LESSON

15

engineering
ECONOMICS
 objective

• Students should be able to describe the basic features of decision-

making.

• Students should be able to construct a payoff table and a decision tree

analysis.

• Students should be able to define and apply the expected value

criterion for decision-making.
 DECISION
RECOGNIZING RISKS
 DECISION RECOGNIZING RISKS
Risk-based decision-making provides a process to ensure that optimal decisions,
consistent with the goals and perceptions of those involved are reached. This process
ensures that all available information is considered and used as appropriate to the
decision at hand.

Definition of terms
1. Risk – the potential that a decision will lead to a loss or an undesirable outcome.
2. State of Nature – an occurrence of a situation over which the decision maker has little or no
control.
3. Alternative – a course of action or strategy that may be chosen by the decision maker.
4. Payoff Table – is a listing of all possible combinations of decision alternatives and states of
nature.
 01
Expected 03
Monetary Value decision tree
(EMV) in risk analysis
topics management

02
payoff table
analysis
 01.
Expected
Monetary
Value (EMV)
 Expected Monetary Value (EMV)
It is the sum of possible payoffs of the alternative, each weighted by the
probability of that payoff occurring. The expected monetary value prepares the
analyst to calculate the expected value.

For each decision alternative and select the alternative giving the best-expected
value. In other words, it is the sum of weighted payoffs for the alternative. The
weight for a payoff is the probability of associated (related) states of nature.

The Expected Monetary Value is how much you can expect to make from a
certain decision.
 Emv analysis in risk management
probability
Probability is the likelihood that any event will occur.

Example
If you toss a coin, there is a 50% chance of showing heads and a 50% chance of showing tails. So, you say the probability of
showing heads or tails is 50%.

The formula to calculate the probability is:

The probability of an event happening = (Number of favorable events that can occur) / (Total number of events)

Total number of events = 2 *because the coin can either show heads or tails
Total number of favorable events = 1 *assuming it’s favorable to show heads
The probability of showing heads = (Number of favorable events) / (Total number of events)
= 1/2
= 50%

So the probability of showing heads is 50% if you toss the coin.

 Emv analysis in risk management
Impact
the amount you will spend if a given identified risk occurs.

Example
You have identified that equipment may break during your project, and new equipment will cost you
2,000 USD.

So, the impact of the risk will be 2,000 USD.

This is a description of the impact.

 Emv analysis in risk management
Expected Monetary Value (EMV) Formula
Expected Monetary Value (EMV) = Probability * Impact

• You will add the EMVs of all risks if you have multiple risks. This will be the expected monetary
value of the project.
• You will calculate the EMV of all risks, regardless of whether they are positive or negative. The
EMV will be negative for negative risks and positive for positive risks.
• Once you calculate the expected monetary value of the project, you will add it to your work costs
estimate and generate the cost baseline. This amount is called the contingency reserve.
• The sum of the EMV of all events is the contingency reserve.
 Emv analysis in risk management
For example, let’s say you have four risks with probabilities and impacts as follows:

You might think you need 4,500 USD to manage

all risks, but that is incorrect. Among all the
identified risks, only a few will occur. The risks
that do not occur will add their EMV to the pool,
and the risks that do occur will use that money.

So, you will need 1,100 USD to cover all identified

risks in this case.

The expected monetary value concept works well to calculate the contingency reserve when you have many risks because
the more you identify, the better your contingency will cover them.
 Emv analysis in risk management

EXPECTED MONETARY VALUE

OF ALTERNATIVES
Steps to Calculate Expected Monetary Value (EMV) in project risk management:
1. Assign a probability of occurrence for the risk.
2. Assign the monetary value of the impact of the risk when it occurs.
3. Multiply Step 1 and Step 2.

Note: This value is positive for opportunities (positive risks) and negative for
threats (negative risks).
 Emv analysis in risk management
Example
You have identified a risk with a 30% chance of occurring. It may cost you 500 USD. Calculate the
expected monetary value for this risk event.

Given: Solution:
The probability of risk = 30% Expected monetary value (EMV) = probability * impact
Impact of risk = – 500 USD
EMV = 0.3 * – 500
EMV = – 150

The expected monetary value (EMV) of the risk event is –150 USD.
 Emv analysis in risk management
Example
You have identified an opportunity with a 40% chance of happening. However, it may help you gain
2,000 USD. Calculate the expected monetary value (EMV) for this risk event.

