Management Reserve (MR)

Management Reserve (MR) is an amount of the contract budget set aside by the project manager at the beginning of a project. The sum of the Performance Measurement Baseline (PMB) and MR equals the Contract Budget Base (CBB). By definition, Management Reserve does not have a specific scope of work and therefore it is not part of the PMB. Management Reserve is established to provide budget for known-unknowns that are within the scope of the contract but out of scope to any control account.

Full Definition of Management Reserve

Management Reserve Best Practice Tips

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A recurring theme H&A earned value consultants find themselves discussing with clients is emphasizing that management reserve (MR) is a very precious budget set aside that must be protected and used appropriately. Unfortunately, MR is often used inappropriately, and quickly depleted in the early stages of a project.

What happens when MR is consumed for other uses than what it was intended? There is no budget available for appropriate uses of MR such as for emerging work, rework, redesign, or make/buy adjustments within the scope of the contract when it is needed in the latter stages of a project. When that happens, a project manager is forced to create a “home” for actual costs for these activities. This results in other inadvisable actions such as:

  • Zero budget work packages which are also known as estimate to complete (ETC) only work packages.
  • De earning the budgeted cost for work performed (BCWP) and opening completed work packages to accept charges.
  • Culling budgets from future unopened work packages, and if they exist, planning packages, summary level planning packages (SLPP), and undistributed budget (UB).

These actions will call into question the integrity of the EVMS and EVM data. The customer conducting EVMS surveillance will also be quick to point out this deficiency in the EVMS implementation and raise the issue to ensure it has management’s attention to correct. The inappropriate use of MR has created a cascade of problems that could have been avoided. In some instances, project personnel were simply not following the rules for the use of MR found in the contractor’s EVM System Description. That’s an easier problem to resolve than other root causes.

The Role of Risk and Opportunity Management in Establishing MR

What H&A earned value consultants often uncover as the root cause of inappropriate uses of MR was that a robust risk and opportunity (R&O) management process would have made a difference in establishing a quantified set aside for MR to handle realized risks. Proactively identifying and managing risks improves project performance. The expectation of specific risks occurring leads to risk handling plans that lower the likelihood and impact of risks. It also provides an informed basis to establish an adequate amount of MR that reflects identified and assessed risks.

The risk assessment provides additional information that assists a project manager’s decision making process to validate a request to use MR is appropriate and has the backup data needed to justify the use of MR and the amount of MR allocated. This detail is necessary for the baseline change request (BCR) approval process as well as the Integrated Program Management Report (IPMR) Format 5 or Integrated Program Management Data and Analysis Report (IPMDAR) Performance Narrative Report (PNR). A project manager is required to identify the changes to MR during the reporting period and provide a brief explanation of the change. This explanation has the potential to pique the interest of the customer to gain a better understanding of why MR was used and the potential impact to the integrity of the EVM data.

Note: MR may increase or decrease for a variety of reasons. The primary use of MR is to handle realized risks within a control account that is within the statement of work (SOW) for the contract. All MR debits or credits should be tracked in a log for full traceability for the entire life of the project. Remember that MR can never be a negative value.

Acceptable Uses of MR

As highlighted in an H&A article titled “The Effective Use of Management Reserve,” examples of the appropriate uses of MR include:

  • Newly identified work is authorized and assigned to a control account manager (CAM). It may be that once the work begins, one or more tasks that were missed in the original planning process now need to be scheduled and resource loaded. Newly identified work could also be the result of internal replanning that required a change in approach or resource requirements.

    An example of this could be a project manager issued a work authorization to a CAM to conduct three tests to meet the requirements in the contract SOW. In the middle of the first test, it becomes clear to the CAM and project manager that a fourth test will be necessary. The project manager and CAM should be aware of this potential risk and be prepared to implement their risk handling strategy as a result of the R&O management process. The CAM can quickly prepare a BCR that the project manager can immediately approve to allocate MR budget to complete the fourth test. 
  • It is necessary to redo a task. This may include unanticipated redesign, remake, or retest. Hopefully, the project’s risk register identified the potential risks associated with the original tasks and management was prepared for the realized risk. 
  • Make/buy adjustments.  This could result in an MR debit or credit. 
  • Statement of work transfers from one organization to another. This could result in an MR debit or credit. 

