The recipe for risk
Organizations must look at risk appetite across the entire enterprise when assessing their portfolios
BY MICHAEL BELLER
Along with his team, Mr. Cutshaw, executive vice president at engineering and construction firm Mesa Associates Incorporated, Knoxville, Tennessee, USA, decided to go forward with a project to build a steam production facility for the U.S. government. Despite not having a strong existing relationship with the client—Mr. Cutshaw's top priority when assessing risk—he felt getting into the government sector was worth the uncertainty.
“If there was an opportunity to get a project in a new market segment, we'd be willing to take on more risk and even lose money,” says Mr. Cutshaw. “I considered it a high risk. We didn't have a relationship, and our partners didn't have a lot of experience. But it would get a lot of notoriety, it was a good fit for our technical resources and it was a great opportunity for developing our portfolio and our client base.”
That type of equation is one organizations must constantly weigh to determine their risk appetite—what types of risks they can take on each project in the portfolio.
Mesa went forward with the project, designing elements of the facility. The partner firm completed construction, and the project came through as expected—that is, except for the cost. Now, Mr. Cutshaw says his company is likely to wind up in a lawsuit because the inexperienced construction firm did not follow industry best practices.
“The risk came true,” he says. “It remains to be seen if it was worth it.”
Risk appetite calculations are making greater penetration in boardrooms across the world. Project selection was the top portfolio management capability leveraged by respondents to PwC's 2012 Insights and Trends global survey.
It's not difficult to see why organizations are expending more effort to track their portfolio risk—the consequences of failure are costly. PMI's 2013 Pulse of the Profession™ report found that for every US$1 million they spent on projects, organizations put US$135,000 at risk. When projects fail, the study found that an average of one-third of the projects’ budgets are gone for good.
“If there was an opportunity to get a project in a new market segment, we'd be willing to take on more risk and even lose money.”
—Tim Cutshaw, Mesa Associates Incorporated, Knoxville, Tennessee, USA
“If you're proactive in having a [risk] plan in place, that will speed up the company's ability to get back on schedule.”
—Jim Hagar, Oregon Bridge Delivery Partners, Salem, Oregon, USA
Fabio Pitorri, CAPM, PMI-RMP, PMI-ACP, PMI-SP, PMP, PgMP, knows a good risk when he sees one. A project manager and technical director with consultancy Dinsmore Associates in Sao Paulo, Brazil, Mr. Pitorri has consulted on projects ranging across industries, from aerospace and defense to construction to IT. Through it all, he has observed one common trait when it comes to risk appetite: “A company usually wants to know what can happen during a project, the probability of these events and their consequences,” he says.
Once an organization knows those risks on each project, it can get a holistic view of risk across the portfolio. Macroeconomic and geographic environments, industry, innovation drive, and projects with added complexity all impact risk appetite, and every organization has its own equations for weighing all the factors. Here are the perks and perils of the four major risk ingredients.
1. The Right Tools for the Task
The decision-making process around an organization's risk appetite is inextricably tied to the firm's industry. Obviously, the risks involved in building a bridge differ from those involved in developing a new medication or launching an app. What's not quite as intuitive is how those divergent risks affect the calculation.
“Industry and risk appetite have a strong relationship,” Mr. Pitorri says. “In the aerospace and defense industry, I noticed companies don't like to run risks because their product can't fail. A failure can cost lives. That's why the industry has a very strong budget for testing and validating its products.”
Apparel, however, may be willing to take on more risk. “They may have problems that damage their brand, but the consequences are not as harmful. The worst thing that happens is maybe someone ends up naked on the street,” he jokes.
In the construction industry, project risks aren't confined to the building process. The price of materials could increase, or the environmental impacts of executing the project could be cost-prohibitive. Those factors must be considered in addition to the usual concerns about budget, schedule and quality.
“You're trying to identify risks from the front end,” says Jim Hagar, economic development manager at Oregon Bridge Delivery Partners (OBDP), Salem, Oregon, USA. “If you're proactive in having a plan in place, that will speed up the company's ability to get back on schedule.”
OBDP, which is managing a 10-year, US$1.3 billion bridge replacement program for the Oregon Department of Transportation, repeatedly revises its risk-appetite calculations based on the progress of each project in the portfolio.
“We go in when the design is 30 percent complete and base our cost estimate on a 90 percent likelihood that a problem could arise to make sure we capture all of the unknowns,” Mr. Hagar says. “At 60 percent completion, we reduce the likelihood to 50 percent. We captured the risks that weren't being captured and stopped having bids come in way over budget.”