Given: Solution:
The probability of risk = 40% Expected monetary value (EMV) = probability * impact
Impact of risk = 2,000 USD EMV = 0.4 * 2,000
EMV = 800

Hence, the expected monetary value of the risk event is 800 USD.
 Emv analysis in risk management
Example
You have identified two risks with a 20% and a 15% chance of occurring. They will cost you 1,000 USD and 2,000 USD
if both happen. What is the expected monetary value of these risk events?

Given:
The probability of risk = 20% and 15%
Impact of risk = -1,000 and -2,000 USD

Solution:
The expected monetary value of two risk events = EMV of the first event + EMV of the second event
EMV of the first event = 0.20 * (–1,000)

EMV of the first event = -200

 Emv analysis in risk management
Cont.
Solution:
The expected monetary value of two risk events = EMV of the first event + EMV of the second event
EMV of the second event = 0.15 * (–2,000)
EMV of the second event = -300

EMV of these two risks events = (–200) + (–300)

= -500

The expected monetary value of these two events is –500 USD.

 Emv analysis in risk management
Example
During risk management planning, your team has identified three risks with probabilities of 10%, 50%, and 35%. If
the first two risks occur, they will cost you 5,000 USD and 8,000 USD; however, the third risk will give you 10,000 USD
if it occurs.

Determine the expected monetary value of these risk events.

Solution:
The expected monetary value of three events = EMV of the first event + EMV of the second event + EMV of the third event

EMV of the first event = 0.10 * (–5,000)

EMV of the first event = -500
 Emv analysis in risk management
Cont.
EMV of the second event = 0.50 * (–8,000) EMV of the third event = 0.35 * 10,000
EMV of the second event = - 4,000 EMV of the third event = 3,500

The expected monetary value of three events = EMV of the first event + EMV of the second event + EMV of the third
event
The expected monetary value of three events = – 500 – 4,000 + 3,500
The expected monetary value of three events = –1,000

The expected monetary value (EMV) of all three events is –1,000 USD.
 Emv analysis in risk management
Expected monetary value also helps you with selecting the right choice.

For example, you have a risk and identified two risk response strategies to manage this risk. How
will you select the best strategy?

Calculate the expected monetary value for each response and select the one that is the lowest.
 Expected Monetary Value (EMV)

List possible actions or events

 02.
payoff table
analysis
 Payoff table analysis
A Payoff table shows alternatives, states of nature, and payoffs.

The Expected Payoff or the Expected Monetary Value (EMV) is the expected value for each decision.

Steps:
STEP 1: Calculate probabilities of outcomes
STEP 2: Calculate all possible outcomes
STEP 3: Fill the outcomes to the payoff table
STEP 4: Make a decision
 Payoff table analysis
example
Mr. Luck runs a small shop with milk products.

He buys his products for $10 and sells them for $15.

The product is not possible to store, any unsold item is scrapped at the end of the day at a scrap value of
$2 per product.

Supplies of products to the shop are made before the number of sales is known, however, Mr. Luck has
records about the last 150 days’ sales.

Based on the records the sales were:

50 days of 150 days - 150 products sold
70 days of 150 days - 200 products sold
30 days of 150 days - 100 products sold
 Payoff table analysis
Cont.

STEP 1: Calculate probabilities of outcomes:

150 products will be sold with a probability of 50 days/150 days, which is 0.33
200 products will be sold with a probability of 70 days/150 days, which is 0.47
100 products will be sold with a probability of 30/150 days, which is 0.2

STEP 2: Calculate all possible outcomes:

E.g. if supply is 150 and sales are also 150, the profit is 150*(15-10)=$750;
however if supply is 150 and sales are only 100, the profit will be 100*(15-10)+50*(2-
10)=$100
 Payoff table analysis
Cont.

