Risk, uncertainty and contingency on large capital projects

The unexpected has a one-sided effect with projects

'The unexpected has a one-sided effect with projects. Consider the track records of builders, paper writers, and contractors. The unexpected almost always pushes in a single direction: higher costs and longer time to completion. On very rare occasions, as with the Empire State Building, you get the opposite: shorter completion and lower costs – these occasions are truly exceptional nowadays'.  

Nassim Nicholas Taleb – The Black Swan: The Impact of the Highly Improbable

Capital projects involve the expenditure of current resources in the expectation of generating future benefits. The future is an uncertain place however, and in order to ensure insofar as it is possible that the expected benefits of a proposed project justify the expenditure of the required resources, a rigorous economic evaluation is required prior to project sanction. Cost and schedule estimates form the basis of this evaluation, and represent a considered view of how much a project will cost and how long it will take to execute. 

The construction industry has a poor track record with respect to cost and schedule estimates; with many projects being delivered late and over budget. A recent review of the UK construction industry found that only 56% of projects were completed within their construction budget and only 48% of projects were completed on time. Employers also have a tendency to underestimate the duration of pre-construction activities. When this is considered in conjunction with the construction phase, only 40% of projects were completed in line with the programme provided at the time of project sanction.  
 

When developing cost and schedule estimates for projects, consideration should be given to the following three elements: 

• Base estimate — a sum of money and time required to deliver the defined scope, plus additional allowances to provide for known but undefined scope.
• Contingency — a sum of money and time required to provide for risk and uncertainty, which when summed with the base estimate should be sufficient to execute the project at a defined level of certainty. It should exclude major changes in project scope, escalation and currency effects, and extraordinary events such as major strikes or natural disasters. Contingency is usually held under the operational control of the project manager.
• Management reserve — a sum of money and time required to provide for risk and uncertainty which when summed with the two amounts above should be sufficient to execute the project at a defined, but higher level of certainty than that associated with contingency. Management reserve is usually held under the operational control of an organization’s management team or project board, and is essentially an allowance for low probability (but potentially high impact) risk.

The level of confidence required for the calculation of a contingency allowance is dependent upon the environment in which the project is being considered and the client organization’s appetite for risk. Should the investing organization have a portfolio of projects and believe that an over-run on one project will be counter-balanced by an under-run on another, it would be prudent to set the level of certainty required at 50% to ensure that funds that could be better utilised elsewhere do not lie dormant within contingency reserves. If however a project is a one-off and the organization’s management team requires assurance that there will be no over-run of the approved budget or time-line, then a higher level of certainty / contingency will be required. In practice, for higher value capital projects undertaken by large organizations, contingency is commonly set at the amount of money and time required to provide 50% certainty (p50) and management reserve is set at 80% (p80) or 90% (p90) certainty. 

When quantified using a suitable methodology, specific contingency amounts of money and time can be linked or associated with individual risks. Such quantification is usually effected through the undertaking of risk workshops and the development and maintenance of risk registers. As a project progresses, the status of each risk should become clearer with funds and float transferring from contingency as necessary to the project budget and programme. Contingency no longer required should be retired, and returned to the investing organisation for use elsewhere within its portfolio. Consequently, the level of contingency should be monitored throughout a project’s life for appropriateness.

… the level of contingency should be monitored throughout a project’s life for appropriateness.

In summary, cost and schedule over-run occurs on capital projects usually because the contingency allowance allocated at the time of project sanction proves to be insufficient to cater for the risk and uncertainty existing within the project. The underlying cause of this insufficiency is a failure on behalf of the project team to identify and quantify risk and uncertainty, or a failure on behalf of management to acknowledge it. While there are a number of methodologies which, if used appropriately, will prove effective in risk quantification; it is also essential for project teams to recognize their biases and their resultant blindness to entire categories of risk and uncertainty; and for the investing organization’s management team to recognize their biases and their resultant deafness to unpalatable numbers.