Balancing project risks and opportunities
Kalle Kähkönen, VTT Building Technology, Finland
Karlos Artto, Helsinki University of Technology, Dept. of Industrial Engineering and Management, Finland
It is apparent that the traditional project risk management practice can provide a useful platform for portraying and communicating potential negative events in projects. But at the same time the project risk management omits largely the positive outcomes, that is opportunities. The modern business and finance management is suggesting that the linkages between risks and opportunities need to acknowledged and taken into account in management practice. This should be taken as a starting point for the development of the new project risk and opportunity management practice that needs to cover both negative risks and positive opportunities, their analysis and balancing.
Experienced project managers, directors and company executives are intuitively balancing project risks and opportunities. In practice this means that when facing unusually high risks then there need to be clear opportunities for an improved benefits, for example high project margin. It is considered to be very important that the practical models and methods for risk management comply with this natural way reasoning and decision-making. Thus, the management of negative risks and positive opportunities should be integrated and the models and methods, which are available, need to be according to this principle.
Basically the word “risk” is very strongly associated with negative outcomes in projects, i.e., project threats and potential problems. As a result the assessment of opportunities is difficult to integrate into current “project risk management” practice where the origin of the main concepts, methods and tools is the world of threats although in the PMBOK® Guide it is mentioned that project risk management includes maximizing the results of positive events and minimizing the consequences of adverse events.
What is needed is an approach, which can integrate smoothly together the management of project risks and opportunities. Perhaps we need to start to talk about risk and opportunity management as a general concept that in a natural way can include the views over negative and positive outcomes without clumsy concepts (“positive risk” or “upside risk”) or methods partly or completely omitting the assessment of positive opportunities. Some other efforts are in line with this proposal. For example, in Statoil corporation a method termed uncertainty management has been developed together with appropriate tools for using the method in project practice (Jordanger, 1998).
Problems Arising From Current Shortcomings
Project risk list is one of the core concepts in practical project risk management. Project risk list is gradually developed based on the present knowledge and data about the project. This list is supposed to capture the most important risks in that project for deciding on risk strategy and responses. Usually a well-elaborated project risk list comprises descriptions of main project risks ranked according to their significance. Often this comes together with qualitative estimates of severity of risks. The risk scoring is a typical qualitative risk analysis technique where one assigns a probability and impact score to each risk according to the predefined scoring list, for example with the scale from 1 to 5. A simple calculation can be applied to define risk severity = probability * impact. This approach is basically a simple one, it is easy to remember, use, and integrate with the project manager's usual working practice. Furthermore, the results from companies are clearly proposing that the project risk analysis carried out in this way usually results in improved understanding of project risks and relating decision making on responses.
The described practice has often been well received and accepted by company people as a first milestone in implementing working project risk management procedures in companies. But this is only the first phase in the learning curve for systematic project risk management practice in companies. As a next step people tend often to prefer a somewhat more comprehensive approach for setting up risk database and for analyzing and communicating on risks in quantitative terms. At this point we come across with the need for showing the potential positive outcomes for discussion and decision-making. The experienced project practitioners know that in their usual projects many important factors, actors and resultant events can turn out to be worse or better as expected. Hence, they need a framework that would cover both the negative and positive sides of the possible outcomes. Examples of practical needs are:
• Project selection. Project sponsors need to have a comprehensive model and understanding of risks and opportunities of project candidates. The potential business benefits; i.e., opportunities need to portrayed together with risks in order to fully understand this picture. From this project's sponsors viewpoint the traditional project profitability assessment methods, such as Net Present Value (NPV), Internal Rate of Return (IRR) and Paypack period calculations are strongly dominating the project selection and analysis at present. In this the risks and opportunities are hardly visible for discussions and communicating over them.
Exhibit 1. A part of project risk efficiency can be missed without a proper framework for discussing and communicating them.
• Project bidding. The markets and company's business strategy require good understanding over project risks and opportunities and how they possibly can neutralize each other. In practice company people are usually copying with this in an intuitive manner and trying to find a solution that would comply with their strategy and needs.
• Master plan preparation. Systematic project risk management is clearly a “homework” type of activity that needs to be done in advance before main decision-making and project realization activities. Thus, the risk and opportunity identification and assessment can naturally have an intensive role in project planning. If this is omitted a lot of redundant and unwanted safety might be present in the project plan and the company might loose a significant part of its competitiveness or potential for success.
• Regular meetings during project realization. Meetings during project realization are strongly tactical decision-making as a joint effort with main project partners. A true working winwin cooperation would require a discussion and communication framework that comprises both risks and opportunities.
The examples above are demonstrating the need for integrated risk and opportunity management. There are several important needs to portray, discuss and communicate project opportunities together with appropriate risks. It this kind of modeling and communication platform is not present it can result losses in project performance, profits other benefits. It seems clear that the traditional project risk management is strongly putting our attention on the negative outcomes in projects. The term risk has basically a negative meaning for people. Thus we do not have a well-defined framework for communicating and portraying together project risks and opportunities.
In modern finance, Harry Markowitz won a Nobel prize with his theory on the asset portfolio management. In this theory he has showed the intimate linkages between risk and opportunity. Nowadays, the integrated joint analysis of risks and opportunities is an important asset management principle (Dembo & Freeman, 1998). The work by Markowitz has been the original source for Exhibit 1 showing that the project efficiency can be far away from optimal if some important opportunities are missed. A project and its realization can be associated with Markowitz's portfolio model since in projects we are also encountering joint effects of risks and opportunities.
