From James Gaius Ibe
What are the nature and sources of project risks? What are the nature and function of project risk assessment? How do firms select risk mitigation strategies? What is the correlation between optimal risk mitigation strategies and effective project risk assessment? How do firms reach forecasted financial targets through quality management and statistical methods? The answers to these strategic questions are critical to effective formulation and execution of optimal risk mitigation strategy that equates marginal cost to marginal benefit of risk mitigation. Additionally, optimal risk mitigation strategy minimizes the known probability and incidence of project risks and maximizes the profit producing capacity of the enterprise.
In this review, we examine some pertinent and extant academic literature on effective project risk assessment and optimal mitigation strategies. Each risk mitigation strategy has costs and benefits. Therefore, the objective function is to maximize the net benefit of risk mitigation strategies. In practice, the optimal risk mitigation strategy equates marginal cost to marginal benefit of risk mitigation strategy by minimizing the incidence of project risks and maximizing the profit producing capacity of the enterprise. Project risk measured by the project standard deviation is the weighted average of possible deviations from the expected value (mean). The project standard deviation captures the likelihood that any uncertain event or condition might adversely affect a project and keep it from being executed as planned.
In practice, project risks like financial risks derive from weighted average of possible variations from expected results based on historical data. Therefore, firms should understand the nature and sources of variations to formulate effective risks mitigation strategies consistent with the profile of the firm which allows it to reach forecasted financial targets through quality management and statistical methods.
Not all project risks-variations are adverse. Some risk events such as innovative approaches or methods of completing an activity or favorable conditions such as lower prices for certain materials are risk-reducing and can facilitate project completion. These favorable events or conditions are called opportunities; but should still be treated as project risks-possible deviations from the expected value (mean).
Some Operational Guidance
Not all project risks can be effectively mitigated. To formulate and execute effective project risk mitigation strategies firms must develop a culture of assessment and continuous improvement. Firms cannot apply or manage what they do not understand, and they cannot measure or understand what they do not know; and they cannot know what they do not believe. Therefore, firms must always inspect what they expect by designing and deploying a robust assessment model that informs collection and analysis of relevant, accurate and timely data.
Sources and Types of Variation
In operations, variation source identification for projects is critical for product quality improvement. Many variation source identification techniques are based on a linear fault quality model, in which the correlation between process faults and product quality measurements are linear. In practice, many quality measurements are nonlinearly related to the process faults. A critical aspect of process characterization is to identify and quantify various sources and types of variation so that they may be minimized.
In addition, the ability to detect and minimize variation in the project processes gives firms competitive advantage, allowing them to provide superior quality products to their customers in the global marketplace and to reach forecasted financial targets through quality management and statistical methods. Traditional quality control focuses on statistical process control (SPC), to detect anomalies and deviations based on product and process measurements. However, this approach does not provide specific operational guidelines to identify the variation sources, a critical step toward variation reduction and the derivative project risk mitigation strategies.
Further, the availability of project and process assessment data as well as the criticality of problems caused by project and process variation led to the significant development of innovative methodologies for variation source identification. In the case of normal causes-common variation, the process is in control-stable and therefore predictable. This means that based on current process pattern, a firm can predict how it will behave in the future, i.e. always within the control limits. In the case of special causes-exceptional variation, the process is out of control-unstable and therefore unpredictable. In other words, based on current process pattern, a firm is not able to predict how the process will behave in the future.
As you know, there are not only different sources of variation but there are also different types of variation. Common cause variation describes random variability that is inherent in the process and special cause or assignable cause variation is due to specific circumstances. The two types variation are controlled variation and uncontrolled variation. Controlled variation is characterized by a stable and consistent pattern of variation over time. This type of variation is random and indicates a uniform fluctuation about a constant level. Uncontrolled variation is characterized by a pattern of variation that changes over time and hence is unpredictable.
The concept of controlled/uncontrolled variation is critical in determining if a process is stable and in control. A process is deemed stable and in control if it runs in a consistent and predictable manner. This means that the average process value is consistent, and the variability is controlled. If the variation is uncontrolled-process is out of control, then either the process expected value (mean) is not consistent, or the process variation is changing or both.
Risk Assessment and Mitigation Strategies
In practice, managing project risks is a process that includes risk assessment and mitigation strategy for identifiable and predictable risks. Project risk assessment includes both the identification of potential risks with known probabilities and the evaluation of the potential impacts of project risks so identified. Risk mitigation strategies are designed to eliminate or minimize the impact of the risk events-occurrences that have a negative or adverse impact on the project. Identifying risk is both a creative and a systematic process. The creative process includes actively developing new insights into situations and applying innovative, unique solutions to project problems. And systems approach entails ability to anticipate and understand the implications of project risks and mitigation strategies across the entire firm.
Finally, there is gathering empirical evidence in the extant academic literature suggesting that during process characterization, firms should endeavor to isolate, eliminate, or minimize all sources of uncontrolled variation. At the planning stage of the project, risks are still uncertain because they have not yet occurred. But eventually, some of the anticipated risks will occur, and the firm must deal with them. There are four basic strategies for managing project risks:
1. Risk Avoidance: The best thing a firm can do with a project risk is avoid it. If a firm can prevent risk from happening, it will not adversely affect the project. The easiest way to avoid project risk is to walk away, but this may not be a viable option. A common risk avoidance technique is to use proven and existing methods rather than adopt innovative methods, even though innovative methods may indicate better potential outcomes. Risk avoidance is often effective but seldom practical.
2. Risk Reduction: If a firm cannot avoid the risk, it can mitigate or minimize the impact. This means taking some actions that will minimize severity of damage to the project. Effective use of management information system, warning system and early problem detection system are some of the industry best practices.
3. Risk Transfer: One of the most effective ways to deal with a project risk is to pay a third party to accept the risk. The most common way to do this is to through insurance or re-insurance.
4. Risk Sharing: This involves partnering with other firms to share responsibility for the risky activities. Partnering with another firm to share the risk associated with a portion of the project is useful when the other firm has expertise or distinctive competency-resources and capabilities a firm lacks.
5. Risk Retention: This is planned assumption of risk by a firm. When a firm cannot avoid, mitigate, transfer, or share a project risk, then it must retain/accept part or all the risk. The most common way to do this is through self-insurance, co-payments, or deductibles.
In sum, there are always costs and benefits for every business decision and strategy. Therefore, firms must always weigh the costs and benefits of project risk assessment and mitigation strategies to decide whether the benefits justify the costs. The optimal mitigation strategy equates marginal cost to marginal benefit, ceteris paribus.
Prof. James Gaius Ibe, is the Chairman/Principal-At Large, of the Global Group, LLC-Political Economists and Financial Engineering Consultants; and a senior professor of Economics, Finance and Marketing Management at one of the local universities.
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