Introduction
Risk is an inherent component of projects. A wide array of approaches and techniques are available that can decrease uncertainty and mitigate undesirable outcomes. With these techniques in place, it is reasonable to expect a positive effect of risk on project cost management. The following report details the mechanisms behind the interconnection of the effects of risk and project cost management.
Risk
To establish the connection between risk and project cost management, it is first necessary to define both concepts and outline their key characteristic features. The first concept is a risk, which is commonly understood as a likelihood of the occurrence of a certain undesirable event. Risk is a broadly defined concept used in multiple domains outside project management. In the majority of cases, the risk is considered a potential source of hazard, either in the form of inflicted damage or deterioration in quality (Dionne 2013).
The literature on project management typically utilizes a definition given in the PMBOK guide, according to which risk is an uncertain event or condition that has the potential to impact some of the elements of the project (Roseke 2015). As can be seen, the definition differs from the generally accepted version in one important dimension – namely, the explicit acknowledgment of its negative impact. Instead, risk in project management is viewed as a threat to certainty.
It is also important to acknowledge the possibility of the phenomenon’s positive effect. From the economic perspective, the risk is commonly associated with the accompanying concept of reward. Some project management theorists go as far as considering risk an essential part of the economic activity (Hopkin 2017). Generally, the risk is inherent to more profitable opportunities due to the lack of certainty associated with them. In the simplest terms, the possibility of potential yield is inseparable from the possibility of a negative outcome. It is also worth mentioning that in some cases the definition introduces a possibility of misinterpretation.
Specifically, the linkage to the project’s objectives opens up the possibility of excluding certain risks by ascribing them to external stakeholders. This aspect can be used to downplay collateral damage or capitalize on the secondary benefits of the project outcomes. An example of the former would be the exclusion of interests of the impacted individuals from the equation, whereas the latter can be exemplified by an unexpected application of a relatively unsuccessful outcome to a suitable area. Thus, it is possible to specify the definition of risk used in the project management field as accounting for the possibility of both negative and positive impacts on project components.
Risk Types
As can be seen, risk as a part of the project management process encompasses a wider variety of options than its popular iteration. This distinction allows for the introduction of two types of phenomena. The first category, known as a pure risk, encompasses the situations where the hypothetical situation harbors a possibility of loss without the respective benefit. Thus, successful avoidance of such risk would allow avoiding negative effects without yielding positive returns.
The concept of pure risk, also referred to as insurable risk in the academic literature, is closer to the popular definition due to the lack of reward. The second type, known as business risk, encompasses both the possible negative and positive effects pertinent to an event. Typically, the said possibilities are mutually exclusive. The easiest example is an investment in innovative technology within an unexplored field which promises significant yield in the case of its successful adoption, while at the same time creating a possibility of failure resulting from the unforeseen barriers. Any project that relies on innovative practices as a means of achieving its goals deals with the described type of risk.
At this point, it is necessary to specify the most common approach to quantifying risk. In the most basic form, risk can be expressed as an estimation of its impact multiplied by the likelihood of its occurrence (Liu, Liu & Liu 2013). The estimated effect typically incorporates direct and indirect financial implications of the scenario, which allows producing a reliable metric. Admittedly, the described approach is limited in its implementation to the most basic cases due to its simplicity and lack of details. For instance, the magnitude and likelihood of monetary benefits can significantly alter the parameter.
Risk Management
With this in mind, it is possible to state that the most feasible way of addressing the identified risks is improving one of its determinants. Simply put, the risk is mitigated either by decreasing the likelihood of its occurrence or by minimizing the magnitude of the negative outcome. This reduction, termed risk mitigation in the academic literature, involves a certain amount of time and effort, usually expressed in the form of mitigation cost in the project’s plan (Talluri et al. 2013).
It is important to understand that complete elimination of risks is an unrealistic goal – in most cases, they are reduced to an acceptable level, which allows for the optimization of the expenses associated with the project. Consequently, the increase in the likelihood and magnitude of possible positive outcomes is expected to have the same effect. The described process is defined as risk management and is considered an important aspect of project management.
