Wednesday, September 14, 2011

Risk in Project Management

Project appraisers have the tendency to be over optimistic. There are two clear tendencies that govern this behavior. One comes from a natural human characteristic and the other comes from voluntary, deliberate and ethically reprehensible actions.

Wishful thinking is the formation of beliefs and making decisions according to what might be pleasing to imagine instead of appealing to evidence, rationality or reality. Holding all else equal, subjects will predict positive outcomes to be more likely than negative outcomes. In one straightforward experiment, all other things being equal, participants assigned a higher probability to picking a card that had a smiling face on its reverse side than one which had a frowning face.

In other way, planners may deliberately underestimate costs and overestimate benefits in order to get their projects approved, especially when projects are large and when organizational and political pressures are high.

No matter the origin of over optimism, you need to overcome it. The result of a project will be always better if you work with reality. Let me say something important: risk is part of reality. Even more, risk is part of the cost. That part of the cost is named “Expected Monetary Value of Risk” (EMV) and it exists.

Let’s make a physical analogy. Quantum mechanics, also known as quantum physics or quantum theory, states a fundamental limit on the accuracy with which certain pairs of physical properties such as the position and momentum of a particle, can be simultaneously known. This is also known as the uncertainty principle.

In practice, it means that we work with the probability of being at a position in a determined moment. It does not mean that matter doesn't exist. It means that there are properties that can't exactly be known, in certain conditions. Try to kick a brick of quantic matter without shoes. You are going to realize that matter exists. You are going to feel exactly the same if you ignore the Expected Monetary Value of Risk when calculating ETC (estimate to complete) of a project. The same is valid to calculate the budget of a project.

How is EMV calculated?