Chapter 10

Managing Risks in Projects

Risk Analysis & Decision Theory

Project Management for Business,

Engineering, and Technology

Expected Value

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What’s a Project?

◼ Goal-oriented Complexity
◼ Time and resource-constrained
◼ Cross-functional
◼ Somewhat unfamiliar and risky
◼ Something is at stake
◼ Follows logical sequence or
progression of phases or
stages
◼ Unique Uncertainty

Risk versus Uncertainty

◼ Most decisions made on large engineering

projects involve elements of risk and/or
uncertainty.
❑ Risk: the situation wherein 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 wherein an
estimate of the probability of an event can not
be made.

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Project Risk
Risk of involves two concepts:
◼ The likelihood that some event will occur.
◼ The impact of the event if it does occur.

Risk = f (likelihood, impact)

Project Risk Analysis – Expected Value Example

◼ Example 1: A project has a baseline cost

estimate of $10M and a failure likelihood of
0.6. If the project fails, net present value of
the project cost would be $5M. What is the
expected cost of the project?

❑ Expected cost: (0.6)*($10M+$5M)

+(0.4)*($10M)
= $13M

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Expected Value

◼ 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

◼ 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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Summarizing with Q&A

Decision Tree Analysis

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Project Risk Analysis – Expected Value Example
cont’d…

◼ Example 1: A project has a baseline cost

estimate of $10M and a failure likelihood of
0.6. If the project fails, net present value of
the project cost would be $5M. What is the
expected cost of the project?

❑ Expected cost: (0.6)*($10M+$5M)

+(0.4)*($10M)
= $13M

Project Risk Analysis - Decision Tree

Analysis example
◼ 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 0.1
❑ Strategy 2 will cost $1M and will reduce the failure
likelihood to 0.4
◼ Which alternative risk response strategy
should be selected?

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Project Risk Analysis - Decision Tree
Analysis example
◼ A decision tree is a diagram wherein
the tree “branches” represent different
chance outcomes. It is used to assess
which risk responses among
alternatives yield the best-expected
consequence.

Project Risk Analysis - Decision Tree

Analysis example
◼ In drawing the tree, circles indicate chance
nodes and squares represent decision nodes.
Failure 0.1 $5M + $2M + $10M
($17M x 0.1)
+($12M x 0.9)
0.9
Strategy 1 Success $10M + $2M =$12.5M

Failure 0.6 $5M + $10M

Do nothing $13M
0.4
Success $10M

Strategy 2
Failure 0.4 $5M + $1M + $10M
$13M
0.6
Success $10M + $1M

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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.

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.

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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.

Summarizing with Q&A

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Class Exercise
Decision Tree Analysis

Decision Tree Analysis – Class

Activity
Consider the following example, in which a contractor is faced with the
decision of whether or not to bid on one of two projects, a dam or a highway.
The contractor is limited to choosing, at most, only one of the projects for
bidding due to limited manpower and equipment available to him. He may also
choose not to bid on either of the projects, in which case it is assumed that he
would neither gain nor lose anything. The contractor has collected data and
performed some preliminary analyses in the two projects as summarized below.
Project Type of Bid Historical Profit Probability of Profit
(Proposed Price) ($1000) ($1000)
Dam High 800 0.2
High 400 0.5
High -200 0.3
Low 500 0.3
Low 100 0.5
Low -400 0.2
Highway High 2,000 0.3
High 1,000 0.6
High -400 0.1
Low 800 0.2
Low 400 0.6
Low -400 0.2

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 $300k 0.2 $800k
$20k
Win 0.2 0.5
$400k
High
$20k Lose 0.3
0.8 -$200k
-$50k

$18k $120k 0.3 $500k

Low
Dam Win 0.4 0.5
$100k
$26k
No Bid
Lose 0.2
$0 0.6 -$50k -$400k
$2,000k
$26k $1,160k 0.3
Win 0.1 0.6
Highway $1,000k
High
$26k Lose 0.1
-$400k
0.9 -$100k

$320k 0.2 $800k

$-16k
Low Win 0.2 0.6
$400k

Lose0.8 0.2
-$100k -$400k

Summarizing with Q&A

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