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Managing Cost Risks (CR)

Success or failure in projects is a direct consequence of Risk Management. A project can be considered failed when no deadlines, cost, quality and/or scope are met. Successful projects must also add some value being aligned with the business. The involvement of key stakeholders from the beginning is essential as they can help to manage risks proactively and reduce uncertainty in collecting requirements, the two main factors of high project failure rates according to Gartner. Nevertheless, in a recent study the main cause for unsuccessful projects are errors during the estimation phase.

Risks, which can be defined as uncertain future events that if it happens will have a negative impact on your project “fit for use” deliverables,  have to be managed from the very early phases of the project, in a proactive way, considering and understanding the parameters of the project (project type, size and complexity), and following-up principles (being aligned with the objectives, fitting the context, engaging stakeholders, communicating effectively, facilitating continual improvement and  creating a supportive culture) in order to achieve the result:

  • Reduce waste/rework and increase client and user confidence.

For that purpose, is essential to obtain senior management support from the beginning.

The impact on project costs resulting from the cost of implementing changes, increase as the project is progressing in its life cycle. However, the involvement of stakeholders and the level of uncertainty and risk that may occur are being reduced progressively:

cost-risk

Process overview by considering impact on project costs:

  • Risk Plan: risk thresholds, probability thresholds, impact thresholds, possible sources of origin for defining risk contingencies.
  • Risks Identification: determining which risks might affect the project as soon as new activities that may require additional costs are identified.
  • Risk Analysis: prioritizing risks for further analysis and actions to mitigate them, a quantitative analysis. During this analysis, the probability and impact of risks events is calculated and translated into project costs impact. This can be determined by using different techniques, including the Expected Monetary Value analysis or Monte Carlo simulation.

One of the most common mistakes in managing project risks is that those risks are evaluated using only such techniques, and does not provide specific risks.

  • Risk Response Plan: Develop options and actions that can increase opportunities and reduce threats to the achievement of the objectives, applying best practices that reduce cost:
    • Check spreadsheet, check assumptions, exploring options for lower cost, improvements identification in process efficiency or negotiating scope reduction.
  • Risk control: tracking and monitoring risks identified and registered, identifying new risks, executing action plans, and defined evaluation of the effectiveness of the implementation of such plans.

Cost Risk is well explained by the following example:

  • Who takes the risk in a fixed price contract, the seller or the buyer? The seller, of course.

Risks analysis for planning project costs

There are three main factors to note in managing cost risks during the cost planning phase:

  • Stakeholders: They can have different requirements for costs that can be managed in different ways, so they should stay involved from the beginning in order to prepare an accurate estimation of the resources required to implement the planned activities.
  • Entire Life Cycle: During the cost planning all the costs of investment regarding resource acquisition and project implementation effort should be identified, and future recurrent costs for operation and support have to be identified as well, considering the costs of the entire life cycle of the product and not only the cost of the project.
  • Project Funding Strategy: The strategy selected for the project funding like self-funding, funding with equity or funding with debt, have to be analyzed since it may impact on the project risks.

Managing risks uncertainty during project cost estimates

Cost estimates are based on the information known at a given time. Decisions such as outsource activities, buy instead of making or resources sharing (in order to reduce costs) have to be considered during the risks analysis as they impact on project costs estimates. Risks often have impact on project costs, whether risks that may be translated into threats or opportunities as well. In project cost estimates, identified risks and the costs associated with its plan to mitigate them must be documented, whether they will be assumed, transferred or reduced:

  • Risk Management Plan: A budget for risk is included.
  • Risk Register: The list of so far not covered risks. In the estimation phase, it has not yet made a comprehensive and detailed analysis of all project risks.

As mentioned before, the uncertainty during project estimation phase is much higher than it will be as the project progresses, therefore the accuracy in estimate costs will be much lower at the beginning. Although the risk management plan includes a first analysis and a budget for them, at the time of estimating project costs there is still much uncertainty and risks not covered yet that have to be consider when determining the project budget.

The uncertainty even at the stage of cost estimates should be reflected in the contingency reserves, which is included as part of the cost baseline, and assigned to respond identified risks through its mitigation plan.

This is the known-unknowns that may impact the project. The risk is known, but its impact cannot be calculated accurately. For example, we know about the technical complexity of an IT project, so we may have a large volume of incidents that would impact on the quality of the deliverables and project schedule, but we are unable to quantify.

This cost can be estimated as a fixed number, a percentage of the total project, or use analytical methods of calculation.

When it comes to uncertainty about work covered by the scope of the project but cannot be identified at the beginning, we talked about management reserves, which is not included in the cost baseline until it is required to use it, through the change control process, even if it is part of the project budget. See the example below:

  • Cost Budget: 1.500€
  • Management Reserve: 100€
  • Cost Baseline: 1.400€
  • Contingency Reserve: 180€
  • Project: 1.220€

Other factors to consider in cost estimates

When estimating the costs associated with different resources such as materials or equipment, the risks associated with variable costs must be analyzed, such as the variability of exchange rates. External factors and the associated risks to them should be identified and estimated, for example the market conditions at any given time.

It is also recommended to consult historical information and lessons learned from similar projects in order to identify risks by analyzing incidents raised during the execution of these projects, and estimate its cost.

Risk management techniques to determine the budget

There are different methods to estimate project costs, and all of them require significant risk management during the budget estimation process.

1- During the estimation and determination of the budget, the project manager should analyze the risks that may impact on project costs, risks which even if low probability of occurrence, suppose extra money.

Example: There is a risk that one of the key people with greater expertise in a specific technology quit the project. Actions such as reaching agreements with technological partner to whom we can swiftly outsource experts to replace the technician, are recommended. The extra cost of this subcontracting and the overtime dedicated to transfer the knowledge should be taken into account in determining the budget.

The experience shows that to achieve the necessary investment for the project, it is recommended to present a specific budget for project risks management (considering costs of the risks that will be transferred or reduce), instead of increasing the budget by a percentage for risks contingencies.

2- We can also use another method to help us decide whether a project should be initiated. All risks are listed and categorized quickly and schematically according to this table.

cost-risk

The number of risks that are located in the “Avoidance” area describes the risk level of a project, which indicates that it should be analyzed whether it is worthwhile or not to initiate the project, also considering its profitability.

Control costs and risks

The cost of changes resulting from risk events occurred during the control phase and the deviation from the cost baseline is analyzed, and extra cost is added to the baseline. This analysis can be performed based on the following parameters:

  • Cost incurred for any unidentified risk, which occurred
  • Deviation of estimated impact to real impact for risks occurred
  • Mitigation Cost vs Cost of Impact

The status of contingency reserves and management reserves is monitored. A risk analysis is performed to determine if the reserves are still necessary, are sufficient or additional reserves are required, as well as the need of using some of the current reserves to cover the cost of risk mitigation or other contingencies.

If the reserves adopted in the budget are no longer necessary because the risk events have not occurred for the identified risks, these reserves should be eliminated from the project budget being able to be used for other projects.

If we properly estimate the contingency reserves necessary for risk response plans and correctly-dimension the management reserves for unforeseen work within the scope of the project, we will to reduce threats to the project objectives increasing the chances of project success.