Contingency reserves are funds that a company allocates to pay for possible undesired outcomes. Some companies simply allot a percentage of each project budget for contingency reserves. Others use the expected value method, which calculates the expected cost of a variety of contingencies. Rather than setting aside funds to pay for all of them in full, the company allocates reserves according to each one's probability of occurring. This method is similar to how insurance companies calculate premiums.
1. List each contingency that could increase your expenses. For example, suppose that these contingencies include having to add extra personnel to the project, outsourcing to outside contractors, failing to meet your soft deadline and experiencing equipment malfunction.
2. Estimate each of these contingency's costs. For example, suppose that the four contingencies would cost you, respectively, $32,000, $48,000, $20,000 and $12,000.
3. Estimate the probabilities of each of the contingencies occurring. For example, suppose that the contingencies have, respectively, a 5 percent, 5 percent, 10 percent and 2 percent chance of occurring.
4. Multiply each contingency's cost by its probability. Continuing the example, 5 percent of $32,000 is $1,600, 5 percent of $48,000 is $2,400, 10 percent of $20,000 is $2,000 and 2 percent of $12,000 is $240.
5. Add these values together. The sum of the values in this example is $6,240. You would need $6,240 in contingency reserves.
- A comprehensive risk management plan must take many contingencies into account, yet you may exclude contingencies with very low probabilities to make your calculations more manageable.
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