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How to Choose Which Risks to Manage in a Project

6 of 9 in Series: The Essentials of Managing Risk in Your Project

All identified risks affect your project in some way if they occur (after all, that’s the definition of a risk). However, you may determine that anticipating and minimizing the negative consequences of some risks if they occur takes more time and effort than just dealing with the situations when they arise.

So your first step in developing a risk-management strategy is choosing the risks that you want to address proactively and which ones you’ll just accept. When making this decision, do the following:

  • Consider the likelihood of a risk and its potential effect on your project. If the potential effect of a risk is great and if the chances it will occur are high, you probably want to develop plans to manage that risk. If both the effect and the likelihood are low, you may decide not to worry about it.

    When the potential effect is high but the likelihood is low or vice versa, you must consider the situation more carefully. In these more complex situations, you can use a more formal approach for considering the combined effect of likelihood of occurrence and potential consequence by defining the expected value of risk, as follows:

    • Expected value of risk = (quantitative measure of the effect if it occurs) × (probability it will occur)

    Suppose you need to buy certain materials for a device you’re planning to build. When you place your order, you think you have an 80 percent chance of receiving the materials by the date promised. However, this means you have a 20 percent chance that something will go wrong and that you’ll have to pay a premium to get the materials from another vendor by the date you need them. You estimate that the materials normally cost $1,000 and that you’ll have to pay an additional $500 to get them from another vendor at the last minute.

    Determine the expected value of this risk as follows:

    • Expected value of risk = Additional cost incurred if you use another vendor at the last minute x probability that you’ll have to use this vendor

    • Expected value of risk = $500 × 0.2 = $100

    You may conclude that, all things being equal, spending more than $100 to reduce the chances of this risk isn’t a wise financial decision.

  • Decide whether a potential consequence is so unacceptable that you’re not willing to take the chance even if it’s very unlikely to occur.

    Suppose your company wants to build a new plant in an area that has been hit hard by hurricanes. The estimated cost of the new plant is $50 million, and the likelihood that a hurricane will totally destroy the building is 0.1 percent. The expected value of this risk is $50,000 ($50,000,000 × 0.001), which the company can easily absorb. However, if a hurricane actually destroys the building, the associated $50 million loss would put the company out of business. So, even though the expected value of the loss is relatively small, the company may feel that even a 0.1 percent chance of its new building being destroyed by a hurricane is unacceptable.

    If you choose to build the plant, be sure you develop a strategy to manage the risk of the plant being destroyed. You may want to reconsider whether you want to undertake the project at all.

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SERIES
The Essentials of Managing Risk in Your Project

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