Risk Management Essay
RISK MANAGEMENT ESSAY The following essay has been written by analyzing the risks associated from the construction managers/ project managers’ point of view. Citing the possible risks associated while working on international or varied geographical location. Risks are associated with almost all levels of the project life cycle and is mutually shared and mitigated by all parties employed within the construction industry.
There are many evidences to state that poor risk mitigation leads to poor performance and hence establish risk management processes and practices are required to be adhered to in order to turn any project’s outcome into a success. The 2000 edition of the Guide to the Project Management Body of Knowledge (PMI,2000) states that a project risk is : ‘An uncertain event or condition that, if it occurs, has a positive or negative effect on a project outcome’. Risks can be broadly classified into 2 categories- speculative risk and pure risk.
Speculative risks can be both positive and negative whereas pure risks are mostly negative by nature. Risk can be defined as the ‘variability of return from an investment’ risk analysis play an important role in any project. All projects are prone to some kind of risk or the other. All projects are appraised making certain assumptions and such assumptions are unavoidable since no 2 projects are unique in all respects and hence a new project cannot be compared with an identical project that was executed in the past. Though there may be similarities in 2 projects, exactly identical projects do not exist.
KINDS OF RISK IN A PROJECT (in the built environment) Projects face a host of risks such as, ? PROJECT COMPLETION RISK Completion of the project in time and within the estimated cost is itself a major achievement. A project that is delayed will result in time over run which will subsequently lead to a cost over-run. If the project promoters are not able to pump in additional funds required to meet the cost over-run, then the project runs the risk of coming to a grinding halt. Also delayed implementation means an increase in interest commitments on the borrowed funds.
When the project promoters find it difficult to meet the interest commitment during the implementation phase, the lenders may not be prepared to fund the project additionally to meet the cost over-run. There can also be technology failures, which may result in the non completion of the project. For projects with long gestation periods in the field of fast developing technology, there is a risk of project not being completed due to technological obsolesce during the course of project implementation. 12 | P a g e ? RESOURCE RISK
Raw material, power, fuel, manpower etc are the resources used by a project. Shortage of raw materials may lead to a reduction in capacity utilization and higher cost of production which will make all profitability estimates wrong. Similarly, shortage of power, fuel, and shortage of skilled manpower will also jeopardize the project profitability, calculations and the project may run the risk of not earning the estimated returns. ? PRICE RISK Price fluctuations of both inputs and outputs (ie, raw material and finished products) affect the project.
Unforeseen happenings such as government’s intervention in price fixation ability of competitors to offer their product to customers at a comparatively cheaper price etc, are likely to have an adverse impact. ? TECHNOLOGY RISK Technology risk may appear in two forms. A project that is based on unproven technology may have hidden defects which may make the project obsolete in technology due to evolution of latest technology. ? POLITICAL RISK Political risk is a major risk as it cannot be predicted easily.
The government intervenes in many forms such as levying and regulating taxes, regulating monopolistic trade practices, imposing import duties, promoting inputs, price – control, ex-proration, nationalization etc. ? INTEREST RATE RISK Fluctuations in interest rate may bring in an adverse effect. For example, if a project is funded by way of long term borrowings at a particular rate of interest, and if the interest rate falls down subsequently the project that availed long term borrowings at a higher interest rate has service the loan only at a higher rate of interest, unless it makes alternative arrangements o mobilize funds at the prevailing interest rate and swap the old borrowings which is a difficult proposition. New entrants who set up similar projects may have access to long term loans at the prevailing rate of interest which may be cheaper. In such a situation, projects that were implemented with high cost borrowings will find it difficult to compete with the new entrants. On the other hand if the interest rate increases in the future, the interest on working capital finance (which normally carries a floating interest rate) increases which will result in lower profit margins than estimated at the time of project appraisal. nterest rate risks can be managed to some extent by entering into interest rate hedging agreements like ‘interest cap’, ‘interest swap’ etc. 13 | P a g e ? EXCHANGE RATE RISK Exchange rate risk, also called as ‘currency risk’ is the risk arising from currency fluctuations. Volatile exchange rates can reduce cost and productivity advantages gained over years of hard work. Firms exposed to international economy face this risk.
