8.1 Risk Management
8.1 Risk Management
8.1 Risk Management
Risk management helps stakeholders understand the nature of the project, involves team
members in identifying strengths and weaknesses and helps to integrate the other projects
management knowledge areas. It is a critical process in project management, which is not often
conducted or handled well. It allows the project manager to view the project across the life cycle
to identify, assess, prioritize, respond to and control project risk. Effective risk management
increases the probability of project success by the following efforts:
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Assistant Professor, Dept. of Business Administration, IIUC
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A risk management may be shown as under:
Business risk:
Normal risk of doing business that carries opportunities for both gains and losses. It occurs as a
result of business decisions such as the decision to use a new technology in a project to leverage
future business opportunities.
Insurable risk:
Risk that presents and opportunity for loss only. For this type of risk you could purchase
insurance premium. Insurable risk is also known as pure risk.
Known risk:
Risks that were identified for a particular project.
Unknown risk:
Risks that were not identified or managed, unknown risk if they occur on a project and found
positive are called windfalls.
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The Standish Group, ‘Unfinished Voyages’ (1996) (www.standishgroup.com/voyages.html)
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Success criteria / sources of risk Weight (%)
User involvement 19
Executive management support 16
Clear statement of requirements 15
Proper planning 11
Realistic expectations 10
Smaller project milestones 9
Competent staff 8
Ownership 6
Clear visions and objectives 3
Hard-working, focused staff 3
Total 100
Financial risk: Is the project affordable and will it provided the expected ROI? What
about opportunity cost? Could the money be better spent elsewhere?
Technology risk: Is the project technically feasible? Will the technology meet project
objectives? Will the technology be obsolete before the product is produced?
The PMI has a specific interest group on risk management. You can check out their website at
http://www.risksig.com/
Risk identification:
Determining which risks might affect the project and documenting their characteristics.
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Developing procedures and techniques to enhance opportunities and reduce threats to the
project’s objectives.
All processes interact with each other and with all knowledge areas within the PMBOK. The
PMBOK also defines inputs, tools & techniques and outputs for each of the process identified
within risk management.
Risk identification
Risk analysis
o Qualitative
o Quantitative
Risk response development
Risk response control
o Implement strategy
Evaluate results
Document results
The above diagram displays that risk management is conducted as a continuous process
throughout the entire project life cycle. Planning and execution are continuous events.
The major issues of risk management process have been elucidated below:
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The most effective way of identifying project risks is by using some form of systematic
approach, whether it be by project management knowledge area, systems development life cycle
phase or developing a customized checklist based on previous project experience.
Risk events are specific things that may occur to the detriment of the project (e.g., significant
changes in project scope, strikes, supply shortages, etc.).
To characterize or define a risk event you need to examine and document the following
parameters:
Expert judgment
Many firms use the past experience and intuition of experts in lieu of or as a supplement to
quantitative risk analysis. One common approach to gathering expert opinion is the Delphi
method. The Delphi method is an approach used to derive a consensus among a panel of experts
to make predictions about future developments. The method uses repeated rounds of questioning
including feedback of earlier responses to take advantage of group input to refine the response.
The process is continued until the group responses converge to a specific solution. This method
works well in developing probability assessments for risk events.
PERT estimations:
Program evaluation and review technology (PERT) analysis, discussed in Block 2, is actually a
highly simplified risk analysis method. It involves the provision of there estimates of an
activity’s duration- pessimistic, optimistic and most likely. The technique places four times the
weight on the most likely estimate than on the optimistic or pessimistic ones. A more accurate
and flexible method is something called Monte Carlo simulation.
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Monte Carlo Simulation for project risk analysis:
Simulation uses a system model to analyze expected behavior or performance. Monte Carlo
analysis is a risk quantification technique that simulates a model’s outcome many times (100-
1000 times) to provide a statistical distribution of the calculated results)
It ties together sensitivity analysis and scenario analysis at a time. This is also a risk analysis
technique which uses a computer to simulate future events and thus to estimate profitability and
riskiness of the project. In simulation analysis, a computer firstly takes at random different
values of each input variables (such as selling price, sales volume, variable cost per unit etc.)
Then the values are combined and NPVs are calculated for each combination and stored in the
computer. The process perhaps repeats for 1000 times to generate 1000 NPVs. Then the mean
and standard deviation is calculated for every set of NPVs. Mean is used as a measure of
project’s profitability and standard deviation or co-variance is used as a measure of project’s
risk.