Depending on the specificities of a project, it can include a varying number of details and tools and can be integrated into the project’s monitoring practices. The scholarly literature contains an assortment of formal methods and tools to perform it with the desired degree of precision (Hopkin 2017). In some cases, it is possible to deviate from the formally accepted guidelines. Nevertheless, in the overwhelming majority of instances, risk management consists of four phases.
First, the risks pertinent to the project are identified. After this, their likelihood and magnitude of their impact is estimated and, if necessary, quantified. Third, feasible responses are developed that are expected to address the risks. Finally, the developed decisions are incorporated into the project’s plan (Talluri et al. 2013). During the project’s lifespan, the monitoring of risks is adjusted by the acquired knowledge.
Cost Management
The second important component of the equation is cost management. In the broadest sense, cost management is a set of activities aimed at the oversight and control of expenses (Kerzner 2017). Depending on a type of project, these expenses may include estimating and modeling, budgeting, funding, and managing of resources by the project’s plan. The primary goal of cost management is to ensure the compliance of the project with the allocated budget (Kerzner 2017). The practice usually encompasses the full life cycle of a project and is finalized during its completion.
The key components of cost management include cost estimation, cost budgeting, and cost control. Cost estimation is based on the approximation of the total cost of the activities included in the project throughout its life cycle. Depending on the specifics of financing schemes and resources available to the project’s management, the variables incorporated into the estimation may include human resources, inventory, equipment, facilities, and available services.
Understandably, for the projects that utilize formalized risk management procedures, risk mitigation costs are also included in the list. After the estimation is complete, it becomes possible to create the project’s cost baseline, which can then be used to draft the project’s budget. The baseline is formed by combining the costs of all of the planned activities and is used during the monitoring phase throughout the project’s life cycle. The baseline can be adjusted by changes in the project’s scope. Finally, once the baseline is approved, it can be used for the detection of deviations from the plan and measurement of their impact. Cost control provides data on the necessity of corrective actions and modeling the expected outcomes of the project.
Cost Management Phases
Cost management is typically performed as an integrative part of the project management process. Thus, it relies on generally accepted phases. During the initial phase, the planned procedures and actions are identified, and their expected cost is modeled. The resulting model is integrated into the final project plan. The data for the model can be extrapolated from previous experience or collected from primary and secondary sources describing similar or applicable cases.
Once the necessary data is obtained and processed, it is necessary to calculate the cost of activities. The calculations can be performed using one of two approaches. The analogous estimation is based on the data obtained internally or from the literature describing applicable projects whereas the parametric approach utilizes mathematical representation to arrive at the conclusions. Importantly, the information produced at this phase is subject to adjustment once new relevant data is available to the manager. The areas characterized by insufficient certainties, such as risks, are addressed by reserving costs for contingency.
Once the costs of each activity are determined, it can be mapped to a specific period, creating a comprehensive budgeting profile of the project. The profile is required to illustrate the expenses incurred at each stage of the project. This feature is used as a basis for project cost control, the final phase was initiated with the launch of the project and terminated after its completion. The results of the analysis are used to determine the success of the project and its consistency with the budget.
Effects of Risk on Project Cost Management
At this point, it becomes apparent that risks encountered during the project’s life cycle comprise a significant part of its cost management procedure. In the majority of cases, risks are associated with financial losses, and, as a result, require formal acknowledgment in the project’s documentation. More importantly, the planning and implementation of the risk mitigation strategies typically require a certain amount of expenses.
In other words, depending on the degree of accountability expected from the management and/or the responsibility demonstrated by the parties responsible for performance monitoring, the final document will include likely or scheduled risk-associated expenses. The former is more consistent with small-scale projects that rely on informal risk identification practices whereas the latter allows for a comprehensive cost management procedure supported by documentation.
