A Brief Examination of Common Cost Related Risk Management Scenarios

In this post, I will try to look at the three of the very common risks associated with the ability of business to manage its project costs. I identify risk, the cause and try to suggest a possible risk mitigation strategy. 

Our policy is to accept the lowest-cost bidder.

Top Risk: The major danger of accepting the lowest-cost bidders is usually related to ending up in a contract with a vendor that uses various shortcuts to offer such a low price.

Cause: It is feasible to assume, that vendors who promise project delivery for an unrealistic or extremely low cost, are doing it just to win the contract. Such vendors would possibly later fill hidden costs and fees to the overall cost of the project. Another potential problem that would allow a vendor to offer their services for a very low price is using practices such as the hiring of unskilled employees, which could result in negligent work practices and eventually a reduced overall quality of work. The risk associated with accepting lowest cost bidder is also a possibility of project delay, which inflates the overall cost of the project.

“A winning contractor may have the lowest initial bid, but they may try to make up the difference through hidden charges and fees for materials and service equipment not included in the original bid.” (Lmchouston.com, 2017).

Mitigation Strategy: In my opinion, the best risk mitigation strategy is to set the minimum technical and performance requirements before accepting any bids. Moreover, always remember, that if the vendor offers its services for a price that sounds too good to be true, then it probably is.

Why will this strategy be effective: The strategy of setting requirement standards before accepting bids is useful mainly because it allows business to identify better the best-value vendors that are worth of becoming candidates for a contract award. Those types of vetted vendors will likely also be able to deliver on requirements. The requirements of suppliers checklist can help business to weed out future partners who probably trade the quality to achieve a low cost.

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No formal change management system in place to track the costs of changes in the scope of work agreed upon between the customer and the supplier.

Top Risk: The major risk is related to a significant increase in project costs and extending the financial plan over the target budget.

Cause: The root issue here is the unpreparedness of the business. The need to track the costs associated with the scope of work should be high on the list of things to implement.

Mitigation Strategy: Aside from having the plan in place that closely follows on the scope of work agreed upon business and supplier, the good way to mitigate the risk is to review the agreements. It is important mainly to make sure that all agreements clearly define vendor expectations. Legal departments should be involved in all contract review activities. Another way is to select the supplier from amongst those whom the business used in the past and where the solid partnership relationship was already established and tested and where reliance on upholding the agreement is expected to be better than with unknown vendors.

Why will this strategy be effective: A good way to handle the issue is to have the Management System in place. However, we also need to remember, that implementation of a management system “is a people process and its success depends upon the company’s employees’ commitment towards the system” (Allan and Sommerville, 2000 p. 602).

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The project could fail because the cost of a key component has increased

Top Risk: The major risk, in this case, is related to the danger of delivering a product whose cost is higher than the budget initially set for the project. The unexpected price increase of the main components would very likely negatively impact the business operations. That could leave the company in a situation where it may not be able to re-structure itself to offset the problem.

Cause: The root cause is related to the price unpredictability, which is a common problem for many businesses that rely on third party components. Every business needs to realize that price changes often occur unexpectedly, especially with external vendors who can modify the pricing models at any given time. The companies who do not prepare for the price increase may end up either absorbing the price increase; or living with the severe effects of the bad planning on their margins.

Mitigation Strategy: One of the best ways to tackle the price unpredictability of the main components is to have a contingency plan in the form of appropriately setting the target budget. Another way to mitigate the risk is to create an operating model that doesn’t rely on components whose price can change. That can be either achieved by setting the long-term price agreements with vendors in charge of delivering the key elements; or reduce the need for vendor lock-in. For example, the vendor could settle for components that are open-source and are widely adopted and recommended by the open-source community.

Why will this strategy be effective: I was involved in numerous projects where it was a common practice to add extra buffers to the estimated cost of components. The additional budget always acted as a buffer that absorbed the possible future changes in price.

According to National Research Council (2005), risk buffering (or risk hedging) is the establishment of some reserve or buffer that can absorb the effects of many risks without jeopardizing the project. A contingency is one example of a buffer; a large contingency reduces the risk of the project running out of money before the project is complete.

On the other hand, avoiding vendor lock-in by selecting open source components would allow creating business plans that do not rely on too many providers and do not come with the risk of the price increase.

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References

Lmchouston.com. (2017) Four Major Problems With Always Accepting The Lowest Bid | Lawn Management Company. [online] Available at: https://lmchouston.com/blog/four-major-problems-always-accepting-lowest-bid [Accessed 9 May 2017].

Allan, C., Sommerville, J. (2000) Driving for business excellence through environmental performance improvements. Total Quality Management, 11(4-6), 602-607.

National Research Council. (2005) The Owner’s Role in Project Risk Management. National Academies Press. 45.

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