CHAPTER FIVE

RISK ANALYSIS
 INTRODUCTION

 Risk analysis provide knowledge of the relative severity of risks on a project. Its purpose is
to develop agreed priorities for the identified risks.

 The risk assessment involves

 To determine the consequence/impact of each risk event on cost, time, scope and/or
quality if the risk event does occur.

 To assess the likelihood of those consequences occurring.

 To convert the consequence and likelihood ratings to an initial priority for the risk.

 The output is a prioritized list of risks and a detailed understanding of the impact
upon the success of the project should they occur.
Qualitative analysis is based on nominal or descriptive scales for describing the
likelihoods and consequences of risks.

Semi-quantitative analysis extends the qualitative analysis process by allocating

numerical values to the descriptive scales. The numbers are then used to derive
quantitative risk factors.

Quantitative analysis uses numerical ratio scales for likelihoods and consequences,
rather than descriptive scales.
 QUALITATIVE RISK ANALYSIS
 In performing qualitative analysis consequences are rated in terms of the potential impact
on scope, cost, quality and/or time, often on five-point descriptive scales ( e.g.
insignificant, minor, moderate, major and catastrophic).

 Likelihoods are rated in terms of those consequences occurring using a descriptive scale
(e.g. rare, unlikely, possible, likely, almost certain).

 A risk assessment matrix is used to combine the likelihood and impact/consequence

ratings to generate initial priorities ( ranks) for the risks.
Impact Ratings
Ratings Level of impact
Insignificant Impact may be safely ignored
Minor Impact minor with routine management procedures

Moderate Large impact, but can be managed with effort using standard
procedures

Major Critical event, potential for major costs or delays, or inappropriate

products

Catastrophic Extreme event, potential for large financial costs or delays, or damage
to the organization’s reputation.
Likelihood Ratings
Likelihood Expected / actual frequency experienced
Rare May only occur in exceptional circumstances; no previous incidence of non-
compliance

Unlikely Could occur at some time; less than 25% chance of occurring.

possible Might occur at some time; 25 –50% chance of occurring; previous

audits/reports indicate non-compliance.

Likely Will probably occur in most circumstances; 50-75% chance of occurring.

Almost Can be expected to occur in most circumstances; more than 75% chance of
certain occurring.
 Probability/impact matrix/ Risk Assessment Matrix

Consequence
Likelihood

Insignificant Minor Moderate Major Catastrophic

Almost certain Medium Medium High High Extreme

R31
Likely Medium Medium Medium High Extreme

Possible Low Medium Medium High High

Unlikely Low Low Medium Medium High

Rare Low Low Medium Medium Medium

R25
Semi-quantitative Scales for Risk Analysis

Likelihood Scale Consequence Scale Numerical Scale

Almost certain Catastrophic 5 or 0.9

Likely Major 4 or 0.7

Possible Moderate 3 or 0.5

Unlikely Minor 2 or 0.3

Rare Insignificant 1 or 0.1

 Impact Ratings
Project Very Low Low Moderate High Very High
Objectives (1) (2) (3) (4 ) (5)

Cost Insignificant cost <10% cost 10%-20% cost 20-40% cost >40% cost
increase increase increase increase increase

Time Insignificant time < 5% time 5-10% time 10-15% time > 15% time
increase increase increase increase increase

Scope Scope decrease Minor areas of Major areas of Scope reduction Project end item is
barley noticeable scope affected scope affected unacceptable to effectively useless
sponsor

Quality Quality Only very Quality reduction Quality reduction Project end item is
degradation barley demanding requires sponsor unacceptable to effectively useless
noticeable applications are approval sponsor
affected
Likelihood ratings

Level Frequency
Very high (5) ≥1 in 2
High ( 4) 1 in 2
Medium (3) 1 in 5
Low (2) 1 in 10
Very Low (1) 1 in 100

Risk score / Severity = Likelihood X Consequence

OR
Risk factor= L + C – (L*C)
 Interval descriptors for risk severity: Cut-off levels are set to provide an initial indication of
priorities based on a set of predetermined risk severity/risk factor categories. .

Risk score Descriptor Indicative management action

16-25 Extreme Immediate action required, senior management will be involved.

9-15 High Senior management attention needed and management.

responsibilities specified for further action.

4-8 Medium Manage by specific monitoring or response procedures,

develop
more detailed actions as resources allow.

