This is the second in a series of three articles about Management Reserve written by EVM SME Mark Infanti. You can read the first article Management Reserve Defined here.
FAR 31.205-7 (c), defines contingency as a possible future event or condition arising from presently known or unknown causes, the outcome of which is indeterminable at the present time and indicates that costs for contingencies are generally not allowable. Those which are foreseeable within reasonable limits of accuracy, e.g., anticipated costs of rejects and defective work may be included in the estimates of future cost so as to provide the best estimate of performance cost.
In contrast, Management Reserve (MR) is not foreseeable and should not be included in the PMB. The challenge then is how to estimate the cost impact of risks, which are uncertain future events, in the proposal cost estimate, so that sufficient budget is available to plan the know work and set aside management reserves.
The EIA 748 standard says “MR is not a contingency that can be eliminated from prices during subsequent negotiations or used to absorb the cost of program changes. The budget being held in reserve must not be viewed by a customer as source of funding for added work scope.” (Unfortunately, this rule is often violated).
This conflict has perpetuated the mindset that MR should be “buried” within allowable cost elements proposed on a project, so that once the contract is negotiated, the contractor then sets aside an amount from the CBB for MR.
In the past, contractors would hold back a percentage (e.g., 10%) from the total negotiated budget to establish MR and distribute the remainder to the Control Accounts. This is no longer considered a best practice. These days, risk management is well-integrated with both cost estimating and earned value management.
Proposal costs are estimated by assessing and quantifying potential risks and opportunities, developing risk and opportunity handling plans, and including the cost of those handing plans in the proposal estimate. Through Monte Carlo and other risk analysis techniques, proposal estimates with specific confidence levels can be developed and proposed based upon a contractor’s risk appetite.
Upon contract award, the risk assessment is updated, and budgets are allocated to control account plans based on the risk inherent in the control accounts’ work scope. Overall budget allocation is typically made at a more challenging level of confidence than the proposal cost estimate, allowing the extra budget for the establishment of management reserve. The allocation of budget to individual control accounts is risk-based, with more budget allocated to high-risk project elements; less budget allocated to lower-risk elements.
One process for assessing and quantifying risk and opportunities and using this information to establish management reserve is as follows:
- During the proposal stage, perform a risk analysis. Quantify the probability of occurrence and the consequences of identified risk events. Identify risk/opportunity handling plans to mitigate or eliminate risk and capture opportunities. Include the cost of risk/opportunity handling plans in the proposal cost estimate. For risks that will be accepted, include the cost of their consequences. Perform additional analysis to determine the level of confidence in the cost estimate. Determine the confidence level required for the acquisition based on management’s risk tolerance. For instance, you may decide to bid a high-risk project with a cost estimate having an 80% confidence level in order to ensure project success.
- When the contract is awarded, budget the Control Accounts at a lower overall confidence level, i.e., selectively issue target budgets lower than the high-confidence estimate, to the control accounts based on their inherent risk, and retain the remaining budget in MR.
- For example; if a task will cost $110,000 with an 80% probability of success; and
- The Control Account may be budgeted at $100,000 (based on a 50% probability of success)
- The remaining $10,000 is maintained in MR
- Some of the allocated control account budgets should be used to plan risk/opportunity handling activities. Generally, not all risk/opportunity handling activities are included in the PMB; usually the handling activities for risks with a high probability of occurrence and consequences will be initially planned. The remainder of the risks/opportunities will be carefully monitored. When it becomes obvious that they are elevating in probability or impact, MR can be issued to prospectively plan risk handling activities. Therefore, MR initially set aside should be carefully reviewed to determine if it is sufficient to handle risks and opportunities not included in the initial PMB. In addition, some amount of MR is also required for unknown unknowns that typically occur on any project and must be based on management judgment, the type work, and past experience with this type of project.
- In the past contractors would just hold back a percentage (10%) from the negotiated budget for MR and distribute the remainder to the Control Accounts. That is not a best practice.
Then there is the issue with a “per-award IBR”. An IBR (Integrated Baseline Review) is designed to provide a meeting that would assure both the client and contractor have a common understanding of the scope of work and the risks involved. This has typically been done after contract award but it is being used more often for follow on contracts and when the bidders list is narrowed to 2 or 3 contractors. If the IBR is pre-award, then the MR cannot be shown. But the risks used to establish the MR are part of the review. There is a potential conflict depending on the experience of the review team.
Once the contract is underway, management reserve can be replenished in two ways.
- Via changes to the contract
- Via prospective replanning, to remove budget that will no longer be required due to the result of opportunity realization.
Planning for contract changes is done exactly the same way as planning the initial PMB. An amount of the contract target cost is set aside in MR based on the risk inherent in the added contract scope. Every time you estimate a change that has risks associated with the new work scope, you should perform a risk analysis, evaluate the cost of the risk and when approved, withhold the risk amount for MR. It is just as valid for a change, as it is for the original project planning.
The realization of opportunities, which are identified in the initial risk/opportunity assessment, and subsequently managed proactively in order to realize them, often results in the elimination of future work that had been planned in the PMB. Budget for this work, which will no longer be required, can be transferred back to MR when the work/planning package containing it is replanned.
The amount of MR needed for a project depends entirely upon the amount of risk it entails. However, data are available to help a PM determine how much is typically required on several types of projects. These data can be used as a benchmark. One of the questions often asked is; “How much MR should I have?” That is an impossible question to answer in general, but here is some background.
Management Reserve Study
There was one study done on Industry Averages for MR that was published in the Acquisition Quarterly Review – Summer 2000 by; David Christiansen and Carl Templin. They reviewed data from the Defense Acquisition Executive Summary (DAES) for the period 1975-1998. This study included over 500 completed and ongoing contracts. The DAES reports reflect summarization of information from contractor Contract Performance Reports (CPRs).
In that report they charted the median percentage of MR by contract category and by acquisition phase. Here are the charts. Figure 2 shows the median percent of MR by contract category and Figure 3 shows the median percentage of MR by acquisition phase.
These are median numbers, not averages. That means there are an equal number of data points above the median as there are below it. The range for the MR percentage was 2.2% to 6.1% where:
MR% = MR budget / Total allocated budget
Notice that for fixed price contracts the percentage is higher. Hopefully that is obvious, as the risk is all on the contractor so the contractor would plan additional MR.
The MR percentage is higher for development contracts than for production contracts. That seems obvious also, as there are a lot more risks in development work than in a production project.
There are a few considerations in establishing and maintaining the MR;
- Once a contract is awarded, refine / reassess mitigation measure(s) included for each risk event. Things may have changed since you proposed the contract which will affect future decisions
- Reduce / transfer value of high cost risk to MR if mitigation effort was successful
- Reevaluate risks and associated MR throughout execution of the contract
- Risks change. When risks are retired, the associated MR is either formally transferred to other risks or retained as “non-specific”
- MR allocated during execution of contract should be directly tied to amount associated with each identified risk
- MR allocations are part of the change control system. They are internal changes but require that a change request is issued and the project manager authorizes the change to the CA(s).
Read the third article in this three part series Using Management Reserve (MR)