Quantitative Risk Management; The Science Behind Cost Plan Contingencies

What is it?

Quantitative Risk Management (QRM) is gaining prominence among developers of large infrastructure projects such as government agencies or institutional investors.

In short, it’s a collaborative process of analysing and modelling a project’s specific risks, simulating those risks using software such as @risk and applying the outputs of those simulations as contingency to the project budget.

The quantitative approach seeks to assess the projects unique risk profile and, using Monte Carlo modelling, apply appropriate contingencies to the client's risk requirements (P80, P50 etc).

Cost plans are specified to a level of accuracy. That could be P50, P80 or P95. What these levels identify are the percentage of times the project will be completed for less than the final cost plan amount. For example, a cost plan figure of $2M, with a P80 accuracy, will have a final cost of less than $2M 80% of the time.

Why do we use QRM?

A typical cost plan, prepared in the early planning phases, will include contingencies to account for unknowns. The two main types are Design and Construction contingencies, but others are sometimes applied in addition.

Design and construction contingencies are normally applied as a percentage of the construction cost. These percentages are based on benchmarks, industry knowledge and industry standards. This approach is efficient, but arbitrary, and doesn't consider the projects specific risks in as scientific a manner as quantitative risk management.

Public sector RFTs often specify a P80 cost plan, but one can’t help but feel this is being included as a box-ticking exercise, with the vendor not fully appreciating what it is, and the process involved.

When is QRM Undertaken ?

Quantitative Risk Assessment is best carried out in the early planning phases of a project. It should form part of the Initial Business Case.

Who is involved in QRM?

The Project QS is the driver of the QRM process, supported by the Project Manager.

While the QS provides the technical backbone of the process, the PM needs to engage with the project’s stakeholders and gain their input to the risk registers.

The Process

When requesting a P80 cost plan from a QS, it's important to understand what this means, and have an understanding of the process required to deliver a P80 cost plan.

The QS will measure and rate their cost plan and produce an estimated cost that does not have any contingencies included. A workshop pulling in several of the project's stakeholders is then required. The workshop will analyse, discuss and agree on the risks, variables and unknowns with the ultimate goal of applying Inherent and Contingent risk allowances to the project budget.

Risk Types

The simplest way to define inherent and contingent risks is;

Inherent = Design Contingency

Contingent = Construction Contingency

Inherent risk involves the risk to the project of variabilities in quantities or rates used. Through the workshop process, the stakeholders (especially the architects and engineers) can identify design components that could change during the design development phase. These changes may be positive or negative in either quantity or materiality. During the workshop, each component is analysed and potential savings or additions are quantified. 

Contingent risk involves the risk to the project that may or may not occur. Examples of this are adverse weather, labour shortages, union action etc. A project manager is very familiar with a typical risk register. During the workshop this register is analysed, likelihood is applied, and maximum and minimum cost impacts are quantified, either during the workshop or following on, based on detail provided by the stakeholders.

It's also important, during the workshop, to analyse opportunities and have them attributed to either the Inherent or Contingent Risk Registers.

With all the data provided during the workshop, the QS can then run a Monte Carlo simulation, which simulates the risk registers a set number of times (usually no less than 10,000 times). The output are contingency figures for inherent and contingent risk which differ according to the project's risk requirements (P50, P80 or P95).

Is QRM For You?

A QS's contingency allowance for design and construction are typically 10% + 10%. These allowances provide coverage for a project and are quick and easy to produce.

Quantitative risk management provides a more scientific approach to project contingency, as well as facilitating buy-in from a broader group of stakeholders. If this approach is required for your project, it's good to understand that more time allocation is required from all stakeholders.

If you believe your project could benefit from Quantitative Risk Management, contact Quantum Insights Advisory.