Hi, this is Ray Sheen.
I'd like to talk about a topic that is often controversial.
That is the creation and use of financial reserves in a budget.
First lets look at what a Budget Reserve is and why you might need one.
A financial reserve is unallocated money that is in the budget.
Like a department or budget that is set aside for purpose or
until some aspect of the required operational activites becomes clear.
The money is reserved for a purpose.
At the business level, the reserve may be to accommodate an expected change in
business or industry environment that has not yet occurred.
If the timing and specifics of the change are not known,
an appropriate list of activities cannot be created.
But while the specifics aren't known, the likelihood of the change is high, so
reserve account is created.
An example could be, if new industry regulations will be issued by a regulatory
body mid-year, but the specific changes are not yet finalized.
At the functional department level the reserve is often for
a new initiative that will be started, but, the details are not known.
I remember that I created a Six Sigma reserve for
my department during the year it was introduced.
I knew I would need to send some people to training and
probably participate in some projects.
But nothing was defined at the time the budget was created.
Another example for department budgets are reserves for responding to emergencies.
These are by nature uncertain.
I don't know when the equipment will need unplanned maintenance.
I don't know know when customers complaints will require overtime and
expedited shipping.
But I do know that those happen periodically
during the course of the year.
So I can create a reserve account that is used to pay for those activities.
Project reserves are needed based upon the risk and uncertainty of the project plan.
A low-risk plan may not need a reserve.
High-risk plans should always carry a reserve, or several reserves.
Let's talk for a minute about why we need reserves.
Now you may be told that you can't have a reserve in your budget, okay.
But then you need to plan your activities with conservative estimates and
low-risk approaches.
Removing the reserve from a high-risk plan just guarantees its failure.
If there is no reserve in a high-risk plan,
your options are limited when the inevitable problem pops up.
You may have to either not do some of the needed work, or
overrun the project, which can create other problems for the organization.
You may have to go back to your stakeholders or
investors to ask for more money.
That will take time and
create delays to the work, which could cause you to miss completion milestones.
You may even have to stop what you are doing, and
go a totally different direction.
Cancelling a project or shutting down a facility
that will inevitably cause you to miss the business targets or goals.
None of these are good options if the original business goals are important in
the strategy, so include appropriate reserves.
If it is high-risk work, it needs a reserve.
Let's talk about how we put a reserve into a functional department budget.
In a functional department budget, a reserve is used to create
capacity to respond to issues that are not specifically in the plan of operations.
These may be unplanned and unwanted activities, or
they may be expected activities, but the timing and details are uncertain.
Things like customer visits, unscheduled maintenance, or
product failure analysis are in those categories.
Often, the amount of reserve can be estimated from recent history.
For instance, how much did we spend last year in that category?
The actual resources that will do this work are often assigned to other
background or fill-in work while waiting for a need for their services to occur.
These background tasks are often administrative in nature and
the suspension of the work for short time will not impact the department efficiency.
While that approach works well for
functional department, I suggest a different approach for project reserves.
Project reserves are based upon the level of risk and risk mitigation in a project.
A low-risk project may not need any reserves.
Even a high-risk project that has proactively embedded risk response
approaches in the project plan, may not need any additional project reserves.
However, if there was no risk analysis done, or, the risk response plans are not
embedded in the approved project plan, then the project should have reserves.
Further, if the project has an aggressive schedules or management targets,
the project manager needs a reserve so that he or she can quickly apply resources
to unexpected small problems and resolve them before they become big ones.
The need for financial reserves can be lowered if there are large schedule or
performance reserves that can be used to resolve the problems.
One quick point about the use of reserves on projects.
I typically will pre-position the project reserves by phase or
deliverable based upon the areas of high-risk.
I often do this by creating a reserve task.
For instance, if I have a task to develop software,
I will include a software debugging task following the development.
Does that mean I want the software developers to provide me with code
full of bugs?
Of course not.
Do I know ahead of time what the bugs will be?
Again, of course not.
But my experience tells me that software development is high-risk.
So I preposition a risk response immediately following the task,
to resolve whatever issues are discovered.
Reserves are an important part of the budgeting process,
they shouldn't just be leftover money.
Instead, they are purposefully allocated in ways to help the organization,
both performance activities and achieve its metrics.