What is Risk?
Risk (n) 1. The degree of probability of loss. 2. The exposure to an event that could result in a loss.
Risk can be characterized by a combination of the probability that the risk event will occur and the consequence of the extent of loss or gain from the occurrence.
Risk is inherent in all activities and management of risk is essential for effective project management. Risk management can be applied to cost, schedule, technical performance, programmatic performance, and any other risk factors that may be deemed important.
Effective risk management involves evaluating each activity to determine the potential for risk and, if appropriate, quantifying the risk. Once the risks are identified and quantified, strategies can be developed to respond to each of the identified risk elements.
Risk Analysis Applied to Cost Estimation
One useful application of risk analysis is to establish an appropriate level of contingency within a cost estimate for a given confidence level. Using a flat percent or a simple algebraic addition to establish contingency is likely to either overestimate or underestimate the required funding for a project.
Using a probabilistic approach such as the “Monte Carlo simulation” method allows the cost of each activity to be defined in terms of a cost probability profile and statistically combined. The result is an improved methodology for establishing project budgets throughout the planning, design, and construction phases. This approach can also be applied to project schedules and, based on the amount of risk management is willing to take, be used to establish the amount of schedule contingency to use for each project activity. In addition, costs can be associated with each schedule element and a “cost” contingency can be calculated using the Monte Carlo method and the resulting cost of schedule contingency added to the cost estimate contingency.
Timberline has applied this methodology to developing cost estimates for several projects over the last four years with excellent results. The more complex a project is, the greater the cost benefit of applying these techniques. A typical SCADA or communications project will benefit from using these techniques to establish and manage budgets. Large and complex projects with high-risk components may require the additional analysis needed to evaluate and establish a contingency for schedule and its associated costs.
Click here for a white paper describing risk-based cost estimation or contact us to discuss your risk management needs.