STEP 3: Fill the outcomes to the payoff table.:

 Payoff table analysis
Cont.
STEP 4: Make a decision:
• Maximax (risk seeker) - choose the best -
order a supply of 200 products

• Maximin (risk averse) - choose the outcome

with the highest expected return under the
worst possible conditions - order a supply of
100 products

• Using expected values (EV - risk neutral Using EV we should choose an order of 150 products.
approach) - calculate the EV of each choice
using probabilities - e.g. EV of outcome 150
ordered, 150 sold is $750*0.33. See the
following table:
 Payoff table analysis
Cont.
• Minimax regret - outcome with the lowest possible regret (opportunity costs) - regret is calculated as a difference between the best
outcome profit and other choices, see the table:

• So based on the minimax regret decision rule we should choose an order of 150 products.
 03.
decision tree
analysis
 Decision tree analysis
A schematic representation of several decisions followed by different chances of
occurrence.

Decision tree analysis implementation steps

1. List all the decisions and prepare a decision tree for the project management

situation.

2. Assign the probability of occurrence for all the risks.

3. Assign the impact of a risk as a monetary value.

4. Calculate the Expected Monetary Value (EMV) for each decision path.
 Decision tree analysis
example
Suppose you are a project manager of a power plant project and there is a penalty in your contract with the main client
for every day you deliver the project late. You need to decide which sub-contractor is appropriate for your project’s
critical path activities. But while selecting a sub-contractor, you should take into consideration the costs and delivery
dates.

• Sub-contractor 1 bids $250,000. You estimate that there is a 30% possibility of completing 60 days late. As per your
contract with the client, you must pay a delayed penalty of $5,000 per calendar day for every day you deliver late.

• Sub-contractor 2 bids $320,000. You estimate that there is a 10% possibility of completing 20 days late. As per your
contract with the client, you must pay a delayed penalty of $5,000 per calendar day for every day you deliver late.

You need to determine which sub-contractor is appropriate for your project’s critical path activities. Both sub-
contractors promise successful delivery and high-quality work.
 Decision tree analysis
Step 1:
List decisions and prepare a decision tree for a project management situation.
 Decision tree analysis
Step 2:
Assign the probability of occurrence for the risks.
 Decision tree analysis
Step 3:
Assign the impact of a risk as a monetary value.
 Decision tree analysis
Path values are calculated by the formulas given below.

Sub-Contractor 1
Path value of completing on-time = Bid Value = $ 250,000
Path value of being late = Bid Value + Penalty = $ 250,000 + 60 x $5,000 = $ 550,000

Sub-Contractor 2
Path value of completing on-time = Bid Value = $ 320,000
Path value of being late = Bid Value + Penalty = $ 320,000 + 20 x $5,000 = $ 420,000
 Decision tree analysis
Step 4:
Calculate The Expected Monetary Value (EMV) for each decision path.

Sub-Contractor 1
EMV = %30 x $ 550,000 + %70 x $ 250,000 = $ 340,000

Sub-Contractor 2
EMV = %10 x $ 420,000 + %90 x $ 320,000 = $ 330,000

Expected Monetary Values (EMV) are very close. Now we are selecting Contractor 2
because of the low cost and low possibility of being late.
takeaways
 Expected Monetary Value (EMV)

Benefits of emv analysis

• It gives you an average outcome of all identified uncertain events.
• It helps you to calculate the contingency reserve.
• In a decision tree analysis, it helps select the best choice.
• It does not require any costly resources, only experts’ opinions.
• It helps you with a make-or-buy decision during the plan procurement
process.
 Expected Monetary Value (EMV)

Drawbacks of EMV Analysis

• This technique is uncommon in small and small-medium-sized projects.
• This technique involves expert opinions to finalize the probability and
impact of the risk; personal bias may affect the result.
• This technique works better when you have many risks.
• If you miss a positive risk, it will affect the outcome.
 Expected Monetary Value (EMV)

summary
Expected monetary value analysis makes it easier to quantify risks, calculate
the contingency reserve and help you select the best choice in a decision tree
analysis. Your risk attitude should be neutral during this process; otherwise,
your calculation may suffer. Moreover, the reliability of this analysis depends
on the input data. A data quality assessment should be thoroughly performed.
This technique increases the confidence level in achieving the project
objectives.
“Successful investing is about managing risk,
not avoiding it.”

— BENJAMIN GRAHAM