1992 AACETRANSACTIONS

F6a

Contingency Draw-down Using Risk Analysis

Randal B. Lorance, PE

INTRODUCTION

Risk analysiitechniqueshavebeenusedfor yearsasone tool for estimatingcontingency.The definition of contingencyadvocated

by AACE hasrecently beenchangedto reflect the useof statisticalanalysisto estimatethe amom added to M esthete to allowfor
changesthal experienceshowswill like@be required. Risk analysiitechniques,like Monte Carlo simulation,are now acceptedas the
singletool or procedurefor estimatingcontingency.Their usageincreasedasprojectsbecamemorecomplexandcomputertechnology
becamelessexpensive,allowing for more sophisticatedmethodsof estimatingthis often misunderstoodamount. Today there are
severalcommerciallyavailablesoftwareproductsapplyingMonte Carlo risk analysistechniquesto depicteconomicmodelsincluding
constructionestimates.

Risk analysiscan be usedby owner companiesto accomplishmultiple objectives. First, management(or client) can establish
guidelinesfor contingency.Theseguidelinesshouldbe usedduring the pmject’sexecutionto drawdown the contingencyand not just
to developthe initial estimate.Second,managementcanestablishoverrun/underrundollar limits wherea project’sauthorizationmust
he reviewed.Third, risk analysiiadvisesmanagementon the appropriatestepsrequiredto reducethe risk andcorrespondiigoverrun
dollar limit if the projectis marginallyeconomical.Finally,managementcanestablishperformancemeasuresfor projectmanagement
groups in companies wherethereare multiple projectsbaseduponthe numberof projectsbeingcompletedoutsidethe approvalrange.

Using risk analysii to managecontingencyoffers severaladvantages.The stepsnecessaryto developthe modelsimproves

communicationswithin the project teamand with the sponsoringorganizationor client. The ownershipof contingencyfunds is not
an issuebecauseall participantsare involved in the processand the amount of contingencyin the forecastis a calculation,not a
negotiation. Many techniquesof managingcontingencydo not involvethe projectteam,or they blindly follow rulesestablishedby the
client when such techniquesmay not be appropriate;

ESTABLISHINGCONTINGENCY

Severaltextbooksare availabledescribingthe technicalaspectsof Monte Carlo simulationand its usefor project risk analysis.
simply stated,the simulationmodelhasuseda randomnumbergeneratorto build the project 1,000or more timesin the computer,
StOtingthe resultsafter eachiteration through the model. The mathematicalmodel is built as a mirror of the estimatewith each
componentbeinginput asa probabilitydistributioninsteadof a discretenumber. Also, the computermodelthen presentsstatistical
re~tionshipsdevelopedfrom the population of resultsfrom eachiteration. The result is a probabilitydistribution (seefigure 1)
representingthe expenditureestimatesor forecastsbasedupon the inputs. The client canestablishexpectationsfor a project team
by eXpre=ingthem in termsof this probabilitydistribution.

This PrObabiity distributionis usuallypresentedgraphicallyasa cumulativedistributionwith the abscissa

(x-axis)beiig cumulative
probability of underrunningor overrunningthe valueson the y-axis. The ordinate (y-axis)then showsthe baseestimate(withon’
contingency)and then dollars and percentagesabovethe baseestimatefor calculatingthe contingency.Without specificguidelines
from the client, this graph should be producedanywayand usedas one pieceof information to help the team in estimatingthe
contingencyfor the project.

l$’ expresSingan acceptablelevel of risk, the client hasprovidedthe project teamwith the informationneededto developthe
con%3encyestimateusingthecumulativeprobabilitydistribution. Someclientmanagements haveprovidedinstructionsto their project

F.6.I
teamsOn how much risk to take at various phasesof their projects. One exampleis a project team with instructionshrom their
managementto selecta 70% probabilityof underrunningduring the conceptualphaseof a project. Contingencyis cakukiteb aSthe
amountrequiredto bring the baseestimateup to the 70%probabilityof underrunninglevel. Folkwing prelimiWy engine+Xing, their
instructionsfrom managementare to then lowerthe probabilityof underrunningto 50%or the meanandto usethis guidelinetiOu@
project completion. “Ihe resulting estimateis called the SO/50estimatemeaningthere is an equal chanceof undemnning Or
overrunningthe project. This SO/XIguidelineis usedby severalcompaniesin the oil industry.
 1992AACETRANSACTIONS

When the client doesnot provide guidelines,the presentationof a cumulativeprobabilitydistribution will provide someinsight
into the client’srisk quotient evenif a specificrule is not provided. Supposethe client insiststhat an 8% contingencyis all it will allow,
while the cumulativeprobabilitydistribution suggeststhat with an 8% contingencythere is a 75% chanceof overrunningthe project;
the project team then knowsthat the project must be tightly managedor an additionalcontingencyneedsto be hiddenwithin the
estimateas allowances.This information is usefulin determininga methodfor drawingdown the contingency.

