Association for Project Management
How to minimise cost risks in projects
Blog posted by: John Ayers, 12 November 2020.
Studies show most projects fail due to poor management of known risks which includes cost. Cost problems are often due to insufficient budget, poor budget control and poor planning. How to minimise the cost (budget) risk on a project is addressed in this blog. The approach to do this is based on my 30 years of project and project risk management experience and knowledge.
To minimise the cost risk, several key factors must be considered as shown below:
1. Type of contract
There are two basic types of contracts and you should know them. The one you choose will determine your risk level:
Firm fixed priced (FFP)
There is no additional funding forthcoming on a FFP contract. This type of contract results in you assuming most of the risk. From the customer’s viewpoint, the cost of the contract is fixed, hence their cost liability is capped. The reason being you are under contract to complete the work scope and deliverables for the contract price. Overruns must be absorbed by you. This results in less risk to the customer but more risk for you. The fee for this type of contract is typically around 12-15 per cent because the risk is higher.
Cost plus (CP)
For a CP contract, the customer assumes the majority of the risk. You get reimbursed for all expenses. You receive the total fee even if there is a large overrun on the project. Your proposal typically does not include cost and schedule for risks especially in a competitive environment. You want to keep the price low to win the job and then look for added scope items and the associated fee. The fee for this type of contract is typically around 7-8% for this type of contract because there is little risk for the for you.
It is virtually impossible to prioritise managing the budget and schedule within the baseline plan at the same time. This means you have to prioritise one over the other depending on the type of contract. For example, for a FFP contract you want to prioritise cost since there is no additional funding forthcoming. This means your decisions are made to protect the cost. Let the schedule extend as required. For a CP type contract, it is just the opposite. Make decisions that protect the schedule since you are reimbursed for your costs.
The major risk for subcontractor cost risk is lack of time to prepare their proposals. Let me explain. Typically, the customer’s request for quote (RFP) allows 60 days to submit your proposal. This means the RFP for the subcontractor has to be prepared and sent to them as soon as possible after receiving the customers RFP to allow them maximum time to submit their proposal. The subcontractors RFP preparation can take two to three weeks or more. So the subcontractor proposals are ‘soft’ (based mostly on estimates). To mitigate this risk, add margin to the subcontractor’s price before it is included in your proposal.
3. Risk assessment
A thorough and complete risk assessment needs to be done during the proposal phase to establish the risk mitigation cost and schedule requirements for inclusion in your proposal. If not done, there is no mechanism to obtain additional funds from the customer post contract award.
4. Cost estimate
Cost estimating starts with a good work breakdown structure (WBS). A WBS organises the contract work scope into manageable tasks called work packages (WPs). A poorly constructed WBS or WPs will lead to poor cost estimating. A bottom up approach (WP level) and a top down sanity check should be done and be consistent. If not, find out which approach is faulty. A top down estimate can be based on previous similar projects adjusted accordingly for project differences, or use another method.
5. Cost control
The best tool in my view to control costs is earned value management (EVM). It measures project progress against the baseline plan. EVM must be setup properly and executed well to be effective. Finance issues an earned value report monthly. The report includes the performance of each WP and is colour coded making it easy and quick to identified poorly performing WPs. This provides maximum time to find problem and fix it.
Risks that come with costs and budgets in projects can be managed and minimised if you keep various factors mind. What type of contract is it? Have you kept the subcontractor in mind? And what about project progress? Although it may seem like a lot of things to do, it will help keep your project costs in check, and lead you to project success.
You may also be interested in
- What is risk management?
- The key to successful project risk management
- Making risk work for your project (APM Learning 🔒)
About the Author
Currently John is an author, writer and consultant. He authored a book entitled ‘Project Risk Management. He has written numerous risk papers and articles. He writes a risk column for CERM.
John earned a BS in Mechanical Engineering and MS in Engineering Management from Northeastern University. He has extensive experience with commercial and DOD companies. He is a member of PMI (Project Management Institute). John has managed numerous large high technical development programs worth in excessive of $100M. He has extensive subcontract management experience domestically and foreign. John has held a number of positions over his career including: Director of Programs; Director of Operations; Program Manager; Project Engineer; Engineering Manager; and Design Engineer. He has experience with: design; manufacturing; test; integration; subcontract management; contracts; project management; risk management; and quality control. John is a certified six sigma specialist, and certified to level 2 EVM (earned value management).https://projectriskmanagement.info/
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