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A Financial Reserve is money that has been budgeted for a general purpose (department, project or initiative, but not specifically allocated to a task or activity.

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Quick reference

Financial Reserves

A Financial Reserve is money that has been budgeted for a general purpose (department, project or initiative, but not specifically allocated to a task or activity.

When to Use Financial Reserves

Operating managers should create appropriate reserves at the time of budget creation and should use the reserves when uncertain work can be defined with another certainty that budgets for the activities can be set. At that time, a portion of the money is removed from the reserve account and allocated to the task.

Instructions

  • A Financial Reserve is normally budgeted.  The company will decide at what organizational level the reserve fund will exist.  It may be at the business level (a “rainy day fund”), it may be at a business unit or department level, it may be at a project level, or even at the level of a category of project expenses.  The lower in the organization, the easier it is too allocate the reserve, which has both pros and cons.
  • A budget reserve is usually set aside for a general purpose that has not yet been clarified:
    • At the business level, for changes in the assumptions about the business environment that were used when creating the budget.
    • At the department level, for activities that are uncertain in the magnitude or quantity (product returns, hiring/firing costs, unplanned maintenance, etc.)
    • At the project level, for tasks or activities with uncertainty that prevent the creation of a detailed plan at the time of the creation of the project plan.
  • The level of uncertainty should be the primary factor when selecting the size of the reserve.  Eliminating a reserve does not eliminate the risk and uncertainty.  If the business needs to reduce the size of reserve, they need to change the activities or goals first.
    • The absence of a reserve when following a high risk plan, has the effect of limiting options available to management.   They are forced to miss targets, change direction, or go back to stakeholders and beg for more money.  Each of those options will result in a delay.
  • Department financial budget reserves are normally allocated to major accounts, but not to specific activities.  These reserves can be used to fund a pool of resources that are an “emergency response team.”  Although the precise nature of the emergency cannot be forecasted, a general level of the course of a year often can be forecasted.  When not working on an emergency they are normally working on “background” or administrative activities that can be suspended for a time without jeopardizing the operation.
    • An example could be an account holding funds that will be used to work on product recalls.  While recalls are not planned, depending upon the industry, they can occur and cause major problems if not quickly and fully addressed.  The reserve account allows the operating manager to take immediate action, rather than preparing a business case and funding request and then going back to senior management for approval and release of funds.
  • The need for project reserves is based upon the level of risk and risk mitigation efforts embedded in the project plan.  Low risks projects normally do not need a reserve.  High risk projects normally do need a reserve.  
    • If a disciplined risk management process is not used, you should assume the project is a high risk project.
    • Project reserves can be held at the project level and allocated by the project manager, or it can be inserted into the project plan as a “reserve task.”  An example of a “reserve task” is the debug task on a software development project.  The software designers and coders do not intentionally create bugs, but experience has shown that software bugs are often uncovered when testing starts.  The specific bugs are not known ahead of time, but based upon the amount of software and difficulty of the writing the code, an estimate can be made as to the amount of debugging effort that will be needed and an appropriate debug task created.  This is a prepositioned project reserve.

 