RISK ANALYSISDURING PROJIXT EXECUTION

The contingencyguidelinesshouldbe followedthroughout the life of the project. Contingencyshouldbe calculatedperiodically

(at leastquarterly) to maintain the guidelinerisk level,as in the 50/50level in the exampleabove. The risk analysismodel usedto
developthe project’sbudgetestimateis a logicalstartingpoint. The cumulativeprobabilityof underrunnlngor overrunninghasbeen
documented,and the risk analysismodel’sinput rangesare established.Theseinput rangesare then usedduring project execution
to help in managingthe contingencydrawdown.

Early ln the project the project team meetsto determinehow the risk analysiimodel’sinput rangeschangeas work progresses
from estimatedamountsto committedamountsto actualexpenditures.With a predefinedprocedurecommunicatedto the client and
all memberson the team,contingencybecomesa calculatedamount. The client is lesslikely to committhe contingencyestimateto
scopechangesearly in the project and not havethis reservefor unforeseenwhen neededduring the project’sexecution.

The proceduredescribedaboveworkswell whenthe projectprogresses accordingto plan. Occasionally,eventsoccur requiring

a reviewof the risksinvolvedon the project. An exampleis shownin figure 2 wherea project’scalculatedcontingencyincreasedafter
an evaluation of the impacts of late equipment deliveriesto the constructionsite. Other exampleswhere rlsk increaseare:
environmentalremediition problemsmay be found, labor strikesat supplierscan slow the progressof a project,natural eventslike
weatherproblemscan increasecosts,etc. As eventsoccur, the forecastfor contingencymay needto increaseinsteadof decreaseas
would occur with more traditional approaches.

This rlsk analysisapproach is consistent with

traditional approaches to managing contingency. Contile I Fast T rack Proiect
Contingencyforecastingduring the project’sexecution
is frequently assumedto track commitmentsin an 4wd- mlEatmlb.N9tmusl - tw
inverserelationship.Manymanagerstrackcontingency - -- 14%
as a percentageof uncommitted funds or use a
formula of reducingcontingencyasestimatedamounts - -- 12%
move to commitmentsand to actual expenditures. r*m -- ~-10%
Many of theseformulasdo not considerthat riskscan ac _.
increaseduring the,executionof a project. EN -~0%
sm ~-
-6%
Using the estimatedcommitmentand cashflows, ry~o--
a contingencydrawdown curvecanbe presentedearly ,*oID -- 4%
in a project. lhls type of presentationwith graphical
depictionsof the confidencerangeover time will help u -- -- 3%
theclientunderstandthenatureofriskforthiscapital It I : I : : : ; : : I : : I ; ; : I I I ; : : : ( : : I I r 0%
project. Frequently,bcility startup expendituresmay ASONOJfNAYJJAS0NDJfYA~JJASONO
a* “(0 (0
be the risklest portion of a project,and a graphical
presentationwould communicate the needfor planning Flgure~2-Ceritigency Draw Down Chart ”
theseexpenditurescarefully to the client.

ovERRIJN/uNDERRuNLIMITs

E&mate overrun and underrun limits can also be establishedwith client guidelinesfor use of the cumulative probability
distribution. The estimate’scontidencefactor canbe established;manyclientsestablishan 80% confidencebctor guidelineby using
the 10% and 90% probability of underrunuing points on the distribution. The table below is an exampleof one management’s
expectationson estimateaccuracyrangesexpressedas percentages of the estimate. Note the narrowingof the accuracyrangeas the

F.6.3
Projectprogresses.Resultsfrom Monte Carlo risk analysisshould follow similar ranges;thus this table is an effectiveyardstickto
memre the effectiveness
of the process.

