Risk Reserves and Individual Projects
We have witnessed a disconcerting trend. That trend is in consolidating risk reserves for projects into one, centrally managed bucket of money. This bucket was once reserved for the unknown-unknowns and was called a Management Reserve. However, more businesses are beginning to strip projects of their known-unknown Project Risk Reserves and placing calculated project contributions to this central bucket based upon a pre-defined risk profile for the project. This practice has the particularly nasty consequence of inflating project IRRs and leading companies to make business decisions without having a sound understanding of the financial risks involved. Additionally, with the Management Reserve divorced from specific projects and unknown risks, we now have a logistical chain to access to the contingency fund at a time when we have encountered a risk to our project. Typically in these events we are trying to institute project saving actions as prompt as possible, this is one more hurdle to achieving that objective. Essentially we want to tie the contingency budgets to triggers (https://valuetransform.com/program-contingencies-must-be-tied-to-triggers) and have as unfettered access as possible for quick response.
Risk reserves have always been a contentious topic. Executives hate to “tie” up investment capital in projects only to get the money back at the end of the year. This causes delays in implementing other valuable projects and detracts from shareholder value. So the move to centrally manage them is not without logic. However, the practice is extremely dangerous.
Understanding this rationale, project managers can ease executives’ fears by building risk plans which concretely tie the unique risks of the project contained within the risk register to the costs associated with the execution of the risk response plans and the probability of occurrence of the risk triggers. By doing this, project managers build the case for the Project risk reserve.
One interesting observation I have made using this method is that some executives fail to understand the rationale of multiplying the probability of occurrence with the value of the risk response plan – the time honored way of calculating the management reserve. They will typically respond, “Doesn’t it cost what it costs?” This observation is intriguing in that this same method is utilized in decision tree analysis which is commonly taught in B-school classes. But this is a topic for another Blog.
How do you communicate risk reserve needs to your executive team?