Inadvisable Uses of MR Commonly Allowed

Although it is often allowed in a contractor’s EVM System Description, it is inadvisable to use MR for direct and indirect rate changes in the future. Note: MR should never be used to make any rate adjustments (or any other adjustments) to historical budgeted cost for work scheduled (BCWS) or BCWP data.

A rate change is not a change to the SOW for a CAM. It is merely a change to the cost of that work. Cost variances that occur because of direct and/or indirect rate changes can easily be explained in a Variance Analysis Report (VAR). Ironically, this use of MR is typically treated as a one-way street. Contractors apply MR when the direct and/or indirect rates are going up in the future but do not return to MR when the rates are projected to go down.

When a contractor’s EVM System Description allows MR to be used for future direct and/or indirect rate changes, ideally, the likely rate changes are identified as a risk and quantified when the initial MR is established for a project. This requirement should be noted in the EVM System Description. That way the set aside for MR includes budget for corporate rate adjustments that are outside of the control of the project manager or CAM. 

Another example of a commonly allowed but inadvisable use of MR is to “true up” a purchase order that is in excess of the original budget at completion (BAC) for material, equipment, or purchased services. For example, a project manager issues a work authorization to a CAM that includes purchasing material, equipment, or services from a supplier. The CAM then reaches an agreement with a supplier with scope, schedule, and budget. If that agreement is greater or less than the BAC, MR should not be applied, nor should budget be returned to MR to make the BAC match the PO value. Assuming the scope does not change, then MR should not be used to wipe out a cost variance whether positive or negative. The cost variance can be easily explained and the EAC can be increased or decreased. This is another example where contractors are treating this as a one-way street; they apply MR when it goes up, but do not return to MR when it goes down. A contractor would not “true up” for internal work overruns/underruns so why “true-up” for material or services provided by a supplier? 

Best Practice Tips

The following is a short list of best practices H&A earned value consultants often recommend clients implement for managing MR.

  • The EVM System Description should clearly spell out what are appropriate and inappropriate uses of MR. It should also provide guidance to eliminate instances of the “one way street” debit from MR. If needed, provide supplemental procedures, decision trees, or other work instructions to help project personnel follow EVM best practices and preserve MR for handling realized risks which typically occur in latter stages of a project.
  • Ensure that the R&O management process is integrated with the EVMS and provides the necessary risk identification and assessment information for the project manager to establish a realistic MR set aside based on quantifiable information. Where applicable, ensure likely rate changes are captured as a potential risk to the project and considered when the initial MR for the project is established if they intend to use MR for rate changes in the future.
  • Conduct recurring training to reinforce the purpose for MR and the appropriate use of MR. A recommended approach is to discuss a variety of use cases with project personnel so they know how to handle various situations that may occur on a project. 

Have you noticed “creative” uses of MR that are contrary to EVM best practices? Hopefully, you identified those situations as part of your EVMS self-governance process and were able to quickly implement corrective actions before your customer pointed out the issue to you. H&A earned value consultants often assist clients with producing procedures or work instructions that clearly spell out how to use MR appropriately. We also offer a range of EVMS training to reinforce EVM best practices including the appropriate use of MR. Call us today to get started.

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Who Owns Subcontractor Management Reserve (MR)?

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Who Owns Subcontractor Management Reserve?

Subcontractor, Prime Contractor… Customer?

There has long been discussion regarding who “owns” a subcontractor’s Management Reserve (MR).  Some believe that since the entire contract value was awarded by the prime contractor to the subcontractor, the MR belongs to the prime.  Unfortunately, they might have been influenced by some of their customers who believe a prime contractor’s MR belongs to the customer – even to an extreme in which the customers interject themselves in the prime contractor’s decision process in using their MR. So contractors might figure that if the customer is doing that to them, they should do the same to their subcontractors.

DCMA Cross Reference Checklist

They may try to justify this by pointing out that in the DCMA Cross Reference Checklist (CRC dated 22 March 2019) Guideline # 14 Sub-question b asks:  

“Is major subcontractor Management Reserve (MR) incorporated and traceable to the prime contractor’s EVMS?”

