RISK ANALYSIS AND MANAGEMENT

WHAT IS RISK IN PROJECTS?

A function of uniqueness of project and experience of project team

Notion of Risk-
The likelihood that a problem will occur
The impact if it occurs
Risk= f (likelihood, impact)
Risk = failure, of not meeting the schedule/ budget/ technical parameters
Risk cannot be eliminated, only reduced

RISK MANAGEMENT
Four aspects -
 Risk Identification
 Risk Assessment
 Risk Response Planning
 Risk Response Control

RISK IDENTIFICETION
 Proceed according to sequence of activities
 Engineering risk- product reliability and maintainability
 Production risk- producability, raw materials availability
 High risk- New technology,
- Developing & testing new equipment, systems or procedures
- Training for new tasks, applying new skills

SOURCES OF RISK
 Any factor which can influence the outcome of project is a risk factor or risk hazard.
 Risk classified as- internal and external
INTERNAL RISKS
 Originates inside the project
 Project managers & the organization generally have a measure of control over them.
 Market risk and Technical risk
 Market risk- Incomplete identification of customer needs
- Failure to identify changing needs
- Failure to identify new products
 Market risk can be reduced by defining needs correctly and modifying during execution if
need be.
 Technical Risk is not meeting the cost, time and performance requirements due to technical
problems with the end items of project.
 It is high in new technologies, new skills, new products
 It is low in projects dealing with familiar activities

EXTERNAL RISKS
 Market Conditions
 Competitor’s action
 Government Regulations
 Interest Rates
 Customer Needs and Behavior
  Supplier relations
 Weather
 Labour availability
 Material or Labour resources

RISK ASSESSMENT
 Only the notable ones require attention
 Risk likelihood- the probability of happening- low/ medium/ high- assign numerical values 0
to 1.0
 Risk impact- specified in terms of time, cost and performance measures- assign numerical
values.
 Risk consequence expected value is calculated as-
(impact) x (likelihood)

RISK CONSEQUENCE USING EXPECTED VALUE

Suppose the likelihood of risk is 0.40. Also, should it happen- it would set the project back by
4 months and increase cost by 300,000 (estimated)
The expected risk consequences for time and cost are thus
Risk consequence Time = (4 months) (0.40) = 1.6 months
Risk consequence cost = (300,000) (0.40) = 12,000

In a complex system with a large number of relationships whose joint failures in several would lead
to system failure, it is common to ignore joint failures in the hope that they will not occur!

Bhopal gas disaster was one such incident which has been attributed to 30 separate causes, with
miniscule joint probability- YET- they did all happen……

RISK RESPONSE PLANNING

Methods of dealing with risk-
 Transferring risk
 Altering plans or procedures to avoid or reduce risk
 Prepare contingency plans
 Accepting the risk
 Mitigating Risk
 Reducing the likelihood an adverse event will occur
 Reducing impact of adverse event
 Transferring Risk
 Paying a premium to pass the risk to another party
 Avoiding Risk
 Changing the project plan to eliminate the risk or condition
 Sharing Risk
 Allocating risk to different parties
 Retaining Risk
 Making a conscious decision to accept the risk

TRANSFER THE RISK

 Warranties, penalties, contractual incentives attached to project cost, schedule or
performance measures.
 Different types of contract share it in different ways
 Fixed cost contract- with contractor
 Fixed price with incentive fee- contractor accepts about 60%
  Cost + incentive- contractor accepts about 40%
 Cost + fixed fee- with the customer
AVOID RISK
 By altering the original project concept
 Eliminating the risky elements
 Minimizing system complexity
 Reducing end-item quality requirement
 Changing contractor
 Safety procedures
 Avoiding reduces payoff opportunities
 New product design…..
REDUCE RISK
Reducing technical risk-
 Employ the best technical team
 Base decisions on models and simulation of key technical parameters
 Use computer aided system engineering tools
 Perform test and evaluations
 Minimize system complexity
Reducing schedule risk-
 Create a master project schedule and adhere to it
 Maintain focus on critical activities
 Allot best workers on time-critical activities
 Schedule risky tasks as early as possible to allow time for failure from recovery
Reducing cost target risk-
 Identify and monitor the key cost drivers
 Use low-cost design alternative reviews and assessments
 Use proven technology
 Perform prototyping and testing on risky components and modules

CONTIGENCY PLANNING
 Identify the risk, anticipate whatever might happen, and prepare a detailed plan of action to
cope with it.
 Initial project is followed, and monitored closely throughout execution.
 A remedial measure to compensate for impact
 An action taken in parallel to original plan

ACCEPT RISK
 Do nothing!
 Cannot be used as an option when the impact is likely to severe.
PROJECT MANAGEMENT is RISK MANAGEMENT
RISK MANAGEMENT PRINCIPLES
 Create a risk management plan that specifies ways to identify all major project risks, and
creates a risk profile for each identified risk
 The risk profile should include likelihood, cost and schedule impact, and contingencies to be
invoked.
 Create a person responsible for risk management- the ‘risk officer’. ( should not be the
project manager)
 The budget and schedule should include risk reserve- a buffer for time, money & other
resources.
 Risks must be continuously monitored and the plan updated to include emerging risks.
  Establish communication channels- and candor within teams- to ensure that bad news
reaches the manager quickly.
 Specify procedures to ensure accurate, comprehensive project documentation – in general
the better the documentation, the more information is available for planning of similar
projects.

