MCM4433 Project Risk Management Chapter 5: Types of Risk Analysis

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Chapter 5: Types of Risk Analysis

1.0 Introduction

There are several ways of analysing and dealing with risk. The degree of risk may
also be affected by the type and form of contract. For example, the Institution of Civil
Engineers’ New Engineering Contract attempts to advance earlier models in relation
to the analysis and allocation of risk. One of its aims is to reduce the extent of
disputes by all interested parties. Such disputes often arise from unclear procedures
in the written contract.

This new form of contract aims to identify the risks more clearly, and the
responsibilities for managing them. The intention is to place the overall management
of risk much more squarely on the shoulders of the project manager (and engineers)
and to reduce significantly the role of the lawyers and insurers on construction
projects. It deals with risk in the following manner:

 By using language which is simpler and more understandable than alternative

forms of contract.
 By outlining a single procedure for compensating the contractor when a risk
occurs.
 By identifying, in one list, a standard risk allocation between client and contractor
as well as allowing a tailored allocation of special risks.
 By directing the user to select his preferred contract strategy, which has the
effect of drawing attention to the differences in the allocation of risk between the
respective strategies.

Whichever contract is selected, a procedure will need to be adopted for dealing with
the particular risks in question. Risk analysis requires a systematic approach which
is designed to suit the model and circumstances in which they are used. The
following method is a fairly general one and consists of two distinct risk analysis
stages:

 Qualitative risk analysis

 Quantitative risk analysis

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2.0 Qualitative risk analysis

Qualitative risk analysis involves a subjective assessment of risks based on their

potential impact and likelihood. It often uses descriptive scales (low, medium, high)
to categorize risks. This method is useful for identifying and prioritizing risks in a
relatively quick and straightforward manner. It's valuable in the early stages of a
project when detailed data might be lacking. There are two aims associated with this
process, namely:

 to identify the risk;

 to make an initial risk assessment.

The process involves compiling a list of the main risk sources with a description of
their likely consequences:

 Examine list of risks compiled from previous projects.

 Investigate potential risks with key project participants.
 Determine possible solutions via brainstorming sessions with the project team.

This process not only helps to examine the potential problem areas with a project,
but also brings considerable benefits in terms of understanding the project. It helps
to focus the minds of the project team members by provoking thought about
management response to the risks. A good understanding between the team
members is also a useful side effect.

Assessment of cost and time improves as the project proceeds – but always
remember that the most significant decisions are made during the early stages of a
project. So a realistic estimate of final cost and project duration is required as soon
as possible. It is at this stage that all the potential uncertainties and risks likely to
affect the project should be identified and, hopefully, fully assessed.

This will also encourage the project manager and his project team to concentrate on
strategies for controlling the risks as well as determining the allocation of risk to the
respective parties. It will also help identify what additional design and resources are
most likely needed.

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3.0 Quantitative risk analysis

Quantitative risk analysis involves a numerical assessment of risks, assigning

specific values to the likelihood and impact of each risk. This approach uses
mathematical models and statistical tools, involving more sophisticated analysis
techniques which usually requires computer application. Hence, the outcome is a
more precise and detailed analysis, often expressed in terms of monetary values. It
is beneficial for projects or situations where a thorough understanding of potential
losses or gains is crucial. This method of analysis requires:

 probabilistic combination of individual uncertainties;

 estimates of uncertainty in predicting the cost and duration of activities.

Computer-generated models and analytical techniques can be useful indicators of

trends and problems for attention, but they should not be relied on as the sole guide
to decisions. Their accuracy depends on the realism of assumptions made, the skill
of the model builder and the accuracy of the data used.

One method for considering project risks is to analyse any risk independently of
others, with no attempt to estimate the probability of occurrence of that risk. The
estimated effects of each risk can then be accumulated to provide maximum and
minimum project outcome values.

In other words, neither a subjective nor an analytical value is given for the probability
of occurrence of the risk event. Instead, each risk event is compounded to determine
the possible effect upon the project, and then, by applying a range of maximum
(critical) to minimum (minor) project consequences, the full extent of the particular
risk can be seen.