While this might sound to some as though it justifies the argument that the MR belongs to the prime, it really doesn’t.  The actual guideline 14 question is simply asking if the contractor implementing EVMS (in this case the subcontractor) simply does or does not “Identify management reserves and undistributed budget.”  Since the subcontractor is implementing their management system on their contract with the prime, the only requirement is that the subcontractor identifies a Management Reserve (MR) amount (which could be zero, by the way). If they do, then (strangely) subquestion b puts the onus on the prime contractor to reflect the subcontractor’s MR in their EVM system [i.e., strange because how would a subcontractor demonstrate to a review team that their MR is being reflected in the prime’s EVM System?]. This question would be more appropriate if the subcontractor was also the prime to a lower-tier subcontractor.

Reporting vs. Ownership

The above only addresses the reporting of a subcontractor’s MR, but what does the government documentation actually say about the “ownership” of the subcontractor’s MR?

Note: A point to remember in this entire discussion is that the Guidelines, the EVMIG, the Cross Reference Checklist (CRC), and the EVMSIG were written to apply to any contractor required to implement EVMS on a contract – whether they be a prime contractor to a government customer or a subcontractor to a prime contractor (their “customer”).

EVMSIG Chapter 3 Introduction

The EVMSIG Chapter 3 Introduction (pg. 17) says this about MR:

“An allowance is made for a portion of the CBB to be withheld outside of the PMB as Management Reserve (MR) for internal management control purposes. MR is intended to provide the contractor with a budget to manage risk within the established contract scope (Guideline 14).”

As this introductory paragraph points out, MR is established by the contractor (or the subcontractor) for their internal management control purposes to have budget to manage risk within the contract scope. There is no mention of customer involvement in the decision-making process.

Para 3.9 (Guideline 14), Intent of Guideline

A more definitive statement in the EVMSIG is: “Para 3.9 (Guideline 14), Intent of Guideline” in the second paragraph – bullets and underlines have been added for emphasis:

  • “MR belongs to the contractor Program Manager, not the Government,…” [ergo, NOT the prime in a prime/ sub relationship]
  • [It] “provides the contractor with a budget for unplanned activities within the current program scope. MR enables program management to respond to future unforeseen events within the work scope of the program by distributing budget to mitigate program risks.”
  • “To establish MR, the contractor’s program management sets aside budget based on the program’s risk management process and assessment.”
  • [MR] “is not a source of funding for additional work scope or the elimination of performance variances.”
  • “MR is not a contingency fund and may neither be eliminated from contract prices by the customer during subsequent negotiations nor used to absorb the cost of contract changes.” And finally,
  • “MR belonging to a major subcontractor must be incorporated into the prime contractor’s EVMS with traceability to the subcontractor’s reported MR.”

Subcontractor Reports

This last bullet specifically points out that the MR belongs to the subcontractor, and that it must be reflected in the prime’s EVMS as reported by the subcontractor.  Some choose to include a subcontractor’s MR in their own MR value; having it there, however, increases the risk of having the prime think they have more MR to use when, in fact, they do not.  The subcontractor’s MR is not the prime’s to use, so the prime would need a very good mechanism in place to keep the two MR amounts separated.  This needed segregation becomes more complicated if the prime has more than one subcontractor.  Regardless of where the contractor places the subcontractor MR, EVMS requires it to be traceable to the MR value the subcontractor reports.

A Contractor’s Control Mechanism

Management Reserve (MR) is something that is allowed to provide a contractor with flexibility in handling the unknowns on a contract.  It doesn’t matter if it is a prime contractor to a government customer or a lower-tier subcontractor to a higher level (or prime) contractor.  MR is a contractor’s control mechanism and should not be subjected to any level of customer involvement.  The guidelines and implementation/ interpretation documentation try to control improper uses of MR (e.g., covering performance variances, performing out of scope work, etc.), but customers – at all levels – should not interject themselves in a contractor’s decision-making process on the use of MR. Remember also, if customers involve themselves in that process, there is a risk that their perceived “direction” to the contractor could make them complicit in poor MR decisions.

Who Owns Subcontractor Management Reserve (MR)? Read Post »

Formal Reprogramming – What Happened?

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Graph of an Increasing Budget

A long time ago, in a galaxy far, far away….an Over Target Baseline (OTB) – by design – was a rare occurrence (and the OTS concept did not even exist as part of Formal Reprogramming). Formal Reprogramming was a very difficult and cumbersome process that most contractors (and the government) really did not like to consider. The government, in its 1969 Joint Implementation Guide, said:

“Reprogramming should not be done more frequently than annually and preferably no more frequently than once during the life of the contract.”

