Risk Management
Last updated: 12-10-2005
Introduction
In design and construction, risk analysis can be described as a systematic methodology and ongoing process by which occurrences that may substantially affect the end product can be identified, quantified, modeled, managed, and monitored. This tool is especially useful as a method of good project management and planning, because the business of building is inherently risky—the risk mitigation methods can be applied to project cost, schedule, quality/performance, safety, and business operations, especially as construction risk increases with the size of the project. Good risk management procedures ultimately measure the team's confidence level in the project on an ongoing basis, and allow the introduction of corrective actions, monetary contingency, and schedule float in order to minimize losses to the project and increase the likelihood of the project being completed on schedule and within budget.
The application of risk management procedures in construction can give early visibility to potential "problem areas" and opportunities, where effort and money can be expended early in the design and construction phases to reduce vulnerability, insurance costs, business or mission interruption, and claims. Early risk identification ensures that design and team effort is concentrated in critical areas, focusing the project team's attention on actions and resources where there is a major risk exposure, or where the greatest time/cost savings can be made through reengineering and streamlined project management. The objective is proactive management of projects, where problems are reduced as they are identified, as differentiated from the traditional approach to construction, which waits until critical problems develop and then implements an immediate (and typically expensive) response which may reduce the impact to the project but likely does not avoid losses as effectively as early risk response. Over time, risk management allows the project team to build a historical profile of risk based upon experience and lessons learned, which will allow for better management of future projects.
Risk management is an organized method of identifying and measuring risk and then developing, selecting, implementing and managing options for addressing risks. There are several types of risk that an owner should consider as part of risk management methodology. These include:
- Schedule risk
- Cost risk
- Technical feasibility
- Risk of technical obsolescence
- Dependencies between a new project and other projects
- Physical events beyond direct control
Risk management seeks to identify and ultimately control possible future events and should be proactive rather than reactive. To be effective, risk management must rely on tools and techniques that help predict the likelihood of future events, the effects of these future events and methods to deal with these future events. Risk management is the responsibility of everyone involved in a project.
Tools and Techniques
Paying attention to detail and implementing appropriate cost and schedule control systems will assist in risk analysis and management. However, one area that deserves closer scrutiny is the use of range estimating as a risk analysis tool. Range estimating can be done in a rather simple fashion by selecting the 20 percent of the line items in an estimate that represent 80 percent of the cost then developing a range for each of those 20 percent and doing a simple process of adding the low and high ranges. A more advanced approach could take the same 20 percent items, establish the range and then use any one of several available software packages to perform a Monte Carlo simulation and produce a risk profile. This approach would give a more accurate projection of the logical highs and lows involved with 20 percent drivers. A sensitivity analysis can also be prepared to vary the key risk parameters.
Finally, it is possible to use a complete risk analysis package that includes range estimating and prepares a risk profile that estimates confidence ranges and contingency amounts. This type of an approach can establish contingencies for not only individual projects but for entire programs.
Monte Carlo or risk analysis is used when establishing a baseline or baseline change during budget formulation. The contingency developed from the Monte Carlo analyses should fall within the contingency allowance ranges presented previously. Monte Carlo analyses and other risk assessment techniques use similar methodology to obtain contingency estimates. There are a number of software packages both publicly and commercially available. The estimator must subdivide the estimate into separate phases or tasks and assess the accuracy of the cost estimate data in each phase. After the project data have been input and checked, the computer program will calculate various contingencies for the overall project based on the probability of project underrun. The random number generator accounts for the known estimate accuracy. Once the program has completed its iterations (usually 1,000), it produces an overall contingency for the project with certain accuracy.
The application of this type of quantitative risk analysis allows the construction project exposure to be modeled, and quantifies the probability of occurrence and potential impact of identified risks. The results can be used to produce a realistic representation, in graphic s-curve form, of the project's total uncertainty and risks. Referring to the s-curve figure below as an example, a contingency amount of approximately $4 million represents 65% confidence in achieving that project cost. For 80% confidence, contingency should be increased such that total project cost is $51 million.
Sample project cost s-curve
Risk management with probabilistic modeling can be used to reduce project contingency from a guesstimate of 10-20% to a quantitatively determined amount, typically in the range of 3-8%. As the project progresses, and the confidence level in project cost increases, the early release of contingency amounts may be achieved and the money may be invested elsewhere.
Major Resources
Publications
- Managing Risk in Construction Projects by Nigel Smith. Blackwell Publishers, January 1998.
- Risk Analysis: A Quantitative Guide by David Vose and Howard A. Doughty. New York, NY: John Wiley & Sons, Inc., April 2000.
- Risk Management and Construction by Roger Flanagan and George Norman. Blackwell Publishers, August 1993.
