Create a risk contingency budget with Expected Monetary Value
Wednesday, March 25, 2009 11:15 AM
Learn how the Expected Monetary Value technique provides a formula for determining the right amount of budget to apply to the risk contingency budget.
Risk management is the process of identifying and proactively responding to project risks. Generally (but not always) you will look for ways to eliminate risks or to minimize the impact of a risk if it occurs.
However, what if you're unsuccessful in preventing some risks? In that case, the risk will actually occur and cause some type of problem for your project. If the risk occurs, there may be some monetary impact on your project.
A risk contingency budget can be established to prepare in advance for the possibility that some risks will not be managed successfully. The risk contingency budget will contain funds that can be tapped so that your project doesn't go over budget.
The question is--how do you know how much money to place into the risk contingency budget account? You can use Expected Monetary Value (EVM) as a technique to quantify the risk into budget terms.
We will need two numbers for each risk:
P--probability that the risk will occur.
I--the impact to the project if the risk occurs. (This can be broken down further into the cost impact and the schedule impact, but let's just consider a cost contingency budget for now.)
If you use this technique for all of your risks, you can ask for a risk contingency budget to cover the impact to your project if one or more of the risks occur. For example, let's say that you have identified six risks to your project, as follows:
|
Risk |
P (Risk Probability) |
I (Cost Impact) |
Risk Contingency |
|
A |
.8 |
US$10,000 |
US$8,000 |
|
B |
.3 |
US$30,000 |
US$9,000 |
|
C |
.5 |
US$8,000 |
US$4,000 |
|
D |
.10 |
US$40,000 |
US$4,000 |
|
E |
.3 |
US$20,000 |
US$6,000 |
|
F |
.25 |
US$10,000 |
US$2,500 |
|
Total |
|
US$118,000 |
US$33,500 |
Based on the identification of these six risks, the potential impact to your project is US$118,000. However, you can't ask for that level of risk contingency budget. The only reason you would need that much money is if every risk occurred.
Remember that the objective of risk management is to make sure that the risks do not impact your project. Therefore, you would expect that you will be able to successfully manage most, if not all, of these risks. The risk contingency budget should reflect the potential impact of the risk as well as the likelihood that the risk will occur. This is reflected in the last column.
Notice the total contingency request for this project is US$33,500, which could be added to your budget as risk contingency. If risk C and F actually occurred, you would be able to tap the contingency budget for relief. However, you see that if risk D actually occurred, the risk contingency budget still might not be enough to protect you from the impact. Risk D only has a 10 percent chance of occurring, so the project team must really focus on this risk to make sure that it is managed successfully. Even if it cannot be totally managed, hopefully its impact on the project will be lessened through proactive risk management.
The risk contingency budget works well when there are a number of risks involved. The more risks the team identifies, the more the overall budget risk is spread out between the risks. The EVM technique provides a formula for determining the right amount of budget to apply to the risk contingency budget.
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