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Agribusiness Project Management

August 2017
Session 7:
Project Risk Management
What is a Risk?

A risk is a future event that may or may not happen, but if it


does occur it will have an effect on project scope, cost,
schedule or quality.
A risk may have one or more causes and, if it occurs, it
may have one or more impacts.
All project activities carry some elements of risk, which are
uncertainties about them that could affect the project for
better or worse.
Project Scope

May Project Cost


occur
what is Project Time
effect on
Risk Project Quality
is a future
event that

May not
happen
Difference between
Business Risks and Project Risk

Business risks are more general and relate to


organization, whereas project risks are relating
specifically to project objectives.
Business risk implies uncertainty in profits or danger
of loss and the events that could pose the risk due to
some unforeseen events in future, which causes
business to fail.
Project risk is an uncertain event or condition that, if it
occurs, has a positive or negative effect on the projects
objectives.
Example of Business Risks and Project Risk

Project scope to build a cannery to the greed


specification within the agreed timescale and budget.
Project risk that the cannery building cost may be
higher than expected because of an increase in
materials or/and labor costs.
Business risk even if the cannery is constructed on
time and within the budget that it will not make money
for the business. This could be because of lower than
expected sales or higher than expected maintenance
costs or exported production transportation cost. These
risks exist outside of the scope of the project, they are
related to post-project period of the projects product
(in our case the cannery construction) life cycle.
Risks Tolerance

Organizations and stakeholders are willing to accept


varying degrees of risk. This is called risk tolerance.
Risk that are threats to the project may be accepted if
they are in balance with the rewards that may be gained
from taking these negative risks.
For Example:
Using unproven productivity-busting software is a risk taken
in expectation that the work will be completed more quickly
and with fewer resources.
The risk of the software not performing as advertised would
need to be considered as part of the risk assessment.
Risks Causes and Outcomes

Risks are caused by a requirement, constraint or


condition that creates the possibility of negative or
positive outcomes.

Requirements,
Potential
Assumptions,
RISKS positive or
Constraints or
negative
Conditions
outcomes
can cause
Causes Event -Consequences

Causes Event Consequences


Example of Risks Causes and Outcomes

Risk Cause change in health and safety legislation


during the build phase of our cannery project.
Risk Outcome increased cost to modify the parts of the
cannery in accordance with the new legislation before it
can used.
Project Impact on cost, schedule and performance
needs to assessed:
Shortage of skilled personnel due to demand by other
building projects
Unexpected cost of inspection and license
The build of the affected parts of the cannery can be
brought forward to finish project on time.
Risks Averse and Risk Prone

Risk averse - someone who does not want to take risks.


Risk prone - someone who is willing to take big risk.
All organizations have a risk tolerance that is affected
by their legal status and their culture. For instance, a
pension fund is likely to be more risk averse than a small
start-up company.
Risk appetite - the degree of uncertainty an entity is
willing to take in anticipation of a reward.
What is Project Risk Management?

Project risk management is actively managing the risks


on your project: to increase the probability and impact
of positive events and decrease the probability and
impact of negative events in the project.

The goal of risk management is to be more proactive


and less reactive.
Why Risk Management?

A project managers work should not focus on dealing


with problems; it should focus on preventing them.

Performing risk management helps prevent many


problems and helps make other problems less likely.
Risk Factors

1. The probability the risk will occur.


2. The range of possible outcomes - risk impact.
3. When in the project lifecycle the risk is likely to occur -
risk timing.
* once the expected timeframe of the risk has passed and it
is no longer a risk, it can be removed from the risk list.
4. How often the risk is expected to occur on the project -
risk frequency.
Known and Unknown Risks

Known risks are those that have been identified and


analysed, making it possible to plan responses for those
risks.
Known risks (known unknowns) that can be
managed proactively should be assigned a contingency
reserve during budget development.
Unknown risk (unknown unknowns) cannot be
managed proactively and may be assigned a
management reserve during cost baseline development.
Project Risk Management Processes
Plan Risk Management the process of defining how to conduct risk
management activities for a project.
Identify Risks the process of determining which risks may affect
the project and documenting their characteristics.
Perform Qualitative Risk Analysis the process of prioritizing of
risks for further analysis or actions by assessing and combining their
probability of occurrence and impact.
Perform Quantitative Risk Analysis the process of numerically
analyzing the effect of identified risks on overall project objectives.
Plan Risk Responses the process of developing options and
actions to enhance opportunities and reduce threats to project
objectives.
Control Risks the process of implementing risk response plans,
tracking identified risks, monitoring residual risks, identifying new risks
and evaluating risk management process effectiveness throughout the
project.
Plan Risk Management

