Use Expected Monetary Value (EMV) to Create a Risk Contingency Budget
Use Expected Monetary Value (EMV)
to Create a Risk Contingency Budget
Expected monetary value (EMV) is a risk management technique to help quantify and compare risks in many aspects of the project. One use of EMV is to make risk-based financial decisions. Another use is to help you create a risk contingency budget.
EMV relies on two basic numbers.
P – the probability that the risk will occur
I – the impact to project if the risk occurs. This can be broken down further into “Ic” for the cost impact and “Is” for the schedule impact.
The risk contingency is calculated by multiplying the probability by the impact.
Risk Contingency Budget
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 P * Ic |
|
A |
.8 |
$10,000 |
$8,000 |
|
B |
.3 |
$30,000 |
$9,000 |
|
C |
.5 |
$8,000 |
$4,000 |
|
D |
.10 |
$40,000 |
$4,000 |
|
E |
.3 |
$20,000 |
$6,000 |
|
F |
.25 |
$10,000 |
$2,500 |
|
Total |
|
$118,000 |
$33,500 |
Based on the identification of these six risks, the potential impact to your project is $118,000. However, you cannot ask for that level of risk contingency budget. The only reason you would need that much money is if every risk occurred at its full impact level. Remember that the objective of risk management is to minimize the impact of risks to 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 is calculated by multiplying the probability by the impact of each risk, and then summing the individual results.
Notice the total contingency request for this project is $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. However, Risk D only has a 10% 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 lessoned through proactive risk management.
Spreading the Risk
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. In the case above, the fact that there are six risks helps pool enough risk contingency to accumulate a protective budget. If you have only identified one or two risks, you may not be able to spread the risk out enough to be as effective as you like. (This same “pooling” concept is applied to insurance as well. Small individual risk probabilities are pooled across thousands of entities to absorb the impact when an individual risk does occur.)
Budgeting for Unknown Risks
The EMV calculations above only reflect the known risks. If you are managing a large project, you need to continue to monitor risks on an ongoing basis. Therefore, you can also ask for additional risk contingency budget to cover risk that will probably surface later that you do not know about now. For example, you could request an additional 5% of your total budget for risk contingency to cover risks that you will encounter later. This is in addition to the risk contingency of the known risks that have already been identified.
