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Why Risk Efficiency is a Key Aspect of Best Practice Projects

Why Risk Efficiency is a Key Aspect of Best Practice Projects

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Why risk e\ufb03ciency is a key aspect of best practice projects
Chris Chapman*, Stephen Ward
Department of Accounting and Management Science, School of Management, University of Southampton, High\ufb01eld, Southampton SO17 1BJ, UK
Received 2 March 2004; received in revised form 26 April 2004; accepted 7 May 2004
Abstract

This paper explains what \u2018risk e\ufb03ciency\u2019 means, why it is a key part of best practice project management, and why it may not be delivered by common practice as de\ufb01ned by some guidelines. This paper also explains how risk e\ufb03ciency can be addressed oper- ationally using comparative cumulative probability distributions (S-curves). Further, this paper explains why risk e\ufb03ciency provides a foundation for a convincing business case for:

\u2022formal project risk management processes designed for corporate needs,
\u2022embracing the management of opportunities as well as threats,
\u2022measuring threats and opportunities to assist decision making,
\u2022developing a more e\ufb00ective risk taking culture,
\u2022taking more risk for more reward.

The argument uses linked examples from four successful cases: the \ufb01rst use of a designed project risk management process by BP for o\ufb00shore North Sea oil and gas projects, the \ufb01rst use of a designed process by National Power for combined cycle gas powered electricity generation, a culture change programme for IBM UK concerned with taking more risk to increase the rewards, and a due diligence assessment of project risk management for a railway infrastructure project. The concepts and tools described are relevant to any industry sector for projects of any size.

\u00d32004 Elsevier Ltd and IPMA. All rights reserved.
Keywords:Best practice; Risk e\ufb03ciency; Project risk management; Opportunity management; Culture change
1. Introduction

Uncertainty which matters is central to all projects. It is not just a question of how long a project will take, or how much it will cost. Uncertainty which matters in- cludes which parties ought to be involved, the alignment of their motives, the alignment of project objectives with corporate strategic objectives, shaping the design and resource requirements, choosing and managing appro- priate processes, managing the underlying trade-o\ufb00s between all relevant attributes measuring performance, and the implications of associated risk.

It might be argued thatformal project risk man-
agement processes are not appropriate for all projects,

but making a choice not to apply formal processes requires a clear understanding of whatbest practice formal project risk management processes could de- liver, and what this should cost, including associated uncertainty and risk.Everyone involved in making such choices needs to understand the implications. Moreover, even if formal approaches are not appro- priate for some projects, informal approaches ought to re\ufb02ect an understanding of the principles underlying formal processes.Everyone involved in projects ought to understand these principles, because they are the basis of simple rules of thumb that work in practice.

Best practicein project risk management is con-

cerned with managinguncertainty that matters in an e\ufb00ective and e\ufb03cient manner. To do so we need to understandwhere uncertainty matters,why it matters, whatcould be done about it, whatshould be done about it, andwho should take managerial and \ufb01nancial

*Corresponding author. Tel.: +44-173-592-525; fax: +44-173-593-
844.
E-mail address:cbc@soton.ac.uk(C. Chapman).
0263-7863/$30.00\u00d3 2004 Elsevier Ltd and IPMA. All rights reserved.
doi:10.1016/j.ijproman.2004.05.001
International Journal of Project Management 22 (2004) 619\u2013632
INTERNATIONAL JOURNAL OF
PROJECT
MANAGEMENT
www.elsevier.com/locate/ijproman

responsibility for it. Best practice in project risk man- agement also involves the elimination of dysfunctional \u2018corporate culture conditions\u2019, like \u2018a blame culture\u2019 which fosters inappropriate blame because managers are unable to distinguish between good luck and good management, bad luck and bad management. In the authors\u2019 view best practice in this sense cannot be achieved without a clear understanding of the concept of \u2018risk e\ufb03ciency\u2019, and its vigorous pursuit using a simple operational tool, cumulative probability distri- butions (S-curves) which compare alternative decision choices. This paper explains why the authors hold this view, and why this implies a general need for the pro- ject management community to understand risk e\ufb03- ciency.

A basic de\ufb01nition of \u2018risk e\ufb03ciency\u2019 is simply

\u2018the minimum risk decision choice for a given level of expected performance\u2019, \u2018expected performance\u2019 being a best estimate of what should happen on average, \u2018risk\u2019 being \u2018the possibility of adverse departures from expectations\u2019.