Careful and explicit planning enhances the probability of


success for other risk management processes.
Planning is important to provide sufficient resources and
time for risk management activities and to establish an
agreed-upon basis for evaluating risks.
The Plan Risk Management process should begin when
the project is commencing and should be completed at
early during project planning.
Risk Management Plan

Methodology. Defines the approaches, tools and data


sources that will be used to perform risk management on
the project.
Roles and responsibilities. Defines lead, support and
risk management team members for each type of activity
in risk management plan and clarify their responsibilities.
Risk Management Plan

(Continuation):

Budgeting. Estimates funds needed, based on the assigned


resources, for inclusion in the cost baseline and establishing
protocols for application of contingency and management
reserves.
Timing. Defines when and how often the risk management
processes will be performed throughout project life cycle,
established protocols for application of schedule
contingency reserves, and establishes risk management
activities for inclusion in the project schedule.
Risk Management Plan

(Continuation):

Risk categories. Provide the means for grouping


potential causes of risk.
Risk Breakdown Structure (RBS) help project team to
look at many sources from which project risk may arise.
Probability and impact matrix. Is a grid for mapping
probability of each risk occurrence and its impact on
project objectives if risk occurs. Risks are prioritized
according to their potential implication for having an
effect on projects objectives.
Risk Breakdown Structure

Project

Project
Technical Organizational
Management

Limited Design
Funding Estimates
Time

Specifications
Prioritization Scheduling
Adherence

Resource
Communication
Availability
Probability and Impact Matrix

Impact Negligible Minor Moderate Significant Severe


Probability
> 81% Low Risk Moderate High Risk Extreme Extreme
Risk Risk Risk
61 80% Minimal Low Risk Moderate High Risk Extreme
Risk Risk Risk
41 60% Minimal Low Risk Moderate High Risk High Risk
Risk Risk
21 40% Minimal Low Risk Low Risk Moderate High Risk
Risk Risk
< 20% Minimal Minimal Low Risk Moderate High Risk
Risk Risk Risk
Identify Risks: Things to remember

Identify Risks cant be completed without the Project


Scope Statement and Work Breakdown Structure (WBS).
Identify Risks happens at the beginning of the project and
continues throughout the project.
Risks can be identified at any time and during any phase
of the project.
Risk management is an iterative process, you should
work to identify risk during any changes to the project,
working with resources and when dealing with issues.
Identify Risk - Risk Register

Risk register includes:

List of identified risks


List of potential responses
Root causes of risks
Updated risk categories
Perform Qualitative Risk Analysis

Things to remember:

Perform Qualitative Risk Analysis is subjective

What is the probability of the risk occurring? High,


medium, low?

What is the impact if the risk does occur? High,


medium, low?
Perform Qualitative Analysis:
Tools and Techniques - Risk Register Updates

Risk ranking for the project compared to other projects


List of prioritized risks and their probability and impact
ratings
Risks grouped by categories
List of risks for additional analysis and response
Watchlist (non-critical risks)
Trends
Perform Quantitative Risk Analysis

Purpose of this process:


Determine which risk events warrant a response.
Determine overall project risk (risk exposure).
Determine the quantified probability of meeting project
objectives.
Determine cost and schedule reserves.
Identify risks requiring the most attention.
Create realistic and achievable cost, schedule, or scope
targets.
Perform Quantitative Risk Analysis
Sensitivity Analysis

To determine which risks have the most potential impact


to the project.
Changing one or more elements/variables and set other
elements to its baseline then see the impact.
One typical display of sensitivity analysis is the tornado
diagram.
Tornado diagram is useful in analyzing risk taking
scenarios.
They provide the positive and negative impact of each
risk on the project and let you decide to choose which
risk to take.
Tornado diagram

Conversion 35% 25% 45%

Price $25.5 $20.5 $29.5

Inflations 5.5% 10.5% 2.5%

FX rate 3.45 4.30 3.00

0 2 4 6 8 10 12 14 NPV, $ Mln

High

Low
Perform Quantitative Risk Analysis: T & T

EMV Expected Monetary Value What is the


probability of the risk occurring multiplied