Monte Carlo analysis also uses pessimistic, optimistic, and most likely estimates and the
probabilities of their occurrence. Simulations such as these are a more sophisticated method for
creating estimates than PERT and can more accurately help determine the likelihood of meeting
project schedule or cost targets. Many organizations globally use Monte Carlo simulation for risk
analysis. PC software programs like @RISK provide Monte Carlo simulation capability to
project management software like MS project and to standard PC spreadsheet.
Sensitivity analysis:
Sensitivity analysis is a project risk analysis technique which indicates how much the net present
value of a project will be changed in response to a given change in a input variable ( such as unit
sales, variable cost per unit), other things remain same. Since the future is uncertain, one may
like to know what will happen to the variability of the project when some variable like sales or
investment deviates from its expect values. In other ward, one may want to do a ‘if what’
analysis or sensitivity analysis. Sensitivity analysis begins with a base case situation in which a
NPV is calculated using expected value for each input. Then, each of the input variables is
changed by several percentage points above & below the expected value and a new NPV is a
calculated using value of input variables. Finally, a set of NPV is plotted in a graph to show how
sensitive the NPV is to change in input variables. The slope of the line in the graph shows how
sensitive the NPV is to change in input variable. Steeper the slope indicates risk or more
sensitivity of the NPV to the given input variable and vice versa.
Scenario analysis:
In sensitivity analysis, only one variable is varies at a time. If the variable are interrelated, as
they are most likely to be, it will be helpful to look at some reasonable scenarios, each scenario
representing a consisting combination of variables.
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In scenario analysis the best and worst NPV is compared with normal NPV. Analysis begins with
a normal or base case condition, then, financial analyst asks for information from the respective
departments about the worst case and best case scenarios. Finally, NPVs are calculated for every
scenario. If the project is successful, the combination of high demand, high selling price, low
variable cost, results high NPV and vice versa.
Break-even analysis:
In sensitivity analysis we ask what will happen to the project if basic input variable changes (if
sales increases, cost decline or some thing else happens). As a project manager, one should know
how much should be produced or sold at a minimum to ensure that the project does not lose
money. Such an analysis is called Break-even analysis. And the level of production at which loss
can be avoided is called break-even production. Break-even analysis may be defined in
accounting terms or financial terms. In accounting terms, the focus of Break-even analysis is on
accounting profit. That is, it will identify at sales level or production level the net income will be
zero. In financial terms, the focus of break-even analysis is on NPV. That is, it will identify at
sales level or production level NPV will be zero.
Risk avoidance involves eliminating a risk or threat, usually by eliminating its causes
(e.g., using hardware or software that is known to work, even though there may be newer
solutions available)
Risk mitigation involves reducing the probability and /or the impact of a risk event.
Risk transference involves transferring the risk to a third party e.g. buying insurance in
the event that you have an accident.
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8.4.3.1 Risk management plans, contingency plans and contingency reserves:
A risk management plan documents the procedures for managing risk throughout the project. It
summarizes the results of risk identification and analysis processes and describes what the
project team’s general approach to risk management will be.
Contingency plans are predefined actions that the project team will take if an identified risk
event occurs. Contingency reserves are provisions held in reserve by the project sponsor for
possible changes in scope or quality that can be used to mitigate cost and or schedule risk.
This requires on going risk awareness and monitoring. New risk may be identified during the
course of the project and should go through the same assessment process as those identified in
advance. When contingency plans are not in place or an unplanned risk event occurs, a
workaround or temporary fix may need to be found.
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6. Sensitivity Analysis: Optimistic, most likely and pessimistic
7. Scenario Analysis: Tight, Aggressive, Average or worst, Best & Base situations
8. Decision-Three Analysis & Probability Analysis
9. Simulation – Monte Carlo
10. Measuring Beta risk of a project or a port-folio & pure play method
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Model Problem on Scenario Analysis:
Problem # 1 Grameen Phone is considering a proposed project for its capital budget. The
company estimates that the project’s NPV is $12 million. This estimate assumes that the
economy and market conditions will be average over the next few years. The company’s CFO,
however, forecasts that there is only a 50 percent chance that the economy will be normal.
Recognizing this uncertainty, he also performed the following scenario analysis:
Identify major sources of risk by making a sensitivity analysis with the change of 10% of all
factors.
Problem #3 ABC Company has the opportunity to invest in a plant for manufacturing a new
product. The demand for which is estimated to be 5000 units a year for five years. The following
data are related to the decision:
1 Machine cost Tk. 50000(no residual value)
2 Selling price per unit Tk. 10
3 Operating cost per Tk. 7
unit
Overhead cost are not expected to be affected by the depreciation (ignored tax). The firm’s cost
of finance is 10%(assumed all cash flows are occurred at the end of year)
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