What this means and how it a\ufb00ects project manage- ment processes is more complex, the focus of this paper as a whole.

Common practicein project risk management involves

a limited agenda relative to best practice. Common practice is largely focused on what we will call \u2018risk events\u2019, rather than the accumulated e\ufb00ect of all the risk events and all other sources of uncertainty which are relevant to decision choices. A \u2018risk event\u2019 in this sense is \u2018risk\u2019 as de\ufb01ned on page 127 of the 2000 edition of the PMBOK by the PMI [1],

\u2018an uncertain event or condition that, if it occurs, has a positive
or negative e\ufb00ect on a project objective\u2019,
with a directly comparable de\ufb01nition of \u2018risk\u2019 on page 16
of the 1997 edition of the PRAM Guide by the APM [2],

\u2018an uncertain event or set of circumstances that, should it occur, will have an e\ufb00ect on the achievement of the project\u2019s objec- tives\u2019.

The above PMI and APM de\ufb01nitions of \u2018risk\u2019 re\ufb02ect and reinforce the common practice focus on \u2018risk events\u2019, as do many of the others covered in an extensive review of risk de\ufb01nitions by Hillson [3]. One of the ex- ceptions in the project risk management area is that used in the RAMP [4] guide, which accords with that used in this paper, expressed slightly di\ufb00erently.

In the authors\u2019 experience common practice in project risk management re\ufb02ects important limiting character- istics which are linked to the PMI/APM views of risk noted above and its lack of compatibility with a \u2018risk e\ufb03ciency\u2019 perspective on risk management. Under- standing how risk e\ufb03ciency is the key to moving from common practice to best practice has to begin by \u2018un- learning\u2019 the common PMI/APM de\ufb01nitions of risk noted above if they are part of the reader\u2019s framing

assumptions, always more di\ufb03cult than just learning
something new.

Risk e\ufb03ciency is a basic concept in \ufb01nancial eco- nomics, central to understanding risk management in terms of \ufb01nancial portfolio decision making models, and the basis of most explanations of the way \ufb01nancial markets work. In this context it is widely seen as \u2018useful theory\u2019, in the sense that it provides an essential con- ceptual framework to make experience operational, to explain basic ideas like \u2018do not put all your eggs in one basket\u2019, and to re\ufb01ne rules of thumb like \u2018keep X% of your portfolio of investments in cash, Y% in equities, and so on\u2019. Its direct application in terms of usable operational tools is problematic, because of practical operational di\ufb03culties using a Markowitz [5] mean\u2013 variance quadratic programming framework, but un- derstanding the concept is an integral part of a \ufb01nancial economics education, and it is widely recognised that this understanding should underlie the use of all asso- ciated tools and rules of thumb. Markowitz was awar- ded a Nobel Prize for Economics for his seminal work in this area, and the basic ideas he developed are generally understood by anyone with a degree in economics, \ufb01- nance, accounting, or business studies. Texts like Brea- ley and Myers [6] provide a modern \ufb01nancial perspective on risk e\ufb03ciency and related subjects like the appro- priate discount rate to use when evaluating projects which most people with an MBA will understand, and some involved in project management may \ufb01nd useful reading.

Risk e\ufb03ciency is also central to understanding the relationship between portfolio theory and decision the- ory, the two key conceptual frameworks for managing uncertainty and risk in terms of making decision choices any context [7]. In simple terms, basic portfolio theory [5] is about continuous variable allocation of resource choices, while basic decision theory [8] is about making discrete either/or choices, using \u2018stochastic dominance\u2019 notions directly comparable to risk e\ufb03ciency. Features provided by a decision theory framework which are particularly useful include multiple stage choices por- trayed by decision trees, statistical dependency por- trayed by probability trees, and a range of approaches to multiple attribute choices. In practice both frameworks need to be integrated, embedding one in the other [7].

