The project manager should take these two actions because they are aligned with the hybrid project management approach, which combines the waterfall and agile methodologies. A hybrid project management approach allows the project manager to plan the high-level project phases using the waterfall method, but execute the work within each phase using the agile method1. This means that the project manager can adapt to changing customer needs and expectations, while still delivering the agreed deliverables within the contract.
By going back to the development team and discussing which second milestone requirements can be performed in the first quarter, the project manager can use the agile method to prioritize and deliver the most valuable features to the customer in an incremental and iterative way. This can help the project manager to show the customer a tangible outcome in the first quarter, while still maintaining the quality and scope of the second milestone.
By asking the customer for their priorities regarding the requirements for the second milestone, the project manager can use the waterfall method to manage the contract and the expectations of the customer. This can help the project manager to negotiate and agree on the changes to the requirements, schedule, and budget of the second milestone, while still meeting the contractual obligations and the customer satisfaction.
The other options are not the best actions to take in this situation. Convince the customer to leave the second milestone in place and not change it may not be possible or desirable, as the customer may have valid reasons to change their expectations and may not be satisfied with the original plan. Escalate the issue to upper management to resolve the problem and suggest a plan may not be necessary or effective, as the project manager should be able to handle the issue with the customer and the development team directly, without involving the senior management. Tell the customer that moving the milestone has a very high impact on the cost of the project may not be enough to persuade the customer to keep the milestone as it is, as the customer may be more concerned about the value and the outcome of the project than the cost.
References: 1: Hybrid Project Management: What is it, Methodology & Software - Teamhood