Chapter

Risk Management

Introduction to Risk Management

Risk management is the practice of dealing with risk,
which includes:
Planning for risk
Assessing risk issues
Developing risk handling strategies
Monitoring risk
Risk management should be consistent with: overall
project management, systems engineering, cost,
scope, quality and schedule
Risk management is often more effective and cheaper
when proactive rather than reactive

Factors in Managing Risk

Amount and quality of information about the actual

hazards that cause the risk
Amount and quality of information on the
magnitude of the damage
Length of exposure to the risk
Avoidability of the risk
The existence of cost-effective alternatives to
accepting risk

Information Sources for Risk Analysis

Studies of similar projects and their risks

Results from tests and prototype development
Data from engineering or other models
Specialist and expert judgments
Sensitivity analysis of alternatives

Sources of Variability
Schedule variability task duration times are random
Budget variability costs may vary
Performance variability product or system may not
achieve its targeted specifications
Market requirement variability product specifications
required by the market may change
Market payoff variability market payoff may change
due to competition, environmental changes, etc.

Tools for Assessing Risk

Tornado Diagram represents a sensitivity analysis of the

input variables
Tornado Diagrams are calculated by varying one factor
at a time while holding all other input variables
constant
Sensitivity Chart considers changes in all input variables
simultaneously
We can use a random number generator to set the value
of each input variable in a sensitivity chart

Tornado Diagram

Project Cost ($000s)

Rank by largest cost

range on top
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Sensitivity Chart

Wage Rate
Direct Labor Hours
Material Units Needed
Early Completion Bonus
Material Unit Costs
Interest Rates
Energy Costs
Overhead

Rank by correlation with total project cost, largest

absolute value on top
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Risk Management Actions

Preventive Actions: what to do in anticipation of
an adverse event, to reduce the probability of
the undesirable event occurring or to mitigate
its effect
May require action before the project actually
begins
Costs of preventive actions may be small,
relative to project value

Risk Management Actions (cont.)

Contingency Planning: what to do if an undesirable
event occurs
Trigger point based on performance invokes the
contingency plan
Frequently involves substantial additional costs

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Managing Risk in Contracts

Fixed price contract - commonly used when it is easy

to estimate material and labor cost accurately
Cost plus contract typically used when accurate
estimation of costs is difficult, may include a cost
ceiling
Units contract client agrees to a fixed price per unit
(within a specified range for the number of units)

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Managing Risk in Contracts

General Form:
Payment to Subcontractor = Fixed Fee + (1 - B) (Project Cost),

where B = cost sharing rate

Cost Plus Contract

B=0
Clients Risk

Fixed Price Contract

Risk Continuum

B=1
Subcontractors
Risk
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Insuring against Risk

Direct property damage: includes insurance for assets,

project materials, equipment, and properties
Legal liability: protection from legal liability resulting
from poor product design, product liability, and project
performance failure
Personnel: protection resulting from employee bodily
injury, loss of key employees, replacement cost of key
employees

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Change Management System

Log costs
Responsibilities clarified
Integrated with project plan
Visible Documentation
Scope changes reflected in baseline and performance
measures

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Risk Management Example: Van Allen

Company
The Van Allen Construction Company is hoping to
sign a contract in the next few months for
demolition work for a new soccer stadium
Indirect and overhead charges will cost
approximately $1,200 per week
The demolition project consists of nine tasks, with
crash times, crash costs, normal times and normal
costs

15

Van Allen Company: Tasks

16

Van Allen Company: Strike

The project manager has become aware that

workers may strike during the demolition project
The probability of a strike is 70%
It is equally likely that the strike will start at any
time
At most one strike will occur
If a strike occurs, its duration has the following
probability distribution

17

Van Allen Company: Question

How should the company manage the risk of a strike?
Should the company take any preventive actions or
plan any contingency actions? If so, what?

18

Van Allen Company: Preventive

Actions
Negotiate directly with the workers involved to reduce the
likelihood of a strike
Write the project contract so that the client assumes any losses
resulting from a strike
Purchase an insurance policy to cover any financial losses
incurred by a strike
Compress the project beyond the time that minimizes total
project costs, to increase the probability of completing the
project before a strike hits

19

Van Allen Company: Contingency

Actions
Hire non-union labor
Assign Van Allen managers to work on the project to
replace any striking workers
Suspend the project until the strike is over

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Van Allen Company: Minimum Cost

Solution (No Strike Considered)
Task

Duration

Immediate

Starting

Finish

Crash

Crash

Normal

Normal

Slope

Marginal

Predecessors

Times

Times

Time

Cost

Time

Cost

(100$)

Cost Incr

(100$)

(100$)

(100$)

START

START

60

40

10

START

50

30

20

70

10

40

24

60

40

20

12

50

30

10

C, D

17

90

11

60

C, D

13

60

30

15

13

17

40

20

E, G

13

17

50

20

10

END

F, I, H

17

17

Totals

Indirect cost=$12*17 days=204

Total cost=$310+$74+$204=$588

530

310

74

Slope=(crash cost normal cost)/(normal time crash time)

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Van Allen Company: Minimum Cost

Solution (Strike Considered)
Task

Duration

Immediate

Starting

Finish

Crash

Crash

Normal

Normal

Slope

Marginal

Predecessors

Times

Times

Time

Cost

Time

Cost

(100$)

Cost Incr

(100$)

(100$)

(100$)

START

START

60

40

10

START

50

30

20

70

10

40

24

60

40

20

12

50

30

10

C, D

17

90

11

60

C, D

13

60

30

15

13

17

40

20

E, G

13

17

50

20

10

END

F, I, H

17

17

Totals

530

The same table as the previous page.

Total expected cost: $588 + $12*3.8*0.7=$619.92

310

74

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Van Allen Company: Insights

The possibility of a strike has only added a constant to
the total cost
Therefore, the tradeoff involved in the crashing
decisions is unchanged by the possibility of a strike
Since the marginal cost for additional crashing is $16
and the marginal indirect cost is $12, it is not
worthwhile to crash the project further, even if the
probability of a strike is 1
However, if there were a penalty for late completion of
the project, then this conclusion might change

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