4.0 Consideration of risk analysis

The risk analysis involves assigning probabilities to risks and evaluating how these
risks might be interconnected. To accomplish this, there are a variety of techniques
including sensitivity analysis, probability analysis, breakeven analysis, scenario
analysis, Monte Carlo simulation etc. are recommended. Before undertaking the risk
analysis, the followings factors are to be considered:

Type and Size of Project: Different projects have varying levels of complexity and
associated risks. The type and size of a project can influence the selection and
application of sensitivity and probability analysis techniques. Larger or more intricate
projects may require a more detailed and comprehensive analysis.

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Information Available: The availability of information is crucial for accurate risk

assessment. The level of detail and quality of information about potential risks should
be considered. In cases where data is limited, the analysis may be more challenging
and may require additional efforts to gather relevant information.

Cost of the Analysis and Time Available: Conducting sensitivity and probability
analyses involves costs and time. It is important to consider the financial resources
available for the analysis and the timeframe in which the analysis needs to be
completed. These factors may influence the depth and scope of the analysis
undertaken.

Expertise of the Analysts: The competence of the individuals conducting the

analysis is a critical factor who may impact the effectiveness of the sensitivity and
probability analyses. Skilled analysts are better equipped to navigate the
complexities of these techniques and provide more accurate assessments.

5.0 Risk Analysis Tools

In project risk management, the efficacy of strategic decision-making relies upon a

nuanced understanding and proficient utilization of risk analysis tools. These
sophisticated instruments serve as the bedrock for comprehensive risk assessment.
It offers systematic insights into the multifaceted risks inherent to project execution.
The following tools coalesce to fortify project managers with the analytical acumen
necessary to navigate uncertainties in the face of intricate project dynamics:
 Sensitivity analysis
 Probability analysis
 Scenario analysis
 Breakeven analysis
 Monte Carlo simulation analysis

5.1 Sensitivity analysis

In the construction industry, sensitivity analysis plays a crucial role in identifying key
variables that pose potential risks, capable of significantly influencing the success or
failure of a project. Variables such as weather conditions, material prices, and labour
availability are assessed to understand their impact on project timelines and costs.
The analysis involves calculating the project's impact across a range of values when
these variables undergo changes. The resultant effect on the project, whether
expressed in terms of NPV, IRR, time, or final cost, is important information.

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To illustrate, consider the risk associated with a potential 2.5%, 5%, 10%, or 15%
increase in the price of steel. The project's outcome is assessed for each of these
potential price fluctuations, and the findings can be graphically represented to
illustrate the percentage variation between the risk of steel price changes and
corresponding changes in project costs. By manipulating these variables, project
managers can effectively identify potential risks and strategically prioritize mitigation
strategies. For instance, they might explore bulk purchasing options, alternative
materials, or contracts that provide price stability.

Essentially, sensitivity analysis proves highly valuable as even a slight change in a

single variable, such as cost or duration, can result a significant impact on the overall
project outcome. When evaluating multiple risks through this method, a 'spider
diagram' serves as an efficient tool for visually presenting the most sensitive risks
(Figure 1). It guides the project manager's attention to those requiring immediate
action. This analytical approach extends to all potential project risks and
uncertainties, allowing for the identification of elements exerting substantial influence
on cost, time, or other project objectives.

Figure 1: Spider diagram to illustrate sensitivity of risk variables

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Hence, the sensitivity analysis can serve the purpose of highlighting the variables
suitable for inclusion in a probability analysis. This is due to the fact that in sensitivity
analysis, each risk is evaluated in isolation, without any effort to numerically quantify
the likelihood of its occurrence. In reality, changes in a variable are typically
intertwined with changes in other project factors, and this is overlooked in sensitivity
analysis.

In due course, as the user acquires proficiency, they can more readily discern risks
bringing significant influence on the project. As a result, the necessity to analyse a
multitude of risks reduces, allowing for a more streamlined focus on those with
substantial impacts.