When a firm has already committed to a foreign currency denominated transaction, the firm is exposed to a exchange rate risk. The firm will incur a loss if the exchange rate of the foreign currency has moved adversely and will earn profits if the exchange rate is moved favorably. Many exchange rate risk hedging tools such as forward cover, leads and lags, currency options, currency swaps etc are available which can be efficiently made use of to maneuver exchange rate risk. TECHNIQUES OF RISK ANALYSIS BREAK EVEN ANALYSIS
The financial viability of a project is estimated by making various assumptions like the cost of raw material, cost of consumables, cost of labor, expected sales realization, expected capacity utilization of the plant etc. after implementation, the project starts earning profit or starts incurring loss depending on the actual sales volume that it could achieve, the actual cost of inputs, the actual sales realization etc of these factors, the , the cost of the inputs and the cost of outputs are decided by the cost of market forces.
Of these factors, the only thing that is under the control of the project promoter is the level of output (ie. Capacity utilization). Hence it is very essential to know the level of operation below which the project will incur losses. Breakeven point (BEP) refers to the level of operation at which the project neither incurs profit nor incurs loss. Calculation of BEP for the given cost and price levels indicates the minimum capacity utilization that the project should aim at in order to be in a no-profit, no-loss situation.
BEP also helps in identifying the level of profit/loss for a specified level of operation and the level of operation required to attain a specified profit/to avoid a specified loss etc. Break even analysis starts with dividing the costs into two broad heads, viz, fixed costs and variable costs Fixed costs: all projects incur certain costs that are fixed in nature. These costs remain constant irrespective of the changes in the volume of output. Variable costs: these are those costs that vary directly with the level of output.
Raw material cost is a variable cost since it depends on the level of output. SENSITIVITY ANALYSIS It is a technique that measures the changes in the profitability of a project caused by changes in the factors that affect the cash inflows of the project. If a small change in one factor leads to a major change in profitability of the proposed investment, the project is considered more sensitive to that factor, in other words the project is more risky. Sensitivity of a project is checked by observing the response of any measure of profitability to changes in critical factors. 4 | P a g e DECISION TREE ANALYSIS Decision tree analysis is a graphical technique that can be used for analyzing the pros and cons of alternative decisions and choosing the best possible course of action. A decision tree is a diagrammatic representation of the logical relationship between the different parts of a complex situation and the possible outcomes of different decisions. A decision tree is made up of nodes and branches where nodes are of two types, viz, decision node and chance node. MONTE CARLO SIMULATION Monte carlo’ is a code name given by Von Newmann and Ulam to the technique of solving problems using random numbers. Monte carlo technique can be used to solve a variety of problems involving stochastic situations. It is a very popular technique and it uses random numbers to solve problems requiring decision making under uncertainty where a mathematical solution is highly complex/impossible. GAME THEORY In real life situations, business firms compete with one another. Game theory deals with situations in which two intelligent opponents have conflicting interests.
To achieve their goals, the two firms will form strategies. The strategy that one firm forms will depend on the strategy that the other firm has already formed / in the process of forming. The objective of the game theory is to develop a rational criterion for the selection of a strategy/ strategies by each player since games are rooted in conflict of interest, the optimal solution selects one or more strategies for each player in such a way that any change in the chosen strategies does not improve the benefit to either player.
SWOT ANALYSIS SWOT analysis is also known as the strength, weakness, opportunity and threat analysis. Swot analysis is done in many situations like mergers and acquisitions, take over and declining trends in profit etc. SWOT analysis can also be done in the absence of the above situations to improve upon the competitive edge of an organization and also to avoid any pitfalls lying ahead that may hamper the growth of the organization.
Project appraisal is an area where Swot analysis is of immense help, particularly when project appraisal is done for expansion/ diversification activities. 15 | P a g e REFERENCES School of the built environment, Heriot Watt University, 2009, Value and Risk Management Project management professional study guide, 1998 Risk management and construction – Roger Flanagan & George Norman Modern construction management (5th edition) – Harris and Mc Caffer.