence of such a fund, emergency requirements, such as medical conditions, natural disasters, or damage to your property, etc. may create havoc to your financial situation. You may find it difficult to carry on your regular life, which may have severe outcomes.
Contingency funds help you to meet large expenses in unforeseen circumstances The importance of a contingency fund is not only to meet unexpected liquidity requirements. The fund may also be used to meet large expenses in-case you decide to leave your job, or stop making money from your primary source of income. However, it is important for you to use the contingency fund only to meet such money requirements in crisis situations that require immediate money, and not to spend the money for other uses.

Contingency Budget Example

A contingency budget is a budget that covers unexpected expenses during the course of a project, whether business-related or personal. It can be thought of as a budget used if a contingency plan needs to be implemented.

When building a home, a majority of construction projects, and personal projects, use a 10 percent contingency budget rate. However, there are instances when it would be best to have a contingency cushion for different line items in a budget to cover unexpected costs that may occur in the duration of the project.

Step 1

You will want to have a budget for each part of the project.

Identify the items in the project’s budget. Identify the separate costs that may be incurred in the duration of the project. For building a house, such costs could be drywalling, roofing, siding, electrical or paint.

It is ideal to have an exhaustive list of items that go into your project. The more complete the list, the better your contingency budget will be once it is complete and the less unexpected costs will set the project behind.

Step 2

Set a contingency rate will based on the type and size of project you are undertaking.

Set a contingency rate. A contingency rate is a rate at which you will “pad” your budget. As a general rule, 10-15% is commonly used and indicates the project expects to run about 10-15% over budget.

You set the rate based on your level of comfort, but being too liberal on the rate and setting it low could be detrimental to your finances. Setting the rate too high can also be an impediment on your project as you will need to set aside more money than necessary to start.

Step 3

Risks such as bad weather can affect the timeline for a construction project.

Identify potential risks in your project. Keeping to a schedule is often important in home construction projects. If pouring the foundation could be late by a week due to weather impediments, then you will need to reschedule contractors to come after the foundation is poured. This risk should be included in your contingency budget.

Step 4

Scheduling conflicts could put your project on hold temporarily.

Calculate the total cost your potential risks could cost your project. These costs are just estimates and do not need to be exact.

Example: Scheduling Risks $2,000 Weather Risks $5,000

Step 5

Make sure to set aside enough of a contingency budget to cover unexpected costs.

Set an amount for your contingency budget. If your total costs are below your contingency rate, set aside an additional amount associated with unexpected costs and risks that cannot be foreseen. For example, we have a contingency budget of $15,000 but only set aside $7,000 for specific risks that may arise. We add the additional amount of $8,000 to cover costs that we can not predict.

Example: Scheduling Risks $2,000 Weather Risks $5,000 Other Risks $8,000

Total Contingency Budget: $15,000

Contingency Fund Formula

In deterministic methods, contingency is estimated as a predetermined percentage of base cost depending on the project phase.

Contingency= % x Base Cost Estimate

In this technique, you take a percentage of the cost of the project and calculate the contingency amount. To do so, you need to have an expert judgment or use some predetermined guidelines or both.

– Expert Judgment

In this method, an expert, or a group of experts with a strong basis in experience and competency in risk management and analysis, determine the percentage of contingency for the project.

Although the experts consider specific situation of the project and determine a unique contingency percentage for the project, they still don’t perform a formal and comprehensive risk analysis on the project. Therefore, this method cannot provide the confidence level for the adequacy of the estimated contingency.

– Predetermined Guidelines

According to the Association of Advancement for Cost Engineering, AACE International, this method may be as simple as providing a single contingency (e.g., percentage of base cost) for use on all estimates of a certain type to complex tables or scoring mechanisms that employ elements of parametric modeling.

A common approach is to establish a table of contingency values and ranges for each of AACE’s estimate classes with alternate values and ranges provided for common risks. For example, for a class 5 concept screening cost estimate, a 40% contingency may be assigned, whereas a class 2 cost estimate may include a 15% contingency.

Although calculating contingency using predetermined guidelines is simple, understandable, and consistent, it cannot effectively address the impact of risks that are unique to a specific project.

Therefore, these deterministic methods are usually used by organizations that are not interested in applying a formal risk assessment and analysis on the project for various reasons such as lack of time, insufficient funds, and the type or size of the project. The typical use of the determinist methods is on small and non-complex projects.

Contingency Budget in Project Management

One 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 a sum of 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.