RISK ANALYSIS METHODS

 Expected Value
 Standard Deviation & Coefficient of Variation
 Decision Trees
 Simulation
 Sensitivity Analysis
 Scenario Analysis

EXPECTED VALUE
Expected Value = Σ [ (Outcomes) x (Likelihood)]

NPV PROBABILITY
200 0.3
600 0.5
900 0.2

STANDARD DEVIATION
 Standard Deviation = √[Σpi (Ei –Ē)2]
Pi = probability associated with ith value
Ei = ith value
Ē = expected value
Coefficient of Variance = Standard Deviation
Expected Value
Standard deviation is the most commonly used measure of risk in finance.

EXAMPLE OF A DECISION TREE PROBLEM

A glass factory specializing in crystal is experiencing a substantial backlog, and the firm's
management is considering three courses of action:
A) Arrange for subcontracting
B) Construct new facilities
C) Do nothing (no change)
The correct choice depends largely upon demand, which may be low, medium, or high. By
consensus, management estimates the respective demand probabilities as 0.1, 0.5, and 0.4.

SENSITIVITY ANALYSIS
 Since future is uncertain, managers may like to know what will happen to the viability of the
project if some variable like sales/ investment decision deviates from its expected value.
 Also called “what if” analysis.
Consider the following example (Rs in ‘000)
YEAR 0 YEAR1 – 10
Investment (20,000)
Sales 18,000
Variable cost (66 2/3 % of sales) 12,000
 Fixed cost 1,000
Depreciation 2,000
Pre-tax profit 3,000
Taxes 1,000
Profit after tax 2,000
Cash Flow from operation 4,000
Net cash flow 4,000(r =12%,t = 10)
Since cash flow is an annuity, the NPV of project is=
= - 20,000,000 + 4,000,000’ PVIFA(r = 12%, n = 10 years)
= -20,000,000 + 4,000,000 (5.650)
= Rs 2,600,000

Since the underlying variables can vary widely, we shall define the optimistic and pessimistic
estimates for the underlying variables. With those values, we shall calculate the NPV for optimistic
and pessimistic values of each of the underlying variables.
Change one variable at a time
Eg. To study the effect of sales (from Rs 18 million to Rs 15 million)- maintain the values of other
underlying variables at their expected levels.(means investment is constant at Rs 20 million, variable
costs at 66⅔ % of sales, fixed cost = Rs 1 million)
pessimistic expected optimistic pessimistic Moderate Optimistic
Investment 24 20 18 -0.65 2.60 4.22
(Rs in million)
Sales 15 18 21 -1.17 2.60 6.40
(in Rs million)
Variable cost as 70 66.66 65 0.34 2.60 3.73
a percent of
sales
Fixed costs 1.3 1.0 0.8 1.47 2.60 3.33
(Rs in million)
 It is a very popular method for assessing risk
 Shows how robust or vulnerable the project is to changes in values of underlying variables
 Indicates where future work may be done
 It is intuitively very appealing since it reflects the concerns that project evaluators normally
have.
 A survey by Manoj Anand “Corporate Finance Practices in India” has revealed that 90% of
the companies surveyed rated it as the number 1 method of Assessing Project Risk.

SCENARIO ANALYSIS
In sensitivity analysis one variable is varied at a time. But if variables are interrelated, as they are
likely to be, there might be a number of plausible scenarios.
Procedure:
1. Select the factor around which the scenario will be built. The factor must be largest source of
uncertainty for success of a project- the state of economy/ interest rate/ market response/
technological development.
2. Estimate the values of each of the variables in the investment analysis (outlay, revenue, costs,
life) for each scenario
3. Calculate the NPV and IRR under each scenario.
Example:
A company is evaluating a project for introducing a new product. Depending on market response-
the factor of largest uncertainty, the management has identified three scenarios -
Scenario 1: product will have moderate appeal to customers at a moderate price.
Scenario 2: product will have strong appeal to a large segment of the market which is highly price
sensitive.
Scenario 3: product will appeal to a small segment of the market which will be willing to pay a high
price.
The following table shows the NPV calculations for the three scenarios

Scenario 1 Scenario 2 Scenario 3

Initial investment 200 200 200
Unit selling price(Rs) 25 15 40
Demand (units) 20 40 10
Revenues 500 600 400
Variable cost 240 480 120
Fixed cost 50 50 50
Depreciation 20 20 20
Pre-tax profit 190 50 210
Tax @ 50% 95 25 105
Profit after tax 95 25 105
Annual Cash Flow 115 45 125
Project Life 10 years 10 years 10 years
Salvage value 0 0 0
NPV (@15%) 377.2 25.9 427.4

The objective of scenario analysis is to get a feel of what happens under the most favorable or the
most unfavorable configuration of the key variables.

 Scenario analysis may be considered as an improvement over sensitivity analysis because it

considers variations in several variables together.
 However, it considers only few defined scenarios- which may not be true in many cases. The
economy does not necessarily lie in three discrete states- boom, recession, and stability. In
fact it can be anywhere on the continuum between extremes.

Sources of Risk
Risk Assessment Form