Contingency Reserves, 3rd Edition
Once this estimate for the project has been produced, a contingency reserve is added. In the language of the 3rd Edition, this is to cover known unknowns. Known unknowns are cost variations attributed to normal variability in materials costs, material quantities, labor hours, and labor rates. In these cases, we know that we are going to have to pay for labor and materials, but we may not know exactly how many labor hours the work will take, what the labor rate will be, exactly what quantity of materials will be required, or what material unit costs (e.g., commodities costs) will be.
Another way of looking at known unknowns is to look at it from a risk management point of view. Some risks are sufficiently likely to occur (have a high enough probability of occurring) so as to warrant treating them as certain events. They are then accounted for in the work breakdown structure and schedule, to include their cost and time impacts. If treated in this way, they are considered a certainty and are automatically included in the performance measurement baseline.
If these risks are treated as a possibility (i.e., not imbedded in the work breakdown structure and schedule) and the associated risk events occur, the portion of the budget set aside for contingency reserves can be tapped to cover those expenses and/or time extensions. According to the 3rd Edition, contingency reserves are added to the project cost estimate to arrive at a cost baseline. This cost baseline is then used as the basis for establishing the planned value baseline and so becomes the "standard". That is, the Performance Management Baseline (PMB)) against which performance measures (earned value management measures) are referenced.
Contingency reserves can also apply to time and schedule. Impacts to the schedule can occur as a result of unplanned work stoppages (natural disasters, failure to pass critical inspections, rework, etc.). In addition to monetary reserves, a contingency reserve of time should also be incorporated into the project plan.
According to the 3rd Edition, contingency reserves are used at the discretion of the project manager. In this paper, I will not go into how PMI recommended implementing time and cost contingency reserves in the Guide's 3rd Edition, other than to say that those explanations have largely been supplanted by the Guide's 5th Edition, making PMI's previous descriptions obsolete. They are not bad, just obsolete.
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Brief Description of Cost Management as Described in the Guide
3rd Edition
