382 IEEE TRANSACTIONS ON ENGINEERING MANAGEMENT, VOL. 52, NO. 3, AUGUST 2005 Optimal Use of Budget Reserves to Minimize Technical and Management Failure Risks During Complex Project Development Robin L. Dillon, M. Elisabeth Paté-Cornell, and Seth D. Guikema Abstract—Project managers are recognizing that adequate resource reserves are a critical success factor in a project develop- ment environment that is complex and uncertain. Yet, justifying the need for project reserves is still a challenge, as is the optimal allocation of any available resources to minimize development uncertainties. This paper presents a multiperiod decision model designed to support the management of reserves considering the risks of failures including technical, managerial, i.e., exceeding budget and schedule, or strategic, i.e., meeting budget, schedule, and technical specifications but not achieving the full strategic value of the project. In this paper, we examine the tradeoffs among these risks and their implications for resource allocation during a project’s development phase. This decision support model is referred to as Dynamic Advanced Probabilistic Risk Analysis Model. It provides decision makers with a quantitative tool to allocate reserves (beyond the bare-bone minimum project costs) among project reserves, technical reinforcements of the engi- neered system, and product enhancements, with the advantage of flexibility over time. The model yields first, coarse estimates of the value of deferring some commitments about the product’s design until critical uncertainties are resolved and second, an estimate of the optimal amount to be invested in testing and reviews. We show that the greater the uncertainties at the onset of the development phase, the greater the value of this information. Index Terms—Budget reserves, decision analysis, project man- agement, resource optimization, risk management. I. INTRODUCTION T HE OPTIMAL management of resource reserves (or contingencies or buffers [1]) is a significant challenge for project managers. These reserves can be defined as the difference between the project’s budget and the bare-bone, minimum cost at which it could be developed. In a review of success factors and future challenges of faster-better-cheaper space missions, Paté-Cornell and Dillon [2] identified the importance of adequate resource reserves for project success, especially when new technologies are involved. That study also recognized the challenges of managing these reserves. Too often, reserves are perceived as wasted resources and set arbi- trarily (i.e., a systematic 10%, 20%, or 30% of the initial, often Manuscript received December 1, 2003; revised August 1, 2004 and March 1, 2005. Review of this manuscript was arranged by Department Editor A. Marucheck. R. L. Dillon is with the McDonough School of Business, Georgetown University, Washington, DC 20057 USA (e-mail: rld9@georgetown.edu). M. E. Paté-Cornell is with the Management Science and Engineering Department, Stanford University, Stanford, CA 93405 USA. S. D. Guikema is with the Department of Civil and Environmental Engineering, Cornell University, Ithaca, NY 14853 USA. Digital Object Identifier 10.1109/TEM.2005.850733 low-cost estimate). How can a project manager realistically estimate adequate reserves? For example, some old project managers claim the best rule of thumb to estimate costs is to take the initial estimate and multiply by . 1 Even if a project manager can convince a sponsor to provide resource buffers, the size and optimal allocation of these reserves remain to be determined. A. Diaz, director of NASA’s Goddard Space Flight Center recently explained the challenge of managing project reserves when he stated: Project managers work in the margins all the time. They are always working on budgeting what is left. They have a plan. The plan has reserves. The conduct of the project is, in essence, the management of the depletion of those re- serves, so that every available resource is used to the max- imum extent possible. The real challenge is how do you know when you have enough? Everybody can’t have as much as they could possibly imagine. So, how do you know when you’ve got enough? Our tools are limited in terms of what we have available to determine what the right cost is. A. Diaz [3] The development of quantitative decision support models for the management of reserves could help address the problem raised by Diaz, for space missions and other types of projects. During development, tradeoffs are often made between holding money in reserves and using resources to enhance product functionality. The earlier these improvements occur in the development phase, the easier and less costly these changes will be. Yet, one needs to keep some reserves to address problems that may arise later. The allocation of development resources to reserves, to the improvement of technical compo- nents, or to functionality enhancements affects the likelihood of achieving various project’s outcomes. In this paper, we present a model designed to support the choice of an adequate reserve level, the optimal allocation of the resources, and the manage- ment of the tradeoffs between keeping a reserve and spending some of it on product enhancement. The contribution of this paper is, thus, the formulation and illustration of a decision support model combining decision analysis, probabilistic risk analysis (PRA), and dynamic programming to help manage re- sources during the development of complex technical systems. Project development is generally structured around specific milestones where decisions can be made (if resources are 1 The validity of this rule of thumb approaches that of the old wives tales, but we included it to emphasize that the management of costs on projects is still more of an art than a science. 0018-9391/$20.00 © 2005 IEEE