Lecture 19~Proj Risk Mgmt - 2

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MTDE 333-500 Project Management for Engineers Dr. Walter Olarte Project Risk Management II Risk Analysis & Decision Theory
Expected Value
What’s a Project? Goal-oriented Time and resource-constrained Cross-functional Somewhat unfamiliar and risky Something is at stake Follows logical sequence or progression of phases or stages Unique Complexity Uncertainty
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Risk vs. Uncertainty Most decisions made on large engineering projects involve elements of risk and/or uncertainty . Risk: the situation in which the project team can estimate the probability of an event. Objective data form experimental tests or historical data Subjective judgment of the decision maker or experts Uncertainty: the situation in which an estimate of the probability of an event can not be made.
Project Risk Risk involves two concepts: The likelihood that some event will occur The impact of the event if it does occur Risk = f (likelihood, impact)
Expected Value The average outcome of numerous repeated events In risk assessment, it is the average outcome of a project if it were repeated many times Mathematically, it is the weighted average of all possible outcomes (where the weights are probabilities) Expected Value = ∑[(outcomes)x(likelihoods)]
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Project Risk Analysis – Expected Value Example Example 1: A project has a baseline cost estimate (BCE) of $10M and a failure likelihood of 60%. If the project fails, the project cost would be an extra $5M. What is the expected cost of the project? Expected Cost : (0.6)*($10M+$5M) + (0.4)*($10M) = $13M …or Expected Value of Project Cost
Expected Value Example 2: If there is a 40% chance that a project will make $100,000 and a 60% chance that this project will lose $150,000, then the expected monetary value of the outcome is: A. + $50,000 B. - $50,000 C. + $90,000 D. - $90,000
Expected Value Example 2: If there is a 40% chance that a project will make $100,000 and a 60% chance that this project will lose $150,000, then the expected monetary value of the outcome is: A. + $50,000 B. - $50,000 = 0.4x100,000+0.6x(-150,000) C. + $90,000 D. - $90,000
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Expected Value Example 3: A project baseline duration (or Baseline Time Estimate BTE) is 26 weeks. If there is a 30% chance that a project will fail and delay 5 weeks, then the expected duration or expected value of time (ET) is: Expected Time = 26*(0.7)+31*(0.3) = 27.5 weeks ..or Expected Value of Project Duration
Expected Value Example 4: A project with 8 WP’s. Cost Impact if risk materializes (10,000*0.8) + (12,000*0.2) = 10,400 Expected Value of Project Cost
Expected Value Example 4: A project with 8 WP’s. If BTE = 26 weeks and CP = J-M-V-Y-W-X, what is the Expected Duration? Time Impact if risk materializes (6*0.8) + (7*0.2) = 6.2 weeks Expected Value of Project Duration (6.2+4.3+6.2+8.6+1.3+1.3) = 27.9 weeks
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Decision Tree Analysis
Project Risk Analysis – Expected Value Example cont’d… Example 1: A project has a baseline cost estimate (BCE) of $10M and a failure likelihood of 60%. If the project fails, the project cost would be an extra $5M. What is the expected cost of the project? Expected Cost : (0.6)*($10M+$5M) + (0.4)*($10M) = $13M
Example 1 (continued): suppose two strategies are being considered to reduce the risk likelihood. Strategy 1 will cost $2M and will reduce the failure likelihood to 10% Strategy 2 will cost $1M and will reduce the failure likelihood to 40% Which alternative risk response strategy should be selected? Do nothing? Strategy 1? Strategy 2? Project Risk Analysis - Decision Tree Analysis example
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Project Risk Analysis - Decision Tree Analysis example A decision tree provides a graphic way to organize information needed for a major decision: Shows decision alternatives to be considered Includes monetary or utility values of alternative outcomes Includes probabilities of outcomes for each decision alternative The expected value of each alternative is the sum of outcome values each weighted by its probability of occurrence The optimum decision alternative is the one with the greatest expected value .
In drawing the tree, circles indicate chance nodes and squares represent decision nodes. Failure Success $10M+$5M 0.6 0.4 $10M Do nothing $10M+$5M+$2M 0.1 0.9 $10M+$2M ($17M x 0.1) +($12M x 0.9) = $12.5M $13M $10M+$5M+$1M 0.4 0.6 $10M+$1M $13M Project Risk Analysis - Decision Tree Analysis example
Decision Tree Analysis The decision tree depicts the choices open to a decision maker at any point in time, the chance events that might result later in time if these choices were actually made, and the final payoff from having traveled along a specific path.
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Decision Tree Analysis Note that in reality, the contractor will not receive the expected profit amount . In fact, the payoffs that the contactor actually receives might vary quite widely. Use of the expected value criterion weights the actual payoffs by their relative frequency of occurrence, producing a decision that is best in the long-run , average sense.
Note! Circle nodes are chance nodes, you need to calculate their expected value combining outcome possibilities. Square nodes are decision nodes, you need to select the best expected value. Always state the end result selection.
Failure Success $10M+$5M 0.6 0.4 $10M Do nothing $10M+$5M+$2M 0.1 0.9 $10M+$2M ($17M x 0.1) +($12M x 0.9) = $12.5M $13M $10M+$5M+$1M 0.4 0.6 $10M+$1M $13M Project Risk Analysis - Decision Tree Analysis example Lowest Expected Cost
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Dam Highway No Bid High Low High Low Win Lose Win Lose Win Lose Win Lose 0.2 0.5 0.3 $800k $400k -$200k 0.2 0.8 -$50k 0.6 0.3 0.5 0.2 0.4 $500k $100k -$400k -$50k 0.9 0.1 0.3 0.6 0.1 $2,000k $1,000k -$400k -$100k 0.2 0.2 0.8 0.2 0.6 $800k $400k -$400k -$100k $1,160k $26k $320k $-16k $300k $20k $120k $18k $20k $26k $26k $0
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