A number of organisations which have been partic- ularly e\ufb00ective users of project risk management have seen risk e\ufb03ciency as central to holistic project man- agement for decades, and best practice project man- agement has to be holistic. For example, risk e\ufb03ciency was central to the published [9] project risk management process for o\ufb00shore North Sea projects which BP in- troduced in the late 1970s and adapted for use world wide by the early 1980s. Risk e\ufb03ciency was an integral part of all the cases described in [10] and associated underlying papers. And risk e\ufb03ciency was central to a

620
C. Chapman, S. Ward / International Journal of Project Management 22 (2004) 619\u2013632

successful early 1990s culture change programme un- dertaken by IBM UK with contributions from both authors of this paper. The 1997 PRAM process [2] as elaborated by the 1997 \ufb01rst edition of Chapman and Ward\u2019s book \u2018Project Risk Management\u2019 gives risk ef- \ufb01ciency a central position, as does the 2003 edition of this book [11], and both editions provide other examples of successful application of an approach to project management which integrates project risk management centred on the pursuit of risk e\ufb03ciency. This is done in the context of describing best practice project risk management processes as we understand them, based on working with organisations which embrace best practice in this sense, as a target if not a current achievement.

What is meant by the term \u2018risk e\ufb03ciency\u2019 in a project management context has evolved considerably since the 1970s. Explaining what it means with minimal com- plexity and how to use it e\ufb00ectively in simple forms has also received considerable attention over this period [7]. This paper re\ufb02ects these developments. But the focus of this paper is providing a concise overview of the impli- cations of successful use of the concept for those who are interested in holistic project management, without fully exploring the associated operational implications for project risk management, leaving the reader inter- ested in technical details to explore them elsewhere [7,11].

The next section of this paper outlines the example which motivated BP to adopt risk e\ufb03ciency as a central concern for all projects world wide, to provide a prac- tical motivating case study as a starting point, and a basis for illustrating linked concepts later. This is followed by the clearest full explanation of the risk ef- \ufb01ciency concept the authors could devise, using simple models in a restricted context, aiming for simplicity without being simplistic. Subsequent sections generalise the concept and elaborate the explanation, including linking it to organisational culture, with further case based examples. Cultural implications are central to a holistic project management perspective.

2. An initial project risk management case study

A major North Sea oil project was about to seek board approval and release of funds to begin construc- tion. Risk analysis using a new process [9] was under- taken to give the board con\ufb01dence in the project plan and its associated cost. One activity involved a hook-up, connecting a pipeline to a platform. It had a target date in August. A 1.6 m barge was speci\ufb01ed, equipment which could work in waves up to a nominal 1.6 m height. Risk analysis demonstrated that August was an appropriate target date, and a 1.6 m barge was appro- priate in August. However, risk analysis also demon- strated that, because this hook-up was late in the overall

project sequence, and there was considerable scope for delays to earlier activities, there was a signi\ufb01cant chance that this hook-up would have to be attempted in No- vember or December. Using a 1.6 m barge at this time of year would be costly because it would be time con- suming. It might mean delays until the following spring, with severe opportunity cost implications. A revised analysis was undertaken assuming a 3 m wave height capability barge, costing more than twice as much per day. This more capable barge was more e\ufb00ective in the face of bad weather, and it avoided the risk of going into the next season because of earlier delays as well as the accumulated e\ufb00ects of bad weather during hook-up, signi\ufb01cantly reducing risk in terms of the threat of a cost overrun relative to the expected cost. It also signi\ufb01cantly reduced the expected cost. Fig. 1 portrays this choice in the cumulative probability \u2018S-curve\u2019 format considered by the board.

The location of the point where the curves cross on the cumulative probability axis (point \u2018a\u2019) indicates that most of the time the 1.6 m barge should be cheaper. However, the long right-hand tail on the 1.6 m barge curve drags the expected cost to point \u2018c\u2019 on the cost axis, beyond the expected cost of the 3 m barge (point \u2018b\u2019). This long right-hand tail, with a horizontal portion, re\ufb02ects the massive increase in cost if an additional season is needed, a low probability but high impact outcome. The 3 m barge curve is relatively vertical, be- cause the outcome is relatively certain. Most of the time the 3 m barge would be more expensive, but on average it would be cheaper, because it avoids the implications of extreme events.

On the basis of this analysis, the 3 m barge was chosen. Further, this change in decision choice was used to demonstrate to the board the kind of insights the new project risk management process provided. The board approved the 3 m barge choice and the project. The board also mandated use of the process world wide for all projects of reasonable size or sensitivity. What they were looking for when they mandated this process was risk e\ufb03ciency in the sense portrayed by Fig. 1 \u2013 revised decision choices which simultaneously reduce both

Cost
1.0
Cumulativep
robability
0
1.6 m barge
initial choice
3.0 m barge
revised choice
c
a
1.6m
b
expected value
Fig. 1. Barge choice example.
C. Chapman, S. Ward / International Journal of Project Management 22 (2004) 619\u2013632
621

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