4.2 Probability analysis

Probability analysis assigns likelihoods to various project risks, enabling project

managers to quantify the probability of specific events occurring. This may involve
assessing the likelihood of delays due to unforeseen weather events, regulatory
changes, or supply chain disruptions. Probability analysis helps in prioritizing risks
based on their likelihood and preparing contingency plans accordingly.

This technique can extend beyond the limitations of a sensitivity analysis by

specifying a probability distribution for each risk and then assessing the effects on
the risk events in total. However, careful interpretation of the results is essential. One
important stage in this type of risk analysis is assessing the range of probabilities
that could result.

4.3 Integration of Sensitivity and Probability Analysis in Risk Mitigation

Combining sensitivity and probability analysis in construction project risk

management provides a holistic understanding. For instance, sensitivity analysis
may identify project duration as a critical variable, while probability analysis
quantifies the likelihood of delays due to adverse weather conditions. Together,
these analyses inform decision-makers about the range of potential outcomes and
guide the development of risk mitigation strategies.

Besides, sensitivity analysis may reveal that the availability of skilled labor is a critical
variable affecting project timelines. Probability analysis can then assign probabilities
to scenarios such as a shortage of skilled labor. This integrated approach helps
project managers assess the overall risk to the project timeline and develop
contingency plans.

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4.3 Scenario Analysis

Scenario analysis is an approach used to evaluate the potential impact of various

future situations on the project's outcomes. It involves creating and exploring
different scenarios to assess how changes in key variables or external factors may
affect the project. It begins by identifying key variables that can significantly impact
the project's success. These may include factors such as weather conditions,
material costs, labour availability, regulatory changes, or unexpected site conditions.

Different scenarios are then developed based on variations in these key variables.
For example, scenarios may include variations in project duration due to adverse
weather, cost increases due to fluctuations in material prices, or delays caused by
unexpected site issues and labour availability etc.

Through scenario analysis, construction project managers can identify potential risks
and develop risk mitigation strategies. For each scenario, they can assess the
effectiveness of existing risk management plans and explore additional measures to
minimize the negative impact.

In resource planning, scenario analysis helps in optimizing resource allocation by

anticipating potential disruptions and allowing project managers to allocate
resources effectively based on the likelihood and severity of different scenarios.

Construction projects are dynamic, and external conditions can change. Scenario
analysis is not a one-time process but involves continuous monitoring and adaptation.
As new information becomes available, scenarios can be updated to reflect the
evolving nature of the project environment.

4.4 Integration of Scenario Analysis and Sensitivity Analysis

In a professional setting, scenario analysis and sensitivity analysis are powerful tools
used to assess and manage risk, aiding decision-making processes. Scenario
analysis involves constructing multiple plausible future scenarios to evaluate the
impact of various factors on a given outcome. It provides a holistic view of potential
outcomes under different conditions, enabling a comprehensive understanding of the
range of possibilities.

On the other hand, sensitivity analysis focuses on quantifying the impact of changes
in individual input variables on the output. It helps identify which factors have the

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most significant influence on the outcomes, offering a more granular understanding

of the system's sensitivity to specific variables.

When integrated, scenario analysis sets the stage by presenting a spectrum of

potential future states, while sensitivity analysis refines the understanding by
quantifying the sensitivity of outcomes to changes in key parameters within each
scenario. Together, they provide a nuanced and robust risk assessment framework,
allowing decision-makers to not only explore various future narratives but also to
discern the critical drivers shaping those narratives.

In a nutshell, scenario analysis paints the big picture, and sensitivity analysis zooms
in to scrutinize the details. This combined approach empowers professionals to make
more informed and resilient decisions, considering both the broader context of
potential scenarios and the specific sensitivities within each scenario. It is a strategic
approach that aligns with prudent risk management and strategic planning practices
in complex and dynamic construction environments.

4.4 Breakeven Analysis

In the realm of construction project risk management, breakeven analysis serves as

a valuable tool for assessing the financial viability and risk exposure of a project. It
essentially determines the point at which total revenues equal total costs, indicating
the threshold at which a project neither makes a profit nor incurs a loss (Figure 2).

