Here’s a common Project Manager story: You, the Project Manager is creating the budget for your project. Your high level WBS (Work Breakdown Structure) is ready and you have the high level estimates needed for a budget baseline.
As a smart Project Manager, you will add a contingency (20-25%, which is common practice nowadays) to account for unknown events that may add to your cost. In that way, you save your project from going over budget. So far so good.
It seems like you have done your due diligence in the Cost Budgeting process.
Next, you go to your Sponsor. He/She likes it, but asks a simple question- What is this 25% and how did you arrive at it? The first part is easy. What about the second? Will a sponsor buy words like “SWAG” or “Industry Standard” from a seasoned Project Manager without understanding the details? Do you have the details? Of course you do. We all do. Industry Standard is the magic answer! Which Industry? What Standard? Is 25% a Standard across the board? Nope. A project at NASA could have a contingency reserve at a much higher percentage than say a software upgrade project at an IT company.
This is where the Overall Budget calculation needs a broader outlook and an in depth view.
Remember, Cost Reserves = Contingency Reserves + Management Reserves
Contingency Reserve and Known unknowns
Known unknowns are Risks that can be identified early in the project that will potentially impact the project later and can be alleviated with a good risk management process. A Contingency Reserve is a fund allocated for Risks remaining after risk response planning.
A Contingency Reserve can be arrived at by looking at your known Risks and their cost impacts.
Steps: Note- This is early in the Project Lifecycle, hence high level information is good enough. You don’t know what you don’t know and that’s the beauty of it.
Management Reserve or Unknown unknowns
These are extra funds set aside for to cover for unforeseen risks or changes to the project. For example-major disruptions in the project caused by serious weather conditions, accidents, or even unplanned scope changes. This could be 10-15% depending on the your company’s appetite.
The Contingency Reserve is a part of the Cost Baseline (within baselined scope) while the Management Reserve is a part of the Cost Budget (outside baselined scope).
As per the PMBOK 3rd Edition, Contingency Reserve is a part of the Cost Baseline. Hence, Project Cost Baseline = WBS estimated costs + Contingency Reserve
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. For simplicity, imagine a different bucket having the Management Reserve that can be tapped into after Management approval when say lightning strikes. The Project Manager normally has the authority to sanction funds from the Contingency Budget for Risk Response activities. This will be a much brighter Sponsor-Project Manager conversation and a win-win.