The Office of the Under Secretary of Defense (OUSD) Acquisition, Analytics and Policy (AAP) – formerly PARCA – , in their latest OTB/OTS guide, states that Formal Reprogramming now has expanded to include an Over Target Schedule (OTS).  However, in that guide, it is stated in Paragraph 1.3.8:

“Ideally, formal reprogramming should be done no more than one time during the life of a contract. However, there may be instances where another formal reprogramming is warranted… When formal reprogramming is accomplished in accordance with the procedures in this guide, with a realistic cost and schedule estimate established for the remaining work, it should not be necessary to undergo formal reprogramming again.”

Today, though, whenever contractors incur a significant cost or schedule variance, instead of resolving the variance cause, the first words seem to be: “Let’s do an OTB or OTS.”  The lure of “getting rid of cost and schedule variances” seems too good to pass up.  Unfortunately, an OTB/OTS implementation has never been an instantaneous process. With AAP’s 12 step OTB/OTS process, it is obvious that the contractor will not be able to start today and incorporate the OTB/OTS in the next Integrated Program Management Data and Analysis Report (IPMDAR) dataset. In fact, AAP’s OTB/ OTS guide states in paragraph 3.8:

“It may be difficult to ascertain the length of time it will take to implement a new baseline based on the scope of the effort. It is not uncommon for the entire process to take up to six months which would be too long of a period without basic cost reporting.”

The last line of the above cited paragraph was referencing the reporting requirements to the customer when an OTB/OTS is being implemented.

The IPMDAR Implementation and Tailoring Guide (5/21/2020) even recognizes the issues with timeliness of implementing an OTB/OTS:

2.3.2.5.5  Formal Reprogramming Timeliness. Formal reprogramming can require more than one month to implement. During formal reprogramming, reporting shall continue, at a minimum, to include ACWP, and the latest reported cumulative BCWS and BCWP will be maintained until the OTB/OTS is implemented. 

So why does it take so long to implement the OTB/OTS?  Can the contractor just adjust the bottom line variances and move on?  Actually no, nothing is really that simple.  This is one of the reasons that implementing an OTB and OTS should not be taken lightly.   The AAP OTB/OTS Guide addresses adjustments this way:

“3.5.6.2 Adjusting Variances: A key consideration in implementing an OTB is to determine what to do with the variances against the pre-OTB baseline. There are essentially five basic options. This is a far more detailed effort than these simple descriptions imply, as these adjustments have to be made at the detail level (control account or work package).”

When considering the number of control accounts and work packages involved in a major contract, a Formal Reprogramming can become a rather daunting task.  The contractor also has to report the effects of the Formal Reprogramming in the IPMDAR Reprogramming Adjustments columns. These adjustment columns appear on both Format 1 and Format 2 of the IPMDAR database, which means the contractor must undertake the assessment for both the contract’s WBS and the OBS – for each WBS element and for each OBS element reported.  This can be further complicated if the OTB/OTS exercise were flowed down to subcontractors for a given program.  The AAP OTB/ OTS Guide, paragraph 3.8 also states:

“The customer should be cognizant of the prime contractor’s coordination complexities and issues with its subcontractors. The time to implementation may be extended due to accounting calendar month overlaps, compressed reiterations of contractor ETC updates, internal reviews, subcontractor MR strategy negotiations, senior management approvals, etc., all while statusing the normal existing performance within a reporting cycle.”

In the early days, when implementing an OTB with variance adjustments, the company and the customer agreed on a month-end date to make the data adjustments.  Then the contractor ran two CPRs or IPMRs (now the IPMDAR): (1) the first report as though no OTB had been implemented [to determine the amount of adjustments to cost variance (CV) and schedule variance (SV) at all the reporting levels] and, (2) the second report [after the OTB implementation had been completed – no matter how long it took] showing the Column 12 adjustments plus whatever BAC changes were being implemented.

Under the current OTB/OTS Guide, it appears as though this process is being done all at once. As stated in the AAP OTB/ OTS Guide paragraph 3.8 above, this implementation could take up to 6 months to complete, so lagging the second report until the OTB/OTS implementation is completed seems logical. The last sentence in paragraph 3.8 also stipulates that regardless of how long implementation takes, the contractor and customer will agree on interim reporting that will be required, further stating that:

“In all cases, at least ACWP should continue to be reported.”