Figure 2: Breakeven Analysis

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The breakeven analysis requires a meticulous breakdown of fixed and variable costs
associated with the construction project. Fixed costs might include overhead
expenses and certain project-specific costs that do not fluctuate with project scale,
while variable costs are influenced by project size and scope.

Employing sensitivity analysis within the breakeven framework helps evaluate how
variations in costs and revenues, driven by potential risks, affect the project's
financial position. Hence, identifying and assessing risks in a construction project is
integral to breakeven analysis. Risks may range from material price fluctuations and
labour shortages to regulatory changes and unforeseen site conditions. Each of
these risks can impact costs, potentially pushing the breakeven point further out
(taking longer duration to offset the cost).

By understanding the breakeven point and the variables influencing it, project
managers can develop strategies to mitigate risks. This may involve negotiating
fixed-price contracts, implementing cost controls, or incorporating flexible scheduling
to adapt to unexpected delays.

It is a decision-support tool, helping project managers and stakeholders make

informed decisions about project feasibility, pricing strategies, and risk mitigation
measures. For instance, if the breakeven point is deemed too high, the project team
may need to renegotiate contracts or reevaluate resource allocation.

4.5 Monte Carlo Simulation Analysis

The Monte Carlo Simulation is a powerful and versatile statistical technique used in
various fields, including project management, finance, and engineering. It models
the probability of different outcomes in a process that involves uncertainty. Named
after the famous Monte Carlo Casino, known for its games of chance, this method
relies on the generation of numerous random samples to approximate the
characteristic of a complex system. In the context of project risk management, Monte
Carlo Simulation helps quantify the impact of uncertainty on project variables. The
procedure is described as follows:

 Identifying Variables: Project managers first identify key variables that have
inherent uncertainty, such as project duration, resource costs, or market
conditions.

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 Defining Probability Distributions: For each variable, probability distributions

are assigned to represent the range of possible values and their likelihood. This
step captures the inherent variability in the project elements.

 Random Sampling: Monte Carlo Simulation involves generating a large

number of random samples from the defined probability distributions. Each
sample represents a potential scenario or iteration of the project.

 Calculating Project Outcomes: For each sample, the project model is run,
considering the randomly selected values for the variables. This process is
repeated thousands or even millions of times.

 Analyzing Results: The simulation produces a distribution of possible

outcomes, offering a comprehensive view of the project's potential performance.
This distribution provides insights into the likelihood of achieving different project
milestones or financial targets.

 Risk Assessment: By analysing the results, project managers can assess the
probability of meeting project goals, identify potential bottlenecks, and
understand the range of possible project outcomes. This informs decision-
making and risk mitigation strategies.

Monte Carlo Simulation is particularly beneficial in complex projects where various

factors contribute to uncertainty. It provides a probabilistic perspective, allowing
project managers to make more informed decisions by considering a spectrum of
possible scenarios and understanding the associated risks.

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Self-Assessment Questions
1. Considering the various risk analysis tools mentioned, such as sensitivity
analysis, probability analysis, scenario analysis, breakeven analysis, and Monte
Carlo simulations, discuss how these tools can be integrated synergistically to
provide a comprehensive risk management strategy for a construction project.
How does each tool complement the others in addressing different facets of risk?
2. Most significant decisions in a project are made during its early stages. How
does the systematic approach to risk analysis, encompassing both qualitative
and quantitative stages, contribute to making informed decisions during the initial
phases of a project? How might this early analysis impact the overall success of
the project?

3. Quantitative risk analysis involves assigning specific values to the likelihood and
impact of each risk. Discuss the potential challenges and limitations associated
with relying solely on quantitative analysis, especially when dealing with
uncertainties in project management. How might these challenges be mitigated?
4. Using the construction industry as a context, provide a detailed example of how
sensitivity analysis can be practically applied to identify and prioritize key
variables that pose potential risks in a construction project. How might the results
of sensitivity analysis inform decision-making and risk mitigation strategies for
project managers in this industry?

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