Introduction to Cost Risk in Risk Management
As a Project Management Institute (PMI)® Project Management Professional (PMP)®, your success depends on managing project risks, including cost risks. A primary concern of many stakeholders is the project exceeding the budget, so a solid risk management plan that addresses cost risks is essential. This article explores types and examples of cost risks and how to mitigate them to increase the likelihood of delivering your project within budget.
On this page:
- What is Cost Risk in Project Management?
- Types of Cost Risks
- Direct and Indirect Cost Risks
- When & How to Determine Cost Risk in a Project
- Example of Cost Risk
- How to Mitigate Cost Risks
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What is Cost Risk in Project Management?
Every project has a budget, and your job as the project manager is to make sure that the project stays within budget. Unfortunately, there is always the risk that a project will cost more than expected. This risk of not staying on budget is cost risk, and it comes with all projects. Some of the most common sources of project cost risks include:
- Poor budget planning
- Not calculating costs correctly
- Unexpected additions to the project (scope creep)
For a PMP, identifying cost risk is essential, but it’s not easy. Because the consequence of not doing a thorough job identifying these types of risks can end up costing shareholders a lot of money, it is worth considering different types of cost risk to make identification easier. A thorough account of all the cost risks also puts the project manager (PMP) in a much better position regarding the establishment of a risk reserve.
Types of Cost Risks
One way of distinguishing between types of cost risks is to consider the ability of the project manager to control them. Project Management Professionals (PMP) should know there are two types of cost risk related to this are internal and external types of cost risk. Some of these risks are avoidable; some are not.
Internal Cost Risks
Internal costs risks stem from changes to the business or organization within which the project management team is working. Examples of internal cost risks may include additional project costs due to:
- Poor project budgeting practice
- Turnover of project management staff
- Project management technology problems that impact productivity
External Cost Risks
External cost risks stem from circumstances beyond the control of the project management team; there isn’t much a project manager can do to control them. For example, if your project uses a lot of gasoline as fuel for project equipment, you are at the mercy of those who control the cost of a barrel of oil. Examples of external cost risks may include additional project costs due to:
- Raw material costs
- Natural disasters
- Changes in regulations
- Increases in external vendor costs
Direct and Indirect Cost Risks
Another dimension of cost risks is direct and indirect cost risks. These are not mutually exclusive with internal and external types; costs risks will be either internal or external, and either direct or indirect.
Direct Cost Risks
Direct cost risks are those that are directly related to the project activities. Examples of costs resulting from direct cost risks could be:
- Rework to correct errors in construction
- Miscommunication that requires additional meetings
Indirect cost risks are those that are not directly related to project activities. Examples of costs resulting from indirect cost risk could be:
- Administrative cost for PMO resources
- Inventory storage
- Temporary housing accommodations for regulatory staff
Additional Cost Risk Categories
In addition to internal/external and direct/indirect cost risk categories, below are other cost risk categories that can help the project manager (PMP) and team discover cost risks they might otherwise miss. Again, these types are not mutually exclusive with the categories above. In fact, some of these are internal, some external, and some may include both; similarly, some of these are direct, some indirect, and some may include both.
Operations Cost Risk
Operational cost risks are the associated risks that come from sub-par operations on the project. Most operations-related cost risks are internal. Examples include:
- Inefficiencies when procuring project resources
- Poor quality management processes
- Redundancies with project communications.
Input Cost Risk
Input costs are those associated with the acquisition of required materials for construction of a product. Many of these are external and beyond the control of the project management team.
Mother Nature and global events are often sources of input cost risks. Examples of input cost risks include:
- Trade disputes
- A pandemic
- A shipping disruptions
- Labor disputes
A number of financial and market-related types of cost risk may include the following. These are generally external cost risks:
Credit risk is the risk that your customers or partners will not pay you This may be external, although project managers (PMP) may be able to mitigate this risk through vetting of customers and partners and writing contracts to protect the project from this type of cost risk.
Interest Rate Risk
Interest rate risk is the risk that your cost of capital will go up due to rising interest rates. Projects involving floating interest rates are more susceptible to interest rate risk. Those dealing with a fixed interest rate tend to be more stable and less volatile.
Exchange Rate Risk
If your project involves purchasing materials or labor overseas, you will have to account for exchange rate risk. This is the risk that exchange rates can suddenly become volatile and exceed what was budgeted. Large, global projects are most at risk of exchange rate risk.