Importance of Contingency Fund

Unless you have a crystal ball that predicts {to the T} your future, anything can happen. And this is precisely the top reason why you should have a contingency fund. Other more evident and rudimentary reasons are:

To hit pause and take a sabbatical from work. We are only humans, and there is only so much work we can do without burnout. This is where a vacation or extended break from work comes in. Having a contingency fund gives you this option.
To avoid unwanted credit card bills or borrowing from friends. Having a contingency fund ensures you don’t max out your credit card when things go awry. It gives you financial independence where you don’t have to rely on your friends or family to bail you out of unexpected inconveniences.
To pay for sudden travel overseas. The unexpected death of a relative in another country or your close friend needs assistance to recover from an unforeseen situation, and there are various reasons why you may have to travel abroad. The return fare can leave a dent in your pocket. Thus, the contingency fund comes in handy in such a situation.
To cover medical bills. The biggest argument put forth for this is medical insurance. Yes, we all are smart enough to invest in one. However, there are a lot of things that the fine print of your medical bills won’t cover, and the last thing you want to stress you out when you are severely ill is your medical bill.
To pay for large expenditures. Not just emergencies, but contingency funds are also essential to pay for significant expenses like an investment of cash in your startup idea. Or put the down payment for a home you have always wanted, and it just went on sale. A contingency fund gives you the freedom to go for those dreams of yours – from a car to a house to even starting your own business someday.

How to Calculate Contingency Cost

While it can be tempting to add a flat percentage to the project cost in hopes that it will cover unforeseen situations, this approach isn’t the most effective – there are too many variables to consider. For example, similar projects run numerous times by an experienced project manager will require a smaller contingency than a new project with unknown elements.

Follow the steps below to calculate a more meaningful contingency – one that takes into consideration the potential risks and focuses on the costliest issues.

Separate your contingencies

To accurately calculate a contingency, specify exactly what the amount will cover. Contingencies are typically used to cover potential project risks, such as unmet objectives, rather than changes in scope. Changes to project scope require a recalculation of both the baseline budget and the contingency.

Including a second contingency amount (or program contingency) can cover risks that weren’t initially identified but become obvious later in the project.

Identify and Determine Potential Risks

Risk planning should be a major part of your project contingency, which is why flat percentages generally don’t work. The easiest way to do this is to multiply the probability percentage by your estimated cost impact, providing a risk contingency for each line item. For example, a risk probability of 20% multiplied by a cost impact of $40,000 equals a risk contingency of $8,000.

Calculate your Contingency

If you perform the risk contingency calculation above for every identified project risk and then add them together, you’ll have a strong contingency calculation. (Consider the flat percentage you would have chosen. Is the calculated contingency more or less than the flat percentage? How would that affect your project?)

Get Sponsor Signoff

Whatever you calculate your contingency to be, you’ll need approval from your project sponsor to set the funds aside. (It’s often easier to keep the contingency separate from the baseline budget, but make sure it’s accurately presented during project sign off.)

Depending on the length of the project, it may be helpful to re-evaluate the contingency, as the balance between the contingency and uncertainties in the forecasted costs to complete remaining work may change as the project progresses.

What is Included in The Contingency of an Estimate?

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.

Contingency “refers to costs that will probably occur based on past experience, but with some uncertainty regarding the amount. The term is not used as a catchall to cover ignorance. It is poor engineering and poor philosophy to make second-rate estimates and then try to satisfy them by using a large contingency account.

The contingency allowance is designed to cover items of cost which are not known exactly at the time of the estimate but which will occur on a statistical basis.”

The cost contingency which is included in a cost estimate, bid, or budget may be classified as to its general purpose, that is what it is intended to provide for. For a class 1 construction cost estimate, usually needed for a bid estimate, the contingency may be classified as an estimating and contracting contingency.

This is intended to provide compensation for “estimating accuracy based on quantities assumed or measured, unanticipated market conditions, scheduling delays and acceleration issues, lack of bidding competition, subcontractor defaults, and interfacing omissions between various work categories.”

Additional classifications of contingency may be included at various stages of a project’s life, including design contingency, or design definition contingency, or design growth contingency, and change order contingency (although these may be more properly called allowances).

AACE International 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
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”

Bottom Line

Successful contingency planning is central to business strategy and committing team time and resources to work through these tips mentioned in this has been crucial in these current challenging times. Spending time doing the right contingency planning, will save your business time and money, should disaster strike.