Guest Post by John Ayers (first posted on CERM ® RISK INSIGHTS – reposted here with permission)
Studies show most projects fail due to poor management of known risks. The known risks on a project are:
Generally speaking, cost problems are due to insufficient budget, poor budget control, and poor planning. How to minimize the cost (budget) risk on a project is addressed in this paper. The approach to do this is based on my 30 years of project and project risk management experience and knowledge.
To minimize the cost risk, several key factors must be considered as shown below:
- Type of contract
- Risk assessment
- Cost estimate
- Cost control
TYPE OF CONTRACT
There are two basic types of contracts. They are: Firm Fixed Price (FFP) and Cost Plus (CP). The one you choose will determine your risk level.
FIRM FIXED PRICED (FFP)
There is no additional funding forthcoming on a FFP contract. As a result, 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 % 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 av 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 prioritize managing the budget and schedule within the baseline plan at the same. This means you have to prioritize one over the other depending on the type of contract. For example, for a FFP contract you want to prioritize 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 customers 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 2-3 weeks or more. As a result, the subcontractor proposals are “soft” (based mostly on estimates as opposed to vendor quotes for example). To mitigate this risk, add margin to the subcontractor’s price before it is included in your proposal.
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.
Cost estimating starts with a good work breakdown structure (WBS). A WBS organizes 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.
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 (EV) report monthly. The report includes the performance of each WP and is color coded (green-good; yellow-caution; red- poor) making it easy and quick to identified poorly performing WPs. This provided maximum time to find problem and fix it.
The type of contract determines your cost risk level. Your have most of the risk for a FFP contract. The customer has the majority of cost risk for a CP type contract. You cannot prioritize cost and schedule requirements within baseline plan at the same time. Select one or the other to prioritize when making decisions on your project. Prioritize cost for FFP contracts. Favor schedule on CP type contracts.
You have control over in-house costs but not subcontractor costs. If you wait for the customers RFP to be issued before you start working with candidate subcontractors, the likelihood is the subcontractors cost proposal will be very risky. To mitigate this risk, start working with them early before the RFP is issued using company money (typically done). Do not forget to add margin to the subcontractors cost proposal before inserting it into your proposal.
Ensure the cost and schedule requirements to mitigate risks are incorporated into your proposal before submitting it to the customer. If you wait until after contract award, there is no mechanism to provide the funding.
Budget estimates should be done on a WP basis (bottoms up) and a top down sanity check. If they are not consistent, reassess both types and adjust accordingly to bring them into alignment with each other.
EVM is the most effective tool I know to control costs. The biggest benefit is to identify poorly performing WPs allowing maximum time to identify the problem and resolve it. EVM must be setup properly and executed well for it to be effective.
Currently John is an author, writer and consultant. He authored a book entitled ‘Project Risk Management. It went on sale on Amazon in August 2019. He has presented several Webinars on project risk management to PMI. He writes a weekly column on project risk management for CERN. John also writes monthly blogs for APM. He has conducted a podcast on project risk management. John has published numerous papers about project risk management on LinkedIn.
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/
If you want to be a successful project manager, you may want to review the framework and cornerstones in my book. The book is innovative and includes unique knowledge, explanations and examples of the four cornerstones of project risk management. It explains how the four cornerstones are integrated together to effectively manage the known and unknown risks on your project.