What Is a Contingency Fund?

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 What Is a Contingency Fund?

Contingency funds are reserves of money set aside for unexpected expenses. Additionally, savvy businesses maintain a contingency fund to cover expenditures beyond their standard operating budget.

Unexpected expenses may include:

  • An increase in the cost of supplies or equipment
  • New technology
  • Repairs or replacement of crucial equipment
  • Unanticipated legal/ business fees
  • Diminished sales
  • Worker strike

Types of Contingency Funds

The best contingency funds are liquid assets such as cash and reliable stocks. Cash allows a business to handle unexpected events more efficiently than other assets.

Stocks and bonds are subject to changes in liquidity. High-traded stocks and bonds tend to be the most liquid.

A contingency fund should be managed to grow over time. A contingency fund should remain as stable and liquid as possible. You should be able to convert your contingency fund into cash immediately.

Alternatives to Contingency Funds

Businesses must resort to alternative methods without a contingency fund for unexpected debts or costs.

There are several alternatives, including:

  • A line of credit
  • Loans
  • Business Interruption Insurance

Management of Contingency Funds for Major Projects

Different methods can be used by engineers to estimate project costs. Estimates can be developed based on project parameters and major costs. The analysis may include historical bid data, actual costs, or a combination of both. To make a complete capital cost estimate, special care must be taken.

Underestimating construction and related costs is a common error in economic analysis and budgeting. The purpose of contingency funding is to manage the risk of cost escalations and cover any shortfalls in cost estimates. When a contingency amount is included in the cost estimate, the impact of overly optimistic estimates is minimized, and potential circumstances can be discussed earlier.

Risk Assessment and Contingency Funding Levels

Rather than simply bumping up the total cost to compensate for poor early planning, the Office of Inspector General (OIG) recommended that risks be defined with specific costs attached. The total project cost estimate should include a risk-allocated cost contingency to mitigate all significant risks. Through risk management and contingency funding, cost escalation risks can be mitigated.

Prior to preparing the initial estimate, a risk assessment should be performed on the entire project to identify and quantify potential risk areas. To update contingency amounts, periodic risk assessments should also be performed throughout the project continuum. Some risk assessment areas may include analyzing different site conditions, utility impacts, hazardous materials, environmental considerations, third-party concerns, etc.

During the preparation of the project cost estimate, risk contingencies can be included as part of the risk assessment. It will help mitigate uncertainties and create a conservative cost expectation.

Risk can be quantified as a contingency amount using probability, severity, and expected dollar value. Once all known risks have been mitigated, the cost estimate’s contingency-funding levels should reflect the remaining risk associated with the project’s major cost elements. An overall management contingency can also be included to cover unknown, unanticipated risks.

For major projects, the following cost elements should be considered:

  1. A construction contingency to cover cost growth during construction;
  2. A design contingency (based on different levels of design completion);
  3. An overall management contingency for third-party and other unanticipated changes; and
  4. Contingencies for areas with high potential for risk and change, e.g., environmental mitigation, right-of-way, utilities, highly specialized designs, etc.

A contractor’s availability and historical contingency levels for similar projects may also be considered when estimating contingency costs.

Contingency Administration and Management

Currently, contingency funding management for major projects is handled similarly throughout the country. In construction, contingencies are generally established and adjusted on a sliding scale or based on the risk of escalating construction costs. At periodic intervals, project funding can be reviewed, and unused contingency funds can be released.

The amount of design contingency depends on the amount of design completed. The design contingency amount in the cost estimate should equal zero when the final design has been completed. Under-design projects are not overestimated, but the contingency is based on the uncertainty inherent in the remaining design.

The scope of Project Oversight Management includes managing deviations from the approved budget and schedule, impacts resulting from the deviations, and initiatives to recover any cost overruns or schedule delays. Despite analyzing individual construction contracts for changes, comprehensive risk and contingency management tools and processes are not always in place.

Contingency funding management procedures can include a continuous risk analysis to quantify and refine contract contingencies, individual contract contingency tracking, and a contingency drawdown plan that includes contingency forecasting.

Large projects should have an overall management contingency. Typically, this contingency is a standalone piece of the cost estimate that is managed by an executive and used for a wide range of uncertainties.

Massachusetts’ legislature approved, and the governor signed a $2.476 billion bailout plan for the Central Artery, of which $1.846 billion was set aside for an overrun and $130 million for contingencies. The $130 million management contingency was managed by Rick Capka, Chief Executive Officer/Executive Director of the Massachusetts Turnpike Authority (MTA). Other Major Projects retain phase or contract underruns within the project as a contingency.

Managing the transfer of costs to and from contingency line items requires careful administration and tracking. Cost transfers should be correlated with the major element type of cost escalation.

When work outside of a clearly defined scope becomes necessary and justifiable, management can decide to pay for the additional work from the management contingency or another appropriate contingency. In contrast, if you have a specific utility issue with a utility contingency, you can analyze cost overruns more effectively by tracking this contingency carefully.

All pertinent reporting should include the reasons for contingency transfers. The purpose of this is to periodically analyze contingency usage rates based on a comparison to the available contingency amounts. Based on this analysis, project managers will be able to determine whether a reasonable and sufficient amount of contingency remains for the project to stay within the latest budget.

Reporting Contingencies in Financial Plans

A financial plan provides the Department of Transportation, States, Congress, project managers, and the public with current information about project costs, financing, schedules, and technical issues.

Construction cost estimates should not be presented as a lump sum total but as the sum of each major element. Contingency amounts can be clearly identified as separate line items associated with each major element.

Contingencies may include:

  • Design contingencies (to reflect the percentage of the design completed to date).
  • Construction contingencies.
  • Management contingencies.
  • Other contingencies based on a risk assessment.

Thus, future update reviewers will be able to see where and how project costs are changing. It may provide insight into recurring patterns and reasons for cost increases. A contingency can be disclosed as a dollar amount or as a percentage of the major element’s cost.

Using an overall management contingency established in the cost estimate can mitigate public and media scrutiny if a major project’s contract escalates in cost. Project management contingencies are highly recommended to mitigate all risks in highly publicized major projects.

Seeking Legal Help

If you need assistance developing or maintaining an effective contingency fund for your business, you should consult an experienced financial attorney. Use LegalMatch to find the right financial attorney for your needs today.

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