Contingency Cost

Contingency cost refers to the expenses set aside to deal with the uncertain or unexpected circumstances or events that may arise while on course to a business or project endeavor. It serves the purpose of providing a cushion or safety net against uncertainties and mitigating potential risks.

It also conveys to the management that some factors exist that could hamper a project despite taking all precautions, planning, and deploying risk management strategies. It helps to ensure a smooth, unhindered project running until it is successful without any risk of unforeseen challenges, negative effects of market volatility, or adverse changes in the scope of the project.

• Contingency cost is a designated budget kept aside for unforeseen or unpredictable circumstances during a business or project undertaking.
• Its primary objective is to offer a protective measure or safety net against uncertainties and minimize potential risks.
• The most common formula to calculate contingency cost is Contingency cost = Probability Percentage * Estimated Cost Impact, incorporating the risk contingency for each item.
• It is the amount reserved to address unforeseen risks or events that may occur during a project, while mitigation cost refers to the expenses incurred in implementing measures to minimize or eliminate potential risks and their negative impacts.

Contingency Cost is a predetermined specific capital kept aside for covering risks, unforeseen expenses, or modifications that might badly impact the budget or scope, or timeline of a project. It is helpful in financial planning and project management for numerous years, having its base in risk management plus the requirement to account for ambiguities. Later on, firms started using it to have funds allocated to manage unexpected events, ensure financial stability, and for project success.

One can determine this cost based on exhaustive risk evaluation during the planning phase of a project. The evaluation considers uncertainties and potential risks that might affect the project's budget, timeline, or scope. After that, a certain percentage of the total project expense is assigned as a contingency budget in the form of a separate line item. Therefore, contingent amounts stars serve as a safety net to withstand unforeseen expenditures and modifications arising during the project implementation.

Positives

It has wide application in industries like construction projects of real estate, manufacturing, IT initiatives, engineering projects, exports, imports, electrical works, wooden work, and international events. Furthermore, it provides certain benefits to the user:

• It allows firms to mitigate risks on project completion and acts as a cushion to any financial needs and uncertain events.
• The amount ensures firms have enough resources to meet unaccounted expenditures without harming the project's finances, goal, and timeline.
• Most importantly, it offers business leaders and project managers flexibility concerning responding to unforeseen situations. It gives them enough space to make informed decisions and execute vital changes to the project without getting constrained by the original budget.
• Investors and stakeholders feel more confident investing in a firm with proactive risk mitigation and assessment ability. Hence, they do not shy away from investing or moving out of a company in times of risks or financial challenges.

Negatives

Besides the benefits cited above, contingency cost has certain negatives too. Hence, below listed are some of its negatives:

• It may force the project managers to rely on it too much, neglecting risk assessment and management, meticulous planning, accountability, and proactive risk control.
• It could also lead to improper fund allocation to the contingency fund.
• Wrong estimation of risks may happen.
• Underutilization of resources may take place.
• Excessive utilization of resources due to wastage of resources may occur.
• Delays in projects and failure of the projects may also be the eventual fallout of overreliance on it.

Therefore, one does not have to consider contingency cost in construction or project contingency cost as fall back option. Rather, effective risk evaluation, careful monitoring, and transparent communication must be deployed to succeed in a project.

It has two main types:

1. Known Contingencies: It includes risks or events that are identifiable and measurable during the project's planning phase. For instance, equipment failures and supplier issues come under it.
2. Unknown Contingencies: These include unpredictable circumstances and unforeseen events that one cannot predict or measure, or anticipate in advance, like cyclones, wars, political instability, and economic recession.

One may utilize different ways to determine the right sum of contingency costs:

• Professionals or subject matter experts could be brought into project assessment to gauge the possible risks and ambiguity.
• The analysis of historical data related to similar endeavors or projects may show patterns of risk. It may also shed light into the sum that needs to be reserved as a contingency, and the degree of contingency needed for a project.
• Finally, a comprehensive risk analysis of the project undertaken would also help identify, quantify, and mitigate potential risks and unpredictability through probability assigning on each impact value.

A systematic approach helps calculate the contingency cost per the project and its industry requirements. However, here is a general approach for the calculation:

• First, one must identify the potential risks of a project to understand its impact.
• Then every risk need assessment based on its chances of occurrence and its possible impact on the project by assigning high, medium, or low scales.
• After that, one must attach a cost percentage or value of contingency to every risk identified as per its impact and probability.
• Then one can use the formula of contingency amount, which is a percentage of a line item or the project's total cost.
• After that, one can calculate the contingency budget by multiplying the total project cost by the contingency percentage to get the initial contingency budget.
• Then they can adjust the contingent budget considering the factors influencing the contingency budget like project complexity, organizational preferences, industry norms, plus the degree of unpredictability attached to the project.
• Finally, communicate the contingency reserves or budget to appropriate stakeholders.

The most widely used formula is as follows:

Contingency cost = Probability Percentage* Estimated Cost Impact While also Getting The Risk Contingency For Every Single Item.

Let us use an example to understand the topic.

Example #1

Suppose a construction company, XYZ Builders, has undertaken a construction project having:

Estimated cost impact = $500,000

Probability percentage = 10% (for a specific risk item)

Therefore, using these in the formula,

Contingency cost = Probability Percentage * Estimated Cost Impact

= 10% * $500,000 = 0.1 * $500,000

= $50,000

Hence for the particular risk item, the contingency cost comes out to be fifty thousand dollars.

Example #2

Suppose Company ABC Software LLC started a software development project. However, during the project, an unexpected delay in system integration happened. Hence, to reduce the risk impact, ABC Software LLC set aside a sum of 10,000 dollars as a contingency-cost. Hence, the amount covered possible modifications, retesting, and additional time to complete the project.

Therefore, the sum allocated for contingency ensured smoother project completion plus reduced the bad impact of unpredictable challenges on the project.

Let us use the table below to compare the two:

This article has been a guide to Contingency Cost & its meaning. We explain how to calculate it, its examples, comparison with mitigation cost, and types. You may also find some useful articles here -

• Contingency Plan
• Cost Overrun
• Reserve Fund