Why do we have two separate reserves to take care of the risks?

There are two kinds of reserves set up to budget for risks: the contingency reserve and the management reserve. The contingency reserve contains the money to do the risks that were identified. The management reserve contains the money to do the risks that were not identified. These two reserves are separated in order to have more control over how they are spent. Use of the two reserves usually requires one additional level of management approval. The normal operating budget of the project is controlled by the individual responsible for the work; the contingency budget is controlled by the person to whom that responsible individual reports. The management reserve requires one more level of approval, the person to whom the responsible person's supervisor reports.

In normal-size projects this puts the contingency reserve under the approval of the project manager and the management reserve under the approval of the project manager's supervisor. It should be noted that someone outside the project approves the spending of funds from the management reserve in this case.

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Our budget philosophy in project management is to allow the responsible members of the project team to manage their own activities. This means that where budgets are concerned, each person on the project team should have the budgeted cost of work scheduled, the BCWS, allocated to the activity she is responsible for. The BCWS budget can be spent by the responsible person without having to get additional approvals. The Project Management Institute has redesignated the BCWS to be called the planned value or PV. It remains to be seen whether the rest of the world will adopt this designation.

There is some danger in assigning the contingency reserve and management reserve to the same individual, however. If this is done, the reserves are tempting pockets of money that might be used to cover poor performance instead of risks that come to be.

For this reason the contingency reserve must have the approval of a manager one level above the individual responsible for the activity where the risk has occurred. This is for risks that have already been identified. When this approval takes place, money is removed from the contingency reserve and added to the operating budget, the BCWS for the activities affected by the risk. When a previously identified risk occurs, the preplanned money to take care of this risk is removed from the contingency budget and allocated to the normal operating budget. The BCWS is adjusted for the amount of money that is added to the project operating budget, and the BCWS is adjusted for the points in time when the new expenditures will occur. The budget at completion, the BAC, will also change.

The management reserve is also tempting. Since the management reserve is money available to take care of risks that have not even been identified, it is tempting for the manager to use this money improperly. Therefore, another level of authority is required for approval for using funds in the management reserve. When this approval takes place, the funds are removed from the management reserve and added to the operating budget, the BCWS for the activities affected by this risk.

Notice that since the risks are all probabilistic in nature, they are not included in the project operating budget and are not included in the BCWS for each activity. Therefore, the operating cost accounts for the project, and the budget at completion for the project does not include the reserves either.

To summarize, the operating budget or the cost baseline is equal to the budgeted cost of work scheduled and does not include the management reserve or the contingency reserve. When risks occur in the project, funds are removed from the appropriate reserve and added to the cost baseline. The total expected expenditures for the project are therefore the sum of the operating budget plus the contingency budget plus the management reserve. The amount of money that is contained in the contingency budget is the sum of the expected values of the identified risks in the project. The amount of money in the management reserve is a percentage of the project or the contingency reserve. The value of the management reserve should be quite small since money in the management reserve is relatively uncontrolled. The amount of funds put into the management reserve is a function of the amount of risk in the project. Very risky projects tend to have larger management reserves than less risky projects.