Legal and Compliance Risk
Legal risk is the risk of penalties and fines or other project costs related to misunderstanding the laws governing your project. This type of risk increases when working internationally or when your project exposes you to different regional or state laws even within the same country. Certain fields can expose you to more legal and compliance risks. Projects in the health care industry in the United States, for example, require a thorough understanding of laws related to patient confidentiality regulations.
Projects are subject to taxes in the areas in which they are working, procuring, sourcing, etc. The risk of misunderstanding or interpreting taxation rules that impact the project may result in unforeseen costs to comply with the pertinent laws or penalties for failing to comply.
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When & How to Determine Cost Risks in a Project
Traditionally, figuring out a project’s cost risk involved analyzing schedule risk and subsequently analyzing cost risk. This can be problematic since the team members analyzing the schedule are concerned about the project being completed in a timely manner, and those analyzing the budget are concerned with the project being completed with as little cost as possible. These interests are often at odds with each other. This disconnect can complicate the risk analysis activities. In fact, this may add cost to the project by extending the time it takes to complete risk analysis, that is, create an operational cost risk.
A better way to analyze cost risk is to use an integrated approach. The sources of risk associated with a project are separated into those that affect time and those that affect cost, expressed as the burn rate per unit of time. The former is the schedule that the project runs on; the latter is how quickly it takes to spend money in a given amount of time.
Since time is money, costs will go up if a project takes longer than planned to complete. To determine cost risk in a project:
- Assess the various risks in the project
- Define, price, and assign resources to different activities
- Look at schedule (time) and cost (burn rate) risks simultaneously to develop estimates
- Use simulation programs such as Pertmaster or Monte Carlo for more accurate cost risk results
Example of Cost Risk
For a cost risk model with inputs, you would compare the number of people working on the project against pay rate and hours (see table below). An example of a common project many of us have taken on is home renovations. As you’re budgeting, you’ll need to break up each part of the project into either time or burn rate.
If the schedule is simple, you can use Excel to create a scatterplot showing the relationship between cost and schedule. As you can see below, the longer something takes to do, the more it costs.
As a Project Management Professional (PMP), your project doesn’t need to be a billion-dollar global project to have multiple types of cost risk involved. We can use a simple project, like a home renovation project, to see how many types of cost risks are present in even small projects.
A few sources of project cost risks for a home renovation project may include:
- Securing permits (financial & compliance risk)
- Cost of the appliances (input cost risk)
- Delivery time for materials (operational risk)
- Taxes on house additions (taxation risk)
Don’t forget about the indirect cost risks of renovating a house. Examples could include:
- Living in a hotel during the renovation
- Not getting rental income if you are renovating a rental property
- Food cost for takeout during renovation
How to Mitigate Cost Risks
Once meeting the challenge of identifying the various cost risks your project faces, it is critical to determine the appropriate response. Defining a risk reserve is essential to any response to project cost risk.
There are two types of risk reserves you’ll want to build as you plan your project: management reserve and contingency reserve.
- Management reserve: This type of risk reserve is kept aside for unknown risks that may or may not happen during the project. Think of it as a buffer for the project. This risk reserve is usually set up by people who have more of a bird’s eye view of the project and is not available to the project manager except with authorization.
Contingency reserve: This is a risk reserve for the known risks of the project. You can think about this type of risk reserve as insurance. An input to calculating this reserve may be done by multiplying the likelihood of each cost risk occurring by the financial consequence of each risk to the project. That is the expected monetary value (EMV) for each risk. Summing those EMVs for the project informs the project manager’s recommendation for the contingency reserve.
Importantly, you will want to track when and how this risk reserve is used during the project’s progress to know when to make adjustments and if the reserve will be sufficient. Note that the goal of the contingency reserve is not to cover cost overages 100% for every risk, but to make the project budget overage acceptable to the sponsor and key stakeholders. Tracking the risk contingency reserve is also a great tool for communicating with stakeholders about project status and progress. If you’re using these types of risk reserves properly, it can protect your project and help manage stakeholder expectations.
While it is never possible to eliminate all risks, including cost risks, understanding the different types of costs risks can help identify them. Considering how important project cost typically is to the sponsor and key stakeholders, insight into these types of risks and strategies for mitigating them are central to effective project management. A risk management reserve and contingency reserve are the most common responses to project cost risks. As a project manager, understanding these risks and how to respond will increase your likelihood of finishing your project within budget, meeting your key stakeholders’ definitions of success, and delivering value to your organization.
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