Project Cost Risk Analysis

This particular article sparked my interest after the lecture on Value at Risk. It seems as if the concepts are intertwined with each other. This article was written by David Hulett, the founder of Hulett & Associates. He explains how critical it is for companies to take their time and be specific in calculating the cost of various projects. Firms that simply take the estimates per component of that particular project and add those estimates up to get their project costs run the risks of over- or under-estimating their costs. Plain and simple, they are taking the easy way out. Hulett advises to conduct a cost risk analysis. This helps gives a more accurate and realistic estimate of the project costs.

What is a cost risk analysis? According to Mr. Hulett, "A formal risk analysis is putting on the table those problems and fear which heretofore were recognized but intentionally hidden." The core reason for doing this analysis was mentioned above, but we can go a little further. Conducting an analysis can help the project manager with a cost that could be higher than the EAC (estimate at completion) with a high probability. It also help firms find the most likely cost for the entire project, while stating the most risky components of the project. Because of that capability, it allows risk managers to take necessary risk minimizing actions for those particular components.

There are several steps in the project cost risk analysis. It all starts with splitting up the components of the project at hand. Then you would proceed as follows:
1. Collect data on the extreme "pessimistic and optimistic" ranges of cost per component. (This step is the most important, yet most difficult to do. It requires gathering information from all risk advisers).
2. Choose the appropriate probability distribution for each component.
3. Using the ranges and distributions determined (for his particular example, he assumed the Triangular distribution was correct), perform a Monte Carlo Simulation. (A procedure for pricing derivative claims by discounting expected payoffs, where the expected payoff is computed using simulated prices for the underlying asset).
4. From these results, you can discover the percentage contingency needed to accommodate a certain level of cost (non specific, whatever that specific risk manager wants to accommodate).
5. From the results, calculate the correlation between the different components. (This is also important because most of the components risks are correlated. Now you can see the level of that correlation).
6. From the results, you can identify the location of the highest risk. This helps managers prioritize the components and their risk management activities.

All of these steps and the results helps the firm determine whether this project is worth taking on. If so, it assists them on designating the amount of resources they will need for each component. According to Hulett and this information, it's safe to say that conducting a cost risk analysis is a procedure of risk management all in its own!

Hulett, David. "Project Cost Risk Analysis". http://www.projectrisk.com/. 1999. 28 January 2009 <http://www.projectrisk.com/Welcome/Cost_Risk_Paper/cost_risk_paper.html>.

McDonald, Robert. "Glossary". Derivatives Market. 2006. Boston: Pearson Education, Inc. P.914