Estimate Confidence
EMmateTvue Accuracy Factor Many projectmanagersasktheir staff to adjustthe input
rangesto Monte Carlo risk modelsto fw&e at a preconceived
ConceptualINmate &SQ-8Q% 80% contingencyamount. This is difbcult whenthe resultsTom the
PreliminaryEstimate 930% 88% risk analysiiare threenumbers,the upper limit, lowerlimit, and
BudgetEstimate f15% 80% forecast amounts,which are presentedto managementfor
Control Estimate 910% 88% projectapprovaland at regularproject reviews
IDefinitiveESmate &5% 80%
fZxecution- Drawdown &5-10% 80%

Most client managersunderstandestimatesand

forecastsexpressedas ranges (see figure 3). Tbe j=orecmt Wnm - Ilnnox, FnnntTrack Proiect Eneimb
normal presentationof rangesby the project team is
similar to the tableahovewith symmetricalranges(ie,
~10%). The rangespresentedare usuallysubjective
estimatesand imply symmetryand possiblya high
degreeof certainty. Risk analysisallowsthe project
team and estimatorsopportunities to calibrate the
estimateand communicatethe real risksinvolvedwith
a project. Further data can be providedto the client
managersor decisionmakerson steps that can be
takento reducethe risksinvolved,andsensitivitiescan
bequantified. For instance,the estimatorscanpresent
the decision-makers with a scenariothat the con&
dence interval can be decreased(estimateaccuracy
increased)by purchasingthe engineeringportion of
key componentsof the processequipment;the deci-
sion-makercanthencalculatethe benefitsbecausethe
datais quantified. Clientswith multiple smallprojects
can use this overrun/underrun limit criteria as an
effectiveperformancemeasureof the projectmanagementeffort. With estimateaccuracyexpressed asa confidenceinterval or range,
the projecteconomicsand overrun,Amderrun limits are establishedat the endsof the interval. A guidelinestatingthat management
ezpects20% of projectsto fall outsidethe range,requiringfuture managementattention.Thus80%of all projectsshouldbe executed
without further management attentionasa resultof overrunningor underrunning.In addition,the X1/50criterion is alsoan effective
goal for eachyear’sannual budgetfor capitalexpendituresand operatingcosts.

The conceptof contingencyis not well understoodby manyprojectparticipants,includingthe client’smanagers.Projectcontrot

engineersare frequentlyaskedto explaincontingencyto nonengineeringparticipants The author’sexperienceis that manyof these
managershaveexperiencewith statisticalconceptsto accomplishother portionsof their business.The ideaof usingstatisticalmodels
to estimatean QIFKJUMtided to QPB
estaipsge
ro &ow for chges r/urr*me spsOws wiUJ&e@be re@&-ed shouldbe easilyundetstond
by mostmanagersin today’sbusiness.The bestapproachis to educateall projectparticipantsearlyin the project Frequently,the
additionalinformationavailablein a quantifiableform will makedecision-makerscomfortablewith Monte Carlo risk analys&.

IF.64
 1992AACE TRANSACTIONS

Frequentlyclient organizationsare lc&ing for waysto managefuture projectsfollowingearlier bad experiences.

The recognition
tbat risks can be managedand WMNmi~tiO~ canbe improvedbetweenprojectparticipantsby usinga tool like this one hasmade
the explanationeasier. Often the conceptsare alreadyin useto manageother portions of the client’sbusinesslike operatingcosts,
inventory, biddingstrategies,or reservoirengineering.

Input to the Risk Analysis Model

Risk analy& is much strongerwhen the entire project team is involved in creatingthe rangesfor each of the components.
Estimatesare modelsderivedby.multiplyingquantityunits timespricesand summingthe results. The inputs to a Monte Carlo risk
analysisare probabilitydistributionsfor eachcomponentof the estimate. Sincethe mathematicsaround multiplying two probability
distributionsis not easy,asimulation techniquelike Monte Carlomodelingmustbe used. Whenthe inputsto the modelaredeveloped
asa teameffort, the individual membersof the teamcanexpresstheir subjectiveconcernsin a mannerthat will allowcommunication
of those concernsto the client in proportion to their impactsto the project. It also allowsfor inputs by all disciplineswith special
weightingto their areasof expertise(Purchasingwith inputs to equipmentand materialcosts,Constructionwith inputs to workhour
inputs, Labor Relationswith inputs to ratesper workhour,etc). Estimatedatabaseswith historicalunit factorsare excellentsources
for probability distributionsfor thosebctors.

Most estimatorsbuild estimatesusingunit ratesthat are the nwst Eke&,whichis usuallythe modein statisticalterms. Ihe mode
is the data point in a populationthat is repeatedthemosttimes. The natureof constructionis that mostprobabilitydistributioninputs
are skewedto the right; thus, the mode will be below the mean (average). Estimateprice and quantity inputs are examplesof
one-hwnpedfi~~ distiutions skewedto the right. Very few estimatorshaveaccessto detailedhistoricaldatabasesproviding
empiricalprobabiity distributions;thus, the inputsusedin practiceare subjective.Commercialsoftwarepackageswith Monte Carlo
featuresallowfor different distributionswith the mostfrequentlyusedbeinga triangular,normal,step,andskewed(beta)distribution.