Project Baseline as the Main Reference Point
Project base estimate comprises our main commitments regarding time, cost and resultant product. Naturally this forms the reference for stating the risks and opportunities being the potential deviations from the expected outcomes. Exhibit 2 shows the appearances of project cost risks and opportunities in relation to the base cost estimate. The situation A demonstrates how a base estimate concerning cost item nn has proved to be too optimistic. In this situation the risk analysis is showing that that even the minimum impact of the identified main risks is above the base estimate suggesting that the minimum impact plus risk premium need to be added to the target budget for this cost item. Furthermore, response planning and decisions on these actions is required for minimizing the final impact of the identified risks. This is a classical example of the appearance of project risks and how one is supposed to tackle them. Risks are resulting only losses and the safety inside the base estimate do not cover at all the negative impacts of the risks.
The situation B presents a case where a saving potential has been identified concerning cost item mm. The base costs estimate for item mm is basically a realistic one including amount of safety that covers the variance caused by the identified risks. However, usually the opportunity potential is easily missed since the situation is accepted as such. The main thinking pattern here is that one is only concerned about the severity of potential problems, and, the additional considerations are omitted since the risks seem not to be serious threats.
The situation C shows how a significant opportunity has been identified relating to the cost item vv. Now it is important that this saving potential is communicated and discussed in a focused way. One should note that now we have termed the outermost left side of the range as the point of maximum impact in Exhibit 2 situation C. Naturally this is due to the fact that the saving potential is an opposite phenomenon compared with the total costs which still is still our reference point.
Understanding and Communicating Opportunities
Perhaps the best-known and most used approach to cover both project risks and opportunities is to portray the range of possible outcomes from minimum impact to maximum impact. Hence the minimum impact can be considered to cover the possible opportunity part as shown in Exhibit 2 / B. This approach is also present in some computer software packages for project risk management. Usually the attention is put on the wideness of each range. The broad wideness of a range is proposing unwanted high variance and low controllability requiring more detailed studies. These studies are used for minimizing the wideness of the range being the main strategy of this approach. The well-known tornado diagramming technique can be used for identifying wide ranges of risks and opportunities (Exhibit 3). The main shortcoming of this approach is that it treats risks and opportunities as single units rather than providing a focused attention on project opportunities.
Exhibit 2. Appearances of project risk (A) and opportunity (B and C) are always relational to the project base estimate.
In order to have a more focused attention one needs to have an approach where both project risks and opportunities can be individually defined and perceived. When defining any risk or opportunity one should define in a clear manner the root cause of the possible event, its effect and the object of the event. Practically any definition can be a single statement of a few words. The main rationale behind the proposed risk and opportunity definition technique is to move away from general definition to more specific definitions that would be more communicative and stimulate for discussions. Furthermore, a graphical illustration technique is required for supporting teamwork. Project risk mapping is a means to graphically illustrate the overall project risk composed of individual risks, their expected effect and likelihood; and the effects of planned actions (Exhibit 4). The expected effect and likelihood portrayed on the risk map can be based on rough estimates, for example ranges of possible outcomes. The risk mapping technique has proved to be an approach that can support a practice where one wants to have focused attention on individual risks and their characteristics. This can encourage detailed discussions and better linkages to actual project practice that can be partly absent if risks are defined and treated in too general terms. Likewise, the project opportunities can be defined and portrayed in a same manner presented here (Exhibit 5). The proposed approach as a whole would contribute toward structured way of managing risks and opportunities where both risks and opportunities would have alike attention.
Exhibit 3. Tornado diagram for showing ranges of outcomes.
Exhibit 4. Project risk map provides a graphical representation of individual risks and their characteristics.
Development of a Practical Approach for Risk and Opportunity Management
In the systematic project risk and opportunity management approach both project risks (potential negative outcomes) and project opportunities (potential positive outcomes) are identified, estimated and put together in an integrated report forming a basis for action planning. The risks and opportunities are partly identified using separate tools. This means that we have a set of check lists, general questions, and past project experience repository for risk identification and another set of same type of tools for the identification of project opportunities. In practice, the tools are partly overlapping but it has been found out that for jumping from the identification of risks to the identification of opportunities usually means that one needs to change way of thinking and, thus it is necessary that the tools are separate at some degree. This approach needs to be a rather simple one as we are now in a situation where first experiences from practice are emerging.
Is There Any Room for Opportunity Realization in your Project?
Opportunities for additional success can be easily lost in projects. Project times and activity times can be inflated. In these time estimates the safety is often misused and misplaced. Practically, there can be often plenty of safety in time estimates resulting in a situation where activity times and project time estimates have potential for time savings but the safety is not visible and work expands to fill up the available time. The time estimates of described type are some of the root causes for increasing and invisible total cost safety. It seems that new kind of openness between project partners is required for copying with this challenge successfully. Rather than having a very drastic approach for reforming our working practice as suggested by Goldratt (1990, 1997) one should encourage gradual development of openness and win-win relationship between project partners. This would strongly benefit from visibility of risks and opportunities and their quantitative valuation.
Exhibit 4. Project opportunity map provides a graphical representation of individual opportunities and their characteristics.
The traditional project risk management is often over-emphasizing risks on the cost of having less attention on project opportunities. This seems to be a problem when trying to meet the practical requirements and needs of companies trying to move toward more comprehensive practice where an integrated approach would be needed for managing both risks and opportunities. This integrated approach should provide possibilities to address characteristics of individual risks and opportunities. A new approach termed project risk and opportunity management has been proposed in this paper. This is relying on practice where risks and opportunities are partly treated separately as single units in order to have clearer focus and more practical basis for communication.
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Proceedings of the Project Management Institute Annual Seminars & Symposium
September 7–16, 2000 • Houston, Texas, USA