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The Risk Assessment for a Proper Project Estimation

The Risk Assessment for a Proper Project Estimation.

Project evaluation is usually carried out by various parameters. But more often project managers, customers or investors are interested in the project term, its cost, and the payback period. All these parameters are linked, and the project budget is usually the most important.

There are a great number of methods used to estimate a project. But it is a very common situation when a project manager forgets to use risk assessment for the estimation of the project budget. There are several factors why this is happening.

Firstly, the risk assessment itself does not completely form the budget of the project, but only provides a portion of the total project budget. Thus, if only risk assessment is used, it is impossible to get the total budget. Secondly, the risks themselves have a probabilistic nature, and investors do not like to deal with the predictions.

These facts explain the low popularity of using risk assessment to form the project budget. However, it is possible to change the attitude of customers and investors to this method.

It is known that the main methods of risk management are reduction, transference, avoidance, and acceptance. It is comfortable to use a diagram like this:

Every possible risk will fall into one of these four sectors depending on the likelihood and potential losses. A project manager can use this chart to categorize risks and choose the best way to manage them.

Therefore, the first way to manage risks is avoidance. Obviously, this method is used for risks with high probability and high potential losses. To avoid a risk means to create an environment in which the risk, in principle, cannot occur. For example, if there is a risk of problems with customs clearance of hardware components, it is possible to find a local producer. If there is a risk of an airplane crash – go by train. Obviously, this avoidance method cannot help to evaluate the budget for risk management, because it advises to avoid a risk altogether.

The second way of risk management is “acceptance”. When a risk is accepted, its consequences are neglected. There are two options: to include the complete cost of this risk in the budget or to not include this risk in the budget at all. This way means to manage a project without taking any action with this risk.
For example, there is a risk that one of the team members can leave the project. If there is another person in the project who can replace him, it’s a proper decision to accept this risk.

The third method is transference of risk. This method is typically selected when the probability of risk is low and potential losses are quite high. A classic example of such a risk is the risk of fire in the warehouse. The probability is microscopic, but the loss if the fire were to happen, would be enormous. Such a risk is typically selected with the transference method, often expressed in the form of insurance.

That is, some external to the project or company subject assumes all financial responsibility for the risk of a cash reward, usually called premiums. When a project manager purchases a premium, the probability of the risk is the same. However, the financial consequences, if the risk were to occur, would belong to an insurance company. Thus, identifying these risks, it is possible to count a risk premium for each of the risks and include that amount in the project budget.

Finally, the fourth method is reduction. This method is used quite often and is one of the most popular ways. It is easy to explain the popularity of this method. These risks have a high probability, but low losses. It is recommended to include into the project plan any preventative events that will reduce the likelihood of any risk or the potential damage. Some events can reduce both parameters simultaneously.

Most of the activities can be scheduled in advance before starting the project. In addition, these activities are often free or do not cost a significant amount. So, the project manager does not usually need to coordinate these activities with the customer. However, some events require additional funding and then the project manager should calculate the budget for the management of these risks and to include them in the overall project budget.

For instance, there is a risk that the customer will be poorly informed about the progress of the project, which would lead to customer dissatisfaction. The probability of this risk is rather high, but losses are relatively low, and this risk must be controlled by reducing its likelihood. It is important to include some periodic meetings with the customer in the communication plan. He will be informed regularly and the likelihood of any communication problems will be reduced. In addition, this action does not cost extra money.

Another example: the project team has a poor understanding of the brand-new technology used in the project. The risk can lead to poor quality of the project results and increase the duration of the project, until the team understand this new technology. The risk can be reduced by including a training course in the project plan. Its cost should be included in the project budget.

Thus, it is possible to create a risk management budget, consisting of the sums required for the risk transference (insurance) and risk reduction (preventive measures). History shows that using risk assessment to create a risk budget is more understandable for an investor, than the more common way of estimating the risk budget based on a percentage of the total project budget.

Another method is a light and fast risk assessment used at the idea stage. This method estimates a level of project riskiness and helps to make a decision on project initiation. For this, it is necessary to determine all the risks and then categorize them on the diagram, described earlier. The amount of risks in the avoidance area describes the riskiness of the project. A large number of risks, which must be avoided during the project implementation, is an alarming signal for investors. In fact, by avoiding a project, investors are avoiding all the risks associated with this project.

Each investor can choose the acceptable degree of risk for a project and compare the number of risks that fall into the zone of “avoidance” with the profitability of the project, and then make a decision. Obviously, investors are not interested in any projects with low profitability and high risks.

In conclusion, both methods of these are recommended for project estimation using risk assessment. The first method is used to form a part of the project budget, regarding risk management. It may be used at the planning stage. The second one is a fast and simple way to analyze project riskiness. It is usually used at the beginning of the project for investment analysis.

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