AllChOl-iIlg

When developingrangesfor input to risk analysis,it is betterto rememberthat subjectivecontldencerangestend to be narrower

than they should be. This a phenOmeMcalledunchoringand can be overcomeby using hvo techniques.First, developthe ranges
early in the estimatedevelopmentprocess.One projectteamdevelopsthe rangesas part of the estimatekick-off meetingtihen the
quality of the inputsto the estimateareknown,but the estimatorsandother participantshavenot developedan ownershipin the inputs
to the estimate. Second,if the modelallowsfor dehnitionof the confidencerangesof the inputs,experiencehasindicatedthat a 70%
confidencerangebetter approximatessubjectiveinputs

Sensitivity Analysis

By analy&g the inputs and resultsof a rlsk analysisa client cangain an understandingof how risky the projectis perceivedby
the project team. Analysisof the inputswill identifysensitiveareaswhereriskscanbe managedin the project. ClassicexamplesinvOlve
items like describingthe scopedefinition,purchasingmajorequipmentcomponents, or completingthe next phaseof engineering;each
Of thesewould lower the riskswhen completed. Other areasmay not be so obvious,like currencyconversions,union vs non-union
craft usage,skidvsstick built construction,transportation risks, engineeringor craft availability,technologychanges,environmentalrule
Changes, etc. As the project teamworkstogetherto developinputsto the risk analysllmodel,theseareasbecomebetter dehnedand
the tinal Monte Carlo risk analysii modelcan be run severaltimesto isolatethe effectsof unusualcomponentsto the model. These
areasOf concerncan then be discussedwith the client, and a plan can be developedto managethe associatedrisks

CONCLUSIONS

Contingencyis a portion of a project’scoststhat can be estimatedin an objectivefashionif managementprovidesguidelinesfor

risk levelsassociatedwith the probability of overrunningthe project. Oncethe guidelineshave beenestablished,the reductionof
contingencyduring the project’sexecutionshouldbe consistentlyestimated.This drawdown of contingencyis easilyaccomplished by
using the initial model inputs and adjustingthe amountsasdoUarsare committedand expended.At any time during the execution
Of the project,the project team can state the forecasthasa 50% (or other guideline)probabilityof underrunningor overrunning.

The prObabiity distribution resultingfrom Monte Carlo risk analysiscan be usedto establishthe overrun and underrun dollar
Utnitsfor a project. This quantifiesthe risks,allowingthe projectteam to statethe rangehasan 80% contldencelevel.

F.65
 Whenprojectshavemarginaleconomics,risk analysisallowsthe projectteamto work with the clieat to lower the high end of the
mnge $ identitjhgandthen managingthe high-riskportionsof the project. Fiially, managementcanestablishperformancemeasures
for projectmanagementgroupsin companieswherethere are multiple projectsbasedupoa the numberof projectsking completed
outsidethe approvalrange.

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N~uebh Morgantown,WV AACE.

2. Bent, LA. 1982.&~pl!&sd

Cc& aannaD
S&edr& ~~IuIIM!.New York Marcel Dekker,Inc.

3. Chase,R.B. andNJ. Aquilano. 1977.lf%xhn~onn

meJQ~ZT&DIUB
~~~DD~IIQ~,A I& CycleAj~~~raxxh.
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4. Cobb, R.A and D.P. Elliott, ed. 1989.ZEBUlEsti-: C~DJD~&~UKJJ

m8 ~tia~~. Technicalmonographseries,CE-2.
AmericanAssociationof Cost Engineers.

Freund,LE. 1971.M&Iuem~tiesA
Bu&stiss. EnglewoodCliffs,NJzPrentice-Hall.

PAosteUer,
F, W.E.KRourke,and G.B. Thomas.1970.Jl%r&MQ wMnBts&sti~ &@&ia~~. Reading,IIIIIB:Addison-Wesley.

Shafer,S.L. 1991.Es-e QplQ

Project R&k Analysis Approdes. ll!44%AACIE Tmtiow. Morgantown,W% AACE.

Schlaifer,W. 1959.It%&&aQ aarmd

8huistics ff0rfll&$mm IDe&k~ny An lIr~~~nncuk~~~
00 meti IEccmotim nnnnailer
UJnncedQ. New York McGraw-Hill.

9. Schrieder,ed. 1964.Meuhar&of Buatiai6xI Test@. New York AmericanElsfsvier.

RandalB. Lorance,PE
Arc0 f%%ia5ka,
Inc.
PQ Box 7099
hadeM, CA,91103

F.6.6