Build in a Managed Cost Contingency
Cost contingency, also called management reserve or "water", is often frowned upon, because it is incorrectly used as a cushion for poor performance, rather than a managed reserve for unidentified work. A properly priced job (where the market will allow it) will have three cost components. These are (1) the work budget, (2) management reserve, and (3) margin.
The first item is the budget for the identified work. It is the sum of all task budgets in your CPM (or other plan). It does not contain any contingency costs.
Management Reserve is funding put aside for unidentified work. In most projects, we are not so perfect so as to clearly identify every work item to be performed. Just as we can surely expect incidents that add time to our project, we can expect to discover cost items that did not go into the original plan. By excluding this contingency from the task budget, the latter remains pure … for measurement of progress and performance. Only when new work is defined, do we move funds from management reserve to the task budget.
A log should be maintained of scope changes, and their effect on the Task Budget, Management Reserve, and Margin (and schedule). If new work is defined, which will not be paid for by the
customer, then the cost of that work is moved from management reserve to the task budget. If new work is added by request of the customer, the tasks and their costs are added to the task budget, without touching the management reserve (I use an Excel spreadsheet to record all changes). Managing the contingency precludes any use of those funds unless the new tasks are defined and added to the CPM baseline.
If we put contingency directly into the task budgets, at the start, we have no way of managing these dollars, and they eventually are considered as available for spending. If we have no contingency at all, we can almost be assured of overrunning the project budget. The answer is a managed contingency … the Management Reserve.