The effects of risk on project cost management depend on the solutions chosen by project managers for minimization of its impact. Risk management techniques are typically based on one of four major approaches, with each having a different effect on cost management. The first approach is risk avoidance, also known as the elimination of risk (Pritchard 2015). This approach is used mostly for large-scale threats that cannot be addressed through other means. In addition to being inefficient from the operational perspective, the method can also result in the reduction of the project’s profitability by eliminating the risk-related benefits (Pritchard 2015). Therefore, this approach has a potentially disruptive impact on project cost management.
The second approach is risk acceptance. This is a polar opposite of avoidance since it does not involve any countermeasures for decreasing the risk’s effects (Pritchard 2015). However, it should not be confused with the lack of risk management efforts. Unlike an unrecognized risk, and accepted one is identified and assessed at the planning stage. Once its potential negative impact is considered negligible or surpassing the costs of its mitigation, the decision is made to proceed with the plan despite the possibility of risk.
From the cost management perspective, accepted risk has a certain amount of financial losses associated with it. However, in most cases, the cost of the strategy can be reliably covered by the resources from the mitigation fund, and the incurred losses can be estimated before the initiation of the project. Therefore, while the connection to cost management is apparent, it does not harbor the potential for disruption.
The third approach is risk transfer. This method is often used in projects involving multiple stakeholders. In a setting where the project is not governed by a central authority and, many parties are responsible for different tasks, it is reasonable to assign risk for deficiencies in each task to the respective group. For instance, the responsibility for the quality of a specific component of the final product (e.g. a wireless module in the computer hardware) can be transferred from the assembler of the PCs to the manufacturer of the unit.
In some cases, project members choose to distribute risk evenly within the team after all specific areas are taken by respective shareholders, in which case the practice is referred to as risk-sharing. As an alternative, the manager may choose to outsource some of the project’s functions to an external entity. This type of risk transfer is reserved for areas that fall outside the core competencies of the project’s team and does not have a significant impact on the total amount of risk faced by the management.
Another familiar example is insurance – an option to transfer risk by buying an insurance policy. In this case, the organization accepting the payment will retain the risk and will be required to cover the losses incurred in the case of the worst-case scenario. It is crucial to point out that in the latter case, the risk itself is not reduced either in likelihood or in severity. The sole aspect that is being addressed is the financial implications of a hypothetical situation. For instance, the manager of a project whose success depends significantly on unpredictable factors, such as weather effects, may choose to insure it against natural disasters. This action does not in any way impact the likelihood of an event or its destructive consequences – it only ascertains that the insurer will cover all incurred losses associated with it.
The fourth approach, risk mitigation, involves taking action aimed at reducing the likelihood or possibility of a hypothetical event before its occurrence by taking precautionary measures. This type combines elements from previous approaches as it requires a certain amount of acceptance, avoidance, and sharing (Pritchard 2015). Risk mitigation can be applied to different aspects of the project, including the protection of investments. The most important difference is the ability to address the core of the issue rather than the resulting financial impact, thus ensuring optimal allocation of resources. On the other hand, it cannot eliminate the issue – instead, it reduces it to a certain degree, which leaves space for uncertainty.
Impact Categories
The impact of risk on project cost management can be grouped into three basic categories. The first is project risk management outlined in the previous section. This category includes the expenses associated with practices and strategies aimed at preventing and mitigating the risks identified at the planning phase, analyzing the emergence of new ones, and tracking the effectiveness of the countermeasures.
The development and refinement of metrics used for risk analysis and compiling of the risk management reports also fall into this category (Hopkin 2017). Depending on the approach selected by the stakeholders, cost management can be performed in-house or with the help of an external party (e.g. an agency that provides risk management services).Understandably, the costs of the operations will differ in each case. Nevertheless, it is apparent that operational expenses at this stage are unavoidable and have an observable impact on project cost management.
