Life and Spiritual Coaching

August 16, 2008

Decision Trees

Filed under: PMP — by Donna Ritter @ 11:57 am
Tags: , ,

A decision tree is a popular tool to use to share information about risks using expected value. Every decision has an outcome and something will happen as a result of the decision. The decision “tree” helps us decide whether we can live with the choices we make; if we choose to eat lunch out or stay in for lunch, whether to build or buy, whether to pursue a line of business or not. These events are out outcomes of whatever decisions are made – not on probability.  However, the outcomes of events do have a probability associated with them. There is a chance they will occur, as well as a chance they will not. It’s important to acknowledge that the outcomes from a single event are mutually exclusive of one another. If outcome 1 happens; outcome 2 cannot. If outcome 2 happens, outcome 1 cannot. For that reason, we can determine their probabilities clearly. If there are only 2 outcomes, and there’s a 40% chance of outcome 1 occurring, then there is always a 60% chance of outcome 2 occurring. The multiple of the outcomes will always sum to 100%.

Here is an example. We have a decision called “where to eat lunch”. We have 3 possible choices which lead to an outcome. The outcome is either “keep customer” or “lose customer”. For this example, we are associating some probabilities and some values of the outcomes. These values are not “Expected values”, but simply values of the outcomes if they come to pass. The costs of the meals are also included. Costs associated with the outcomes represent lost business through negative word of mouth communication. Revenues associated with outcomes represent newly acquired business by virtue of the positive experiences associated with the meal.

So we have 1 Decision – Where do we eat? There are 3 choices, we can eat at a hot dog vendor for – $10, fast food for -$20, or Fine dining for -$150. If we eat at the hot dog vendor we stand a 10% chance of keeping the customer which leads to outcome 1 ($500). That gives us a 90% chance of losing the customer if we eat at the hot fog vendors place (-$600). Choice 2 is eating at a fast food place costing -$20. It leads to a 40% chance of keeping the customer valued at $750 and a 60% chance of losing the customer valued at -$300. The third choice is fine dining costing -$150 leading to a 60% chance of keeping the customer valued at $1000 and a 40% chance of losing the customer valued at -$100.

Now we have enough information to figure out the best outcomes for our company. If for example, we select a hot dog vendor for this client lunch and achieve a positive outcome, the total benefit for the company will be $490 (outcome of event – cost of lunch). If we choose last food and have a positive outcome with the customer, the net benefit to the customer is $730.

When looking at risks, we need to also take the potential losses into consideration. Returning to the hot dog example, the negative impression generated may cost an additional $600 in lost business. That combined with the initial cost of the lunch would mean losses to the company on the order of -$610.

 

Stay tuned for part 2.

 

Donna

July 14, 2008

Expected Monetary Value

Filed under: PMP — by Donna Ritter @ 12:24 pm
Tags: ,

 

 

This is the process concerned with identifying, analyzing, and responding to project risk. (PMBOK)

It is also the art and science of identifying, assessing and responding to project risk throughout the life of a project and in the best interests of its objectives. Now in all of the projects I’ve managed in my 30 years of experience, there has always been risk.

 

The trick to the game is to figure out what the risk tolerance of your stakeholders is. How much risk are they willing to put up with and how much do they want solid fallback plans for?

In some cases, a level of uncertainty is acceptable and the level of contingency planning can be as simple as put another person on the project, or slip the schedule.

 

Sometimes it’s not so simple, and the stakeholders want to know the monetary value or expected value of the probability of a risk occurring. The basic level for excepted value is:

 

Expected monetary value (EMV) = probability * impact

 

The expected value result can either be added to the costs of the project or subtracted from the project’s profit. The project profit or cost is usually referred to as the baseline. The baseline is the initial approved cost or profit structure for the project.

 

Project EMV = project cost + risk expected value – opportunity expected value

                                    -Or-

                                 = project value/profit – risk expected value + opportunity expected value

 

Remember, risk increases the cost and decreases the profit; and opportunity increases the profit and decreases the cost. Risks are bad things that may (often do) happen to us on projects, sometimes expressed as “threats”. Opportunities are good things that may happen to us on projects and may enhance the overall situation.

 

With that in mind, let’s work through a few examples.

 

Example: You have a project with total planned costs of $100,000. What information of value to an expected monetary analysis do you have so far? The baseline ($100,000). Now with that bit of information, let’s add some more considerations and complexity to it. For this same project, with total planned costs of $100,000, there is a risk that one of your team members, Matthew, will be crowned Prince of Arabia! If that happens, we’ll lose $8,000 in the process of replacing him on the team.  Now what new information do you have that helps you out? You have the Risk Impact ($8000).

After checking with highly placed sources within Arabia, we have learned that there is about a 60% chance that Matthew will be approved as the new Prince. What new information do we have now? We have the probability (60%).

Now for this project we know that the cost is $100,000, and there is a 60% chance we’ll lose Matthew, costing the project $8000. What is the Expected Value of this risk happening to our project? In this instance, we are looking at the expected value of the risk. It has a potential cost of $8000. But, since the probability of it happening is only 60%, its EMV = $8000*.6 = $4800. We have now calculated the EMV for this risk event. We have to apply the EMV in the context of the project as a whole. What is the EMV of the cost of the whole project? The answer is $104,800 ($100,000 + $4,800).

We also need to consider any opportunities which may offset the cost of the risk. For this project, in addition to the potential concerns of Matthew’s leaving, we have just received some good news! We may have the opportunity of a bonus from the customer, which would reduce costs by $20,000. The chance of us getting the bonus is 30%. What is the expected value of this chance? It is $6000, 30%*$20,000. Are you still with me here?

Now we have a lot more information for the stakeholders. The project will cost $100,000. There is a risk of losing Matthew at an additional cost of $8000, but there is only a 60% chance of that occurring. There is also an opportunity for a bonus of $20,000, with a chance of 30% of that occurring. With all of these considerations, what is the Expected Monetary Value of this Project? It is $98,800. This is calculated by taking the cost baseline of $100,000 + $4800 (risk of losing Matthew) and subtracting the EMV of the opportunity because it will affect our costs. That is $6000. So the total Expected Monetary Value of this project is $98,800.  That incorporates both known risks and opportunities.

For our project we now have a new perspective. Nancy from accounting finally came through with the numbers on how we are expected to profit from the project. Specifically, she was able to establish that the project will yield about $210,000 in revenues. That will be offset by the cost of $100,000, but management is asking for a risk analysis. To review, what is the baseline profit of the project? It is $110,000 ($210,000 – $100,000).

Next we need to take into account the risk of losing Matthew which would increase cost by $8000. There is also an opportunity of a bonus that will increase revenues. Let’s list our information:

·         The project has a cost baseline of $100,000

·         Revenues are anticipated at $210,000

·         There is a 60% chance we’ll lose Matthew at a cost of $8000

·         There is a 30% chance we’ll earn a bonus of $20,000

·         For a few kickers, there is a 10% chance we’ll hit obstacles increasing costs by $30,000

·         There’s a %70 chance we’ll have a legal fight costing $10,000

With all of this new data, what is the new EMV? It is $100,000 (baseline cost) – $4800 ($8000 * %60) + $6000 ($20,000*30%)-$3000 ($30,000* %10) – $7000 ($10,000*70) = $101,200

 

So from a risk perspective, this project is worth doing.

 

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