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“The first step in the risk management process is to acknowledge the reality of risk.
Denial is a common tactic that substitutes deliberate ignorance for thoughtful planning.”

                       
                        Charles Tremper Ph.D.
                        CIO AAHSA

 


ACM DL Author-ize serviceReturn at risk
Phillip G. Armour
Communications of the ACM, 2010

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%

Right?

No, not right.  This calculation is valid if and only if:

  • We have a 100% guarantee of cost containment at $1m (the project will not/can not over- or under-run) AND
  • We have a 100% guarantee of value returned at $1.1m.

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 :

COST:

  • 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

VALUE:

  • 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. 

Return at Risk