The second category is the risk management infrastructure or the expenses associated with the implementation of the developed plan into the project’s life cycle. The practices in question include the development of strategies, programs, and policies intended for mitigation of the identified risks, employee training necessary for the effective use of the measures, and risk reporting practices utilized throughout the project’s life cycle. Similarly to project risk management, the infrastructure costs can be quantified relatively easily by combining resources allocated for the purpose.
The third category includes the cost of mitigating individual risks. This is the most diverse and least specific category since its scope and magnitude cannot be estimated with a reasonable degree of certainty. As a result, it also poses the greatest challenge to the project’s budget. The cost of project risk management and infrastructure can be reliably determined on the project’s planning phase by consulting with a human resource manager and incorporating historical data from similar activities.
However, to determine the cost of mitigating specific risks, it is necessary to identify their nature, likelihood, and expected impact. As was explained above, these parameters are required (but not necessarily sufficient) for the assessment of the risk value. Therefore, it is reasonable to assume that at least in some instances, several secondary factors may be required for an accurate evaluation. Also, the impact of risk in question can be associated with certain benefits, which should also be acknowledged in the evaluation. As can be seen, the specific risk category includes several variables that cannot be defined with a reasonable degree of certainty.
However, it is possible to expect that with responsible risk management practices in place, the adverse impact of risk on cost management will be minimal. On the one hand, the existing risk management infrastructure will provide the necessary resilience via mitigation strategies. Since the cost of these practices can be reliably determined in the planning stage, it will have no significant disruptive impact on the project’s cost. On the other hand, it can be expected that the most apparent and significant risks will be recognized and included in the risk mitigation programs and policies, thereby eliminating the need for additional expenses and, by extension, decreasing the uncertainty of cost management.
At this point, it is worth acknowledging that in a real-world setting, identifying and addressing all possible risks would be an unrealistic objective. Thus, the third category of risks will not be eliminated. However, it can be covered by funds allocated for the occasion. Thus, responsible risk management at the planning stage has the potential to minimize the risk-associated expenses and decrease uncertainty to the degree where it can be covered by mitigation funds.
Conclusion
As becomes apparent from the information above, the effect of risk on cost management is one-directional – the existence of risk requires certain countermeasures to avoid or decrease its adverse effects and, by extension, introduces necessary expenses. In addition to the decrease of losses, such an approach offers greater predictability and consistency of cost management practices. In the long run, such an approach also ensures the minimization of losses and compliance with the project’s budget, which are top priorities of project cost management. Understandably, the effect differs in magnitude depending on the approaches adopted by managers and the types of risk faced by the project.
It is also apparent that the opposite may occur, with irresponsible cost management introducing additional risks associated with the financial limitations of the project. Finally, in some cases, it is possible to capitalize on the advantages provided by certain risks, which contributes to a potential positive effect. Thus, it is safe to conclude that risk and project cost management have the capacity for a mutual effect.
Reference List
Dionne, G 2013, ‘Risk management: history, definition, and critique’, Risk Management and Insurance Review, vol. 16, no. 2, pp. 147-166.
Hopkin, P 2017, Fundamentals of risk management: understanding, evaluating and implementing effective risk management, 4th edn, Kogan Page Publishers, New York, NY.
Kerzner, HR 2017, Project management: a systems approach to planning, scheduling, and controlling, 12th edn, John Wiley & Sons, Hoboken, NJ.
Liu, HC, Liu, L & Liu, N 2013, ‘Risk evaluation approaches in failure mode and effects analysis: a literature review’, Expert Systems with Applications, vol. 40, no. 2, pp. 828-838.
Pritchard, CL 2015, Risk management: concepts and guidance, 5th edn, CRC Press, Boca Raton, FL.
Roseke, B 2015, Project risk management according to the PMBOK. Web.
Talluri, SS, Kull, TJ, Yildiz, H & Yoon, J 2013, ‘Assessing the efficiency of risk mitigation strategies in supply chains’, Journal of Business Logistics, vol. 34, no. 4, pp. 253-269.