Hints and Tips

  • If possible time-phase your reserve, allocating a portion to each month or quarter rather than leaving it as one lump sum for the end of the year.  That can reduce the likelihood that you will have a big variance due to timing issues.
  • If asked to reduce or eliminate reserves from a department or project budget, you should go back to the estimates and revise them so that they are conservative.  If asked to reduce the estimates, agree to aggressive estimates if you can have a reserve to allocate against the inevitability that several of the estimates will be too aggressive.
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  • 00:02 Hi, this is Ray Sheen.
  • 00:04 I'd like to talk about a topic that is often controversial.
  • 00:08 That is the creation and use of financial reserves in a budget.
  • 00:14 First lets look at what a Budget Reserve is and why you might need one.
  • 00:18 A financial reserve is unallocated money that is in the budget.
  • 00:21 Like a department or budget that is set aside for purpose or
  • 00:25 until some aspect of the required operational activites becomes clear.
  • 00:29 The money is reserved for a purpose.
  • 00:33 At the business level, the reserve may be to accommodate an expected change in
  • 00:36 business or industry environment that has not yet occurred.
  • 00:39 If the timing and specifics of the change are not known,
  • 00:42 an appropriate list of activities cannot be created.
  • 00:45 But while the specifics aren't known, the likelihood of the change is high, so
  • 00:49 reserve account is created.
  • 00:51 An example could be, if new industry regulations will be issued by a regulatory
  • 00:55 body mid-year, but the specific changes are not yet finalized.
  • 00:59 At the functional department level the reserve is often for
  • 01:02 a new initiative that will be started, but, the details are not known.
  • 01:05 I remember that I created a Six Sigma reserve for
  • 01:07 my department during the year it was introduced.
  • 01:10 I knew I would need to send some people to training and
  • 01:12 probably participate in some projects.
  • 01:14 But nothing was defined at the time the budget was created.
  • 01:17 Another example for department budgets are reserves for responding to emergencies.
  • 01:22 These are by nature uncertain.
  • 01:24 I don't know when the equipment will need unplanned maintenance.
  • 01:27 I don't know know when customers complaints will require overtime and
  • 01:30 expedited shipping.
  • 01:31 But I do know that those happen periodically
  • 01:33 during the course of the year.
  • 01:34 So I can create a reserve account that is used to pay for those activities.
  • 01:38 Project reserves are needed based upon the risk and uncertainty of the project plan.
  • 01:42 A low-risk plan may not need a reserve.
  • 01:45 High-risk plans should always carry a reserve, or several reserves.
  • 01:50 Let's talk for a minute about why we need reserves.
  • 01:53 Now you may be told that you can't have a reserve in your budget, okay.
  • 01:57 But then you need to plan your activities with conservative estimates and
  • 02:01 low-risk approaches.
  • 02:02 Removing the reserve from a high-risk plan just guarantees its failure.
  • 02:06 If there is no reserve in a high-risk plan,
  • 02:09 your options are limited when the inevitable problem pops up.
  • 02:12 You may have to either not do some of the needed work, or
  • 02:15 overrun the project, which can create other problems for the organization.
  • 02:19 You may have to go back to your stakeholders or
  • 02:21 investors to ask for more money.
  • 02:23 That will take time and
  • 02:24 create delays to the work, which could cause you to miss completion milestones.
  • 02:29 You may even have to stop what you are doing, and
  • 02:31 go a totally different direction.
  • 02:33 Cancelling a project or shutting down a facility
  • 02:36 that will inevitably cause you to miss the business targets or goals.
  • 02:39 None of these are good options if the original business goals are important in
  • 02:43 the strategy, so include appropriate reserves.
  • 02:46 If it is high-risk work, it needs a reserve.
  • 02:50 Let's talk about how we put a reserve into a functional department budget.
  • 02:54 In a functional department budget, a reserve is used to create
  • 02:56 capacity to respond to issues that are not specifically in the plan of operations.
  • 03:01 These may be unplanned and unwanted activities, or
  • 03:04 they may be expected activities, but the timing and details are uncertain.
  • 03:08 Things like customer visits, unscheduled maintenance, or
  • 03:11 product failure analysis are in those categories.
  • 03:14 Often, the amount of reserve can be estimated from recent history.
  • 03:17 For instance, how much did we spend last year in that category?
  • 03:20 The actual resources that will do this work are often assigned to other
  • 03:23 background or fill-in work while waiting for a need for their services to occur.
  • 03:28 These background tasks are often administrative in nature and
  • 03:30 the suspension of the work for short time will not impact the department efficiency.
  • 03:35 While that approach works well for
  • 03:36 functional department, I suggest a different approach for project reserves.
  • 03:41 Project reserves are based upon the level of risk and risk mitigation in a project.
  • 03:45 A low-risk project may not need any reserves.
  • 03:48 Even a high-risk project that has proactively embedded risk response
  • 03:53 approaches in the project plan, may not need any additional project reserves.
  • 03:58 However, if there was no risk analysis done, or, the risk response plans are not
  • 04:02 embedded in the approved project plan, then the project should have reserves.
  • 04:06 Further, if the project has an aggressive schedules or management targets,
  • 04:10 the project manager needs a reserve so that he or she can quickly apply resources
  • 04:14 to unexpected small problems and resolve them before they become big ones.
  • 04:19 The need for financial reserves can be lowered if there are large schedule or
  • 04:23 performance reserves that can be used to resolve the problems.
  • 04:27 One quick point about the use of reserves on projects.
  • 04:30 I typically will pre-position the project reserves by phase or
  • 04:33 deliverable based upon the areas of high-risk.
  • 04:36 I often do this by creating a reserve task.
  • 04:39 For instance, if I have a task to develop software,
  • 04:42 I will include a software debugging task following the development.
  • 04:46 Does that mean I want the software developers to provide me with code
  • 04:49 full of bugs?
  • 04:50 Of course not.
  • 04:51 Do I know ahead of time what the bugs will be?
  • 04:54 Again, of course not.
  • 04:55 But my experience tells me that software development is high-risk.
  • 04:58 So I preposition a risk response immediately following the task,
  • 05:03 to resolve whatever issues are discovered.
  • 05:08 Reserves are an important part of the budgeting process,
  • 05:10 they shouldn't just be leftover money.
  • 05:13 Instead, they are purposefully allocated in ways to help the organization,
  • 05:18 both performance activities and achieve its metrics.

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