Perhaps this agreement with the customer should also specify the content of the first IPMDAR following OTB/OTS implementation.

All things taken into account, the process of requesting and getting approval for an OTB or OTS can be a long and difficult process, especially if, at the end of it all, the contractor’s request is denied.  Even if it were approved and the contractor implements and works to the newly recognized baseline, immediately doing another one is not a pleasant thought – and remember, it was not intended to be pleasant. Reprogramming was always supposed to be a last resort action, when reporting to the current baseline was totally unrealistic.

Now, what about those cases where a contract has one or two elements reporting against totally unrealistic budget (or schedule) baselines?  The AAP OTB/ OTS Guide does cover a partial OTB, but reiterates that this is still an OTB because the Total Allocated Budget (TAB) will exceed the Contract Budget Base (CBB).  In the early days, however, the government allowed what was called Internal Operating Budgets (IOBs) for lower level elements (control accounts, or specific WBS elements, etc.) that were having problems resulting in an unrealistic baseline for the work remaining. The 1987 Joint Implementation Guide, paragraph 3-3. I (5) described IOBs as follows:

“(5) Internal Operating Budgets. Nothing in the criteria prevents the contractor from establishing an internal operating budget which is less than or more than the total allocated budget. However, there must be controls and procedures to ensure that the performance measurement baseline is not distorted.

(a) Operating budgets are sometimes used to establish internal targets for rework or added in-scope effort which is not significant enough to warrant formal reprogramming. Such budgets do not become a substitute for the [control] account budgets in the performance measurement baseline, but should be visible to all levels of management as appropriate. Control account managers should be able to evaluate performance in terms of both operating budgets and [control] account budgets to meet the requirements of internal management and reporting to the Government.

(b) Establishment and use of operating budgets should be done with caution.  Working against one plan and reporting progress against another is undesirable and the operating budget should not differ significantly from the [control] account budget in the performance measurement baseline. Operating budgets are intended to provide targets for specific elements of work where otherwise the targets would be unrealistic. They are not intended to serve as a completely separate work measurement plan for the contract as a whole.”

Current literature no longer specifically addresses Internal Operating Budgets (IOBs), but with the recent trend of contractors jumping to the OTB/OTS conclusion, it might be a better alternative to have individual instances of unrealistic budgets (or schedules) that do not otherwise push the total program to the need for a complete OTB and/or OTS implementation.

These could be good discussion topics for future AAP and DCMA meetings with industry representatives, to determine if there are ways to streamline the process, or at least reduce the amount of requests to implement Formal Reprogramming.  Variances are, after all, performance measurement indicators that should not just be routinely and artificially eliminated.

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Management Reserve; Comparing Earned Value Management (EVM) and Financial Management Views of “Reserves”

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Management Reserve & Earned Value ManagementPerhaps you have witnessed the collision of earned value management’s views on “management reserve” with the Chief Financial Officer (CFO) and the finance department’s views on “balance sheet reserves.” Most companies tend to organize EVM, the function, reporting to either the programs’ organization or to the finance organization. Either will work but either can fail if the two organizations do not understand the interest of the other.

In this article we will outline three areas. The first will be EVM and Management Reserve (MR). The second will be finance and balance sheet “contingencies, loss provisions, or reserves.” The third will compare the two views and identify where they are similar and where they differ.

We will use two terms for both EVM and Financial Management; “in play” and “on the sideline.” “In play” for EVM means that it is in your Performance Measurement Baseline (PMB) and Budget at Completion (BAC). “On the sideline” for EVM means “not in scope” therefore in MR. “In play” for financial management means recorded on the balance sheet (e.g.: current liability; an accrued liability). “On the sideline” for financial management means not recorded on the balance sheet, because it is more likely than not that a liability has been incurred.   If material, however, it will likely be disclosed in the notes to the financial statements, even if it is not recorded on the balance sheet.

 

Earned Value Management and Management Reserve

A program manager and his or her team must deal with – mitigate – risk or be consumed by those risks as they become issues. There are two types of risks, known and unknown. The known risks are entered into a risk register, and their likelihood and consequence are determined. Mitigation for those known risks is done at the activity level in a program’s Integrated Master Schedule (IMS) (Planning and Scheduling Excellence Guide — PASEG page 141, ¶ 10.3.1). Mitigation of known risks is part of the PMB (in the BAC) and is therefore “in play.”

