Contingency

The chance that a future event is likely to cause a negative impact on an organization or person

What is a Contingency?

A contingency is the chance occurrence that a future event is likely to cause a negative impact on an organization or person. It is a condition or a probable future event occurring by chance, deliberately or not. In addition, its occurrence and the resulting effects will necessitate special or extraordinary measures to be implemented.

 

Contingency

 

Examples of Contingencies

In business and project management, contingency is often described as a cover (financial or otherwise) that insulates a commercial or non-commercial entity in the event of an unforeseen or uncertain occurrence. Hence, the expenditure incurred when that unforeseen contingency actually occurs becomes an event occurring by chance.

Planning for contingencies becomes key regardless of not knowing the nature or scope of the contingency. An analysis that involves forecasting into the future is required to measure the nature and scope of likely contingencies. The analysis should cover the possible remedies or protective measures to be implemented beforehand to avoid or mitigate the negative effects of the contingency.

In an organization, the analysis is referred to as a contingency plan. Its sole purpose is to provide a safety net or insurance to enable an organization to survive the potentially negative effects with as little harm (or cost) as possible. Contingency plans in business are often known as business continuity plans.

 

Examples of Contingencies

 

How It Works

Planning is crucial for contingencies, especially in business. Contingency planning normally involves the assignment of cash or capital reserves by a company to meet unforeseen events. It boils down to the ability to withstand shocks from the occurrence of an unexpected event through access to liquidity to offset negative financial impacts, such as a sustained period of poor sales and increased costs. Three common methods used to mitigate contingencies include:

 

1. Credit lines

Tactical contingency plans will involve setting up lines of credit when the business is still healthy to ensure credit will be conveniently accessible in times of need i.e. when negative events occur.

 

2. Insurance

A company or organization can also take out an insurance policy against the occurrence of such contingencies. An insurance policy will cover losses incurred during and after the occurrence of a negative event.

 

3. Capital raising and revenue retention

Although the above method normally refers to banks, other businesses and organizations can also build capital reserves through revenue retention and raising new capital. It will strengthen balance sheets to absorb the negative effects of contingencies. Banks normally adopt minimum capital requirement levels as a function of their risk-weighted assets.

 

Contingency Planning

A contingency plan is a blueprint generated by management to assist an organization to deal with the occurrence of unforeseen negative events. It is a preventative control tool designed to mitigate reputational or financial harm to an organization due to unexpected circumstances.

The major objective of the contingency plan is to ensure business continuity during and after a catastrophic event. Hence, the plan helps organizations recover from the effects of major risks threatening their survival. It should also be able to thwart any negative publicity that may arise as a result.

A contingency plan ensures that an organization is able to react proactively to unexpected events in order to limit the hemorrhage on revenues and profits. It is also known as Plan B, back-up plan, business continuity plan, or disaster recovery plan. A template outlining the contingency planning process is highlighted below:

 

Steps in Creating a Contingency Plan

An effective contingency plan should be well researched and enhanced with employee and stakeholder collaboration. The steps to be taken are indicated below:

 

1. Create a contingency policy

A contingency policy statement should be created to communicate clear guidelines to be followed when handling disaster events. The statement should be communicated to all relevant employees to optimize the quality of the response.

 

2. Identify resources

An inventory of resources that the organization possesses and those that it can access should be prepared beforehand. They are resources that help to mitigate the effects of a disaster or negative eventuality.

 

3. Identify key risks

Identification of key risks that are likely to affect the organization is a crucial step. It should be a collaborative process through the involvement of departmental heads and even outside consultants.

A business impact analysis (BIA) can also be employed to determine the probability of occurrence of a particular event and its potential impact on critical business processes. A BIA also assists in the identification of future risks and their priorities.

 

4. Prioritize risk impact

Once all risks are identified, the next step is to prioritize them based on the likely severity of their impact on the organization. A follow-up prioritization parameter is the probability of occurrence.

 

5. Draft a contingency plan

The existence of different risks threatening the organization requires different plans. As indicated above, prioritization of risks according to potential impact is key. The contingency plan should provide multiple scenarios to cover a wider range of the scope of risks and circumstances.

Focus should also be emphasized on loss minimization. The contingency plan should clearly outline the actions to be taken before and after the events materialize and ensure the resumption of normal operations. The responsibilities of each employee, including their action points and timelines, should be well articulated.

Strategies to create a contingency liquid reserve to absorb potential losses should be set up during the planning phase. They include setting up a line of credit or raising funds in the interim to be set up as contingency reserves for unexpected events.

It is also crucial to buy insurance cover, which will come in handy if losses are incurred. However, insurance policies will require upfront or periodic premiums that need adequate budgeted provision in the contingency plan.

 

6. Share the plan

The contingency plan should be shared amongst all relevant employees and stakeholders. It will ensure an optimized response from all concerned persons when the time comes.

 

7. Test the plan

An important step in contingency planning is the testing of the plan to measure its effectiveness. Mock exercises and simulations should be conducted to test the response and execution time and will prepare staff for the real thing before it happens.

Testing can reveal weaknesses or vulnerabilities in the plan and indicate where it needs improvement. It can be discovered that there is a need for additional resources or additional staff training. Remedying these weaknesses will increase plan effectiveness and organizational preparedness.

 

8. Review and update the plan

The plan can be rendered less effective or ineffective over time due to changes in the environmental landscape and technology. Hence, it is paramount to review, update and maintain the contingency plan from time to time as warranted.

 

Possible Actions for Mitigating Contingency Risks

 

Possible Actions for Mitigating Contingency Risks


Contingencies in Project Management

In project management, contingencies normally refer to cost, i.e. funds set aside in reserve to deal with unexpected events. However, they also refer to other aspects of the project, such as resource shortage and meeting deadlines. Contingency plans should be prepared for all the risks mentioned in the sections above.

It is advisable that project managers do not disclose that they hold contingency reserves to other members of the project team. It is because disclosure can result in an opposite effect where the contingency reserves will be seen as a license to exceed budgetary allocations.

Project contingencies are usually expressed in percentage terms. The initial stages of the project are typically the riskiest and higher percentages of contingencies are applied. However, as the project progresses, percentages on contingencies are gradually reduced as there will be fewer unknowns and clearer project direction.

Reducing a contingency during a project typically involves the following issues:

  • At the planning stage, total costs estimates should include an additional premium e.g. 10% contingency.
  • About 5% to 10% of contract value can be included as a contingency in the cost plan.
  • The project owner often retains a certain percentage of the amount due to the contractor. It is called retention (normally 5%). The retention is taken as insurance to make sure the contractor executes the project as per the terms and conditions of the contract.

 

More Resources

CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:

  • Commitments and Contingencies
  • Project Management
  • Liquidity
  • Risk Management

CFI's Corporate & Business Strategy Course

Learn to perform Strategic Analysis in CFI’s online Business Strategy Course! The comprehensive course covers all the most important topics in corporate strategy!