GlossaryKind of term: Cost and economicsRisk allowance
What is a risk allowance?
A risk allowance is a surcharge in an estimate for a named uncertainty, such as a tight tolerance, an unfamiliar material or a thin wall.
A risk allowance is an amount or extra time in an estimate for an uncertainty you can name while estimating but whose consequences you cannot yet judge precisely. Examples are a thin wall that may chatter, a flatness requirement across a large face, a material the shop has little experience with, or a small thread in a tough material, where a tap may break. The allowance covers costs that may arise, not profit.
What does a risk allowance depend on?
A risk allowance can go into an estimate in two ways. As a percentage of cost it is quick to set, but detached from its cause. On the operation where the risk sits, as extra time, an extra setup, extra inspection time or a scrap allowance, it can be traced. A common approach is expected extra cost: what it costs if it goes wrong, times the likelihood that it happens. That likelihood is itself a judgement, not a measured value, and such an expected value only averages out over several orders: if one order really goes wrong, the allowance usually does not cover the damage. What happened on an earlier batch gives a pointer on a repeat order, not a fixed likelihood.
How does a risk allowance work in practice?
A flat allowance on every quote can make easy parts too expensive while still under-covering the difficult ones. An allowance tied to a feature can be explained to the buyer and revised on a repeat order. Whatever is still undecided at quoting, such as a tolerance awaiting confirmation or a finish without a price, belongs on the quote as an assumption or qualification. An allowance does not answer an open question; it only prices the uncertainty.
What is a risk allowance often confused with?
A risk allowance is not margin: margin is what you want to earn, the allowance covers costs that may arise. Nor is it an ordinary mark-up on material or subcontract work, which covers known handling such as ordering and goods-in inspection. A scrap allowance for the losses you expect from a known process is an ordinary estimate item; only the part for uncertain losses, on a new feature or material, is a risk allowance.
Frequently asked questions
How do you set a risk allowance?
Name the risk first: which feature, which requirement, which material. Then estimate what it costs if it goes wrong, in extra time, inspection or scrap, and how likely that is. Put the result on the operation where the risk sits.
Does the risk allowance go on the quote as a line?
Usually not; it sits in the price. An open point does belong on the quote as an assumption, for example a tolerance still to be confirmed. The customer then knows what the price rests on.
Do you drop the risk allowance on a repeat order?
Look at what the first batch showed. If the feature ran steadily, the allowance can be lowered or removed. If it needed extra time or scrap as a rule, that time belongs in the estimate itself, not in an allowance.