The second type of risk – unknown or unknowable risks – are covered by management reserve if within the Scope of Work (SOW) of the existing contract. If contractor and customer conclude that the realized risk is outside the existing contract, then an Engineering Change Proposal (ECP) would likely be created by the contractor; and a contract modification would be issued by the authorized customer contracting officer if they agreed.   The program manager should ask this question of his team: what work is “at risk” and what work is not “at risk?” Does labor or material present more risk? Management reserve “is an amount of the overall contract budget held for management control purposes and for unplanned events” (Integrated Program Management Report–IPMR DI-MGMT-81861 page 9, ¶ 3.2.4.6). Management reserve is “on the sidelines.” MR has no scope. MR is not earmarked. MR stands in waiting.

 

Earned Value Management Reserve (MR) Compared To Financial Management “Contingency”

Because the audience reading this blog is most likely from the EVM community, I’ll offer a Financial Management example of a company that faces many risks and must manage those risks or be consumed by them. Altria Group, Inc. and Subsidiaries (stock symbol: MO) are in the tobacco, e-Vapor and wine business. Altria’s history clearly shows that the company measures and successfully mitigates the risks they face. Altria faces a blizzard of litigation each year and must protect its shareholders from that risk. So how does Altria manage known risks (mostly from litigation) and how does Altria handle unknown risks?

Altria is a publicly traded company and its annual report (10K) is available on-line to the public. This data is from their 2014 annual report.

I am an MBA, not a CPA, so I’ll stick to Altria’s 2014 balance sheet. For those not familiar with financial statements, a balance sheet has on its left hand side all of a company’s assets – what the company owns and uses in its business (current assets = cash, accounts receivable, inventory; long term assets = property, plant and equipment). The right hand side of a company’s balance sheet shows current and non-current liabilities and shareholders’ equity. The top right hand side of the balance sheet includes current and non-current liabilities (accounts payable, customer advances, current and long-term debt, and accrued liabilities like income taxes, accrued payroll and employee benefits, accrued pension benefits and accrued litigation settlement costs) and the bottom of the right hand side of the balance sheet includes shareholders’ equity consisting of common and preferred stock, paid in capital and retained earnings.

Altria’s 2014 annual report shows under current liabilities; accrued liabilities; settlement charges (for pending litigation Contingency note # 18) a value of $3.5 billion dollars. The 2013 amount was $3.391 billion dollars.

So Altria has “in play” $3.5B for litigation for 2014. In financial terms, Altria has recorded $3.5 billion in expense related to the litigation, probably over several years as it became more likely than not that a liability had been incurred and was reasonably estimable. In EVM terms Altria has $3.5B in their baseline, or earmarked, or in scope for litigation (court cases).

What happens if Altria ultimately has more than $3.5B in litigation settlement costs? What does Altria have waiting on the “sidelines” to cover the unknown risks? Essentially Altria has on its balance sheet waiting “on the sidelines” $3.321 billion in cash and the ability to borrow additional funds or perhaps to sell additional shares of stock to fund the settlement costs. In EVM terms Altria has $3.5B in its baseline (on its balance sheet) to manage the risks associated with litigation. Altria’s market capitalization at the market close on May 17, 2015 was $52.82 billion and its 2014 net revenues were $24.522 billion. It is reasonable to understand that Altria has more than enough MR.

 

Differences Between EVM MR and Financial Management Balance Sheet Reserves

In EVM, MR is only released to cover unplanned or unknown events that are in scope to the contract but out-of-scope to any control account. A cost under-run is never reversed to MR, and a cost over-run is never erased with the release of MR into scope.

In industry in general, and Altria in particular, if the “in play” current liability for settlement charges of $3.5B are not needed (an under-run), then Altria will reverse a portion of the existing accrued liability into income, thereby improving profitability. If Altria’s balance sheet reserve of $3.5B is insufficient, then Altria’s future profits will be reduced as an additional provision will be expensed to increase the existing reserve (an over-run).

[Humphreys & Associates wishes to thank Robert “Too Tall” Kenney for authoring this article.]

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