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“The first step in the risk management process is to acknowledge the reality of risk.
Return is not what we think it is
Ok, so we have a project that will cost us $1m and we expect a net return of $1.1m. This gives us a Return on Investment (ROI) of
$1m/$1.1m * 100% = +10%
No, not right. This calculation is valid if and only if:
The moment we introduce <100% probability of cost containment and/or value returned into this situation, not only does the answer change, the calculation changes.
If probability is less...
Under a typical set of project: If :
- The expected cost of the project is $1m, but it could be as low as $900,000 and as high as $1.5m
- The probability of achieving the $1m cost is only 20%
- The cost probability profile is a beta distribution
- The expected net return on the project is $1.1m--it could be as low as $900,000, but it won't exceed $1.1m
- The probability of achieving the $1.1m return is only 20%
- The value probability profile is a reverse beta distribution
Then the Risk-Weighted Return is actually around:
MINUS 22% (!) This project will likely lose around $295,875.
The difference is the Cost of Risk. The failure of organizations to (a) recognize the cost of risk (b) calculate it and (c) factor it into their business commitments is one of the major reasons why software projects are under-resourced at inception, overly stressed in progress, and fail in implementation.
Risk Weighted Return Calculator
I have developed a "Risk Weighted Return" Calculator, if anyone is interested. Drop me a line.