2. Global Appetites
The traditional risks that come with expansion, from unreliable vendors and labor pools to the challenge of working across international borders, may be balanced across the portfolio by the potential benefits.
“Think about the supplier and labor relationship: When you have plants in several countries, you have stronger relationships with your suppliers and produce at a lower cost,” Mr. Pitorri says. “You will run more risks, but have more opportunities, too. Threats and opportunities are very related.”
The advantage of global expansion falls to larger firms, says Jomar Nieva, PMI-RMP, PMP, vice president, Asia Pacific, at risk management consultancy Risk Quotient Pte Ltd. in Hong Kong. “Big companies have the balance sheet where they can take that risk” of entering an uncertain market, he says. “Their sheets are strong enough. They can invest in that market even if it means they have to have a long payback period.”
Such organizations also have the advantage of being able to balance their risky ventures with safer, more reliable projects at home.
The eurozone, still dealing with economic recession and cooling economic growth in many markets, has organizations reluctant to expand to new countries. Failure to act may have long-term consequences if organizations leave those untapped markets open to new competitors with higher risk appetites.
3. Tricky Recipes
Tough projects hold the promise of great reward, but each uptick in the degree of difficulty almost guarantees to raise the number and severity of risks. More people working on the project, for example, necessitates more information sharing and a greater chance for communications to breakdown. “When you misunderstand something in a project, then something will probably go wrong, and this means re-work,” says Mr. Pitorri.
A project with a longer timeline means more uncertainty, and that forces a firm to increase the likelihood of a risk factor breaking in the wrong way, says Mr. Hagar. These long-term considerations must be taken into account when weighing the risks of each project in the portfolio against each other.
“If you know you're doing a project with 100 different components and you're looking at piece 100 that won't be done for eight years, you put a lot more dollar value or schedule value in there on the front end, because you don't know what's going to happen,” he says.
One way to mitigate the risk on an intricate, long-term project, Mr. Hagar notes, is by contractually obligating a winning bidder to buy all the materials in advance. That saved the Oregon Department of Transportation a significant amount of money on a recent job.
“The longer the duration, the more risk there is in seeing a spike in certain material costs, specifically steel and asphalt,” he says. “That was figured into our bid, but we avoided about a 12 percent spike in steel prices within about six months after the bid was done.”
“When you have plants in several countries, you have stronger relationships with your suppliers and produce at a lower cost. You will run more risks, but have more opportunities, too.”
Fabio Pitorri, CAPM, PMI-RMP, PMI-ACP, PMI-SP, PMP, PgMP, Dinsmore Associates, São Paulo, Brazil
“Innovation will not change risk appetite. Risk appetite will determine whether a company is innovative or not.”
—Jomar Nieva, PMI-RMP, PMP, Risk Quotient Pte Ltd., Hong Kong
4. The Unknown Ingredient
Risk appetite's hydra-headed nature is further complicated by innovation: Any product aimed at revolutionizing an industry inevitably carries a great deal of risk. Firms that innovate are ones that see risk not as a detriment, but as an opportunity, and take that into account when calculating their appetite.
“Innovation will not change risk appetite,” Mr. Nieva says. “Risk appetite will determine whether a company is innovative or not.”
As an example, Mr. Pitorri pointed to a several ongoing projects to develop vaccines. The sponsor wants baselines for the projects to come to fruition, Mr. Pitorri says, but the innovation and risks involved in any vaccination project makes it nearly impossible to estimate an end date.
“It's not easy to say if we'll accomplish the goal in one month or in two years,” he says. “This kind of innovation brings a lot of uncertainty. We've seen lots of vaccination research projects that discover something not related to the initial scope.”
COOKING WITH FIRE
The last ingredient of the risk appetite recipe is, of course, the fundamental ability to actually mitigate risks. No organization can adequately figure out its risk appetite if it doesn't also know the maturity of its risk management capabilities.
A firm can more readily take on an innovative project with added complexity—regardless of industry or environment—if it has the right people to manage the associated risks. The Pulse study found that 81 percent of high-performing organizations use risk management practices.
“It's like a set of brakes for a car,” says Mr. Nieva. “A race car drives very fast because the driver is very confident in its brakes. Risk management is your set of brakes. The better your brakes, the higher your appetite.” PM
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