1-3 Low Manage by routine procedures, unlikely to need specific

application of resources
 A three dimensional risk magnitude perspective includes a third dimension duration-
short term(1), medium-short term (2), medium term (3), medium-long term(4) and long
term(5). (Refer to Figure 6.2 Page 112)
In a three dimensional risk assessment the risk severity is given by

Risk factor/ Severity score= likelihood X Consequence X Duration

Due to exposure time is a complicating issue, it is usually ignored in much of risk analysis
except for discounted cash-flow models for investment projects and some quantitative long-
term health project studies.
Qualitative Risk Analysis: Output

The probability impact matrix is used to generate initial priorities (Ranks )for the risks.
Identify and establish a periodic review of the top ten project risk items (Tracking).
Prepare a watch list that includes a list of risks that are low priority, but are still identified as
potential risks.

Identify risks that should be evaluated quantitatively.

In addition to a list of risks, qualitative risk analysis includes noting urgent risks that may move
right into risk response planning, or they may be simply the first ones for which you plan a response.
 QUANTITATIVE RISK ANALYSIS

The aim of quantitative risk analysis is to analyze numerically the probability of each risk occurring and its
consequence on project objectives

Expected Monetary Value (EMV) considers an event’s probability of occurrence and the loss or gain
that will result. It is calculated by multiplying each possible outcome by its probability of occurring and
then adding the result.

Example:
Project Risks 1 – Weather: There is a 25 percent chance of excessive rain fall that’ll delay the
construction for two weeks which will, in turn, cost the project Birr 80,000.
Project Risks 2 – Cost of Construction Material: There is a 10 percent probability of the price of
construction material dropping, which will save the project Birr100,000.
Project Risks 3 – Labor Turmoil: There is a 5 percent probability of construction coming to a halt if
the workers go on strike. The impact would lead to a loss of Birr 150,000. Compute the expected
value.
Risk Probability consequence PXI
(EMV)

Risk 1 25% -80000 -20000

Risk 2 10% 100000 10000

Risk 3 5% -150000 -7500

The project’s Expected Monetary Value based on these

project risks is:
-($20,000) + ($10,000) – ($7,500) = - $17,500
 Decision Tree Analysis. A diagramming and calculation technique for evaluating the
implications of a chain of multiple options in the presence of uncertainty.

Example: The following decision tree illustrates the decision to lease or own your
business with probabilities in which there is uncertainty involved .To determine
whether to lease or to have your own business the decision maker must compute the
expected value at each probability (or circle).
EMV lease= .8x12,0000+0.2x0= $ 96, 000
EMV own business = .05x100,000+ 0.5x80,000 = $90,000
Decision : Lease
Class Activity: Suppose a manager of manufacturing company wants to make a
decision whether to build a new plant or upgrade the existing plant with investments of
$ 120 million and $ 50 million respectively. If he builds a new plant with a 65% of
probability that future demand for product is strong he expects a revenue of $200
million but $90 million if demand is weak. On the other hand, second option of
upgrading the existing plant with a 65% strong demand is assumed to generate
revenue of $120 million, but $60 million if demand is weak.

 Prepare a decision tree

 Calculate the net path value ( Revenue-Investment)
 Calculate the expected monetary value
New plant EMV = (.65x80) + ( .35x -30)= $41.5 million
Upgrade plant EMV = (. 65x 70) + .35x 10)= $49 million
Decision: upgrade plant ( maximum EMV = $49 million
Exercise 1: A manager of a furniture company has been quite successful the past
three years. She is thinking whether or not it is a good idea to expand her company
this year. The cost to expand her company is Birr 1.5M. If she does nothing and
the economy stays good and people continue to buy lots of furniture she expects
Birr 3M in revenue; while only Birr 1M if the economy is bad. If she expands the
factory, she expects to receive Birr 6M if economy is good and Birr 2M if economy
is bad.
She also assumes that there is a 40% chance of a good economy and a 60% chance
of a bad economy.

Draw a Decision Tree showing these choices and advice the manager what she
should do.
Exercise 2 : suppose a farmer must decide what to do with his land for the next
growing season. He can choose to plant corn or soybeans or to not plant anything at
all. If he plants nothing at all, the government farm subsidy will pay him $30 per
acre. If the farmer decides to plant corn or soybeans on his land, there is some risk
involved. The yield per acre depends on the amount of rainfall. Too much rain or too
little rain will give poorer results than the right amount of rainfall. There is a 40
percent probability that the rainfall will be low; there is a 40 percent probability that
the rainfall will be medium; and there is a 20 percent chance that the rainfall will be
high.
If the farmer decides to plant corn, the yield per acre will be $0, $90, and $50,
respectively, if the rainfall is low, medium, or high. If the farmer decides to plant
soybeans, the yield per acre will be $40, $70, and $20, respectively, for low,
medium, and high amounts of rainfall.

Draw a Decision Tree showing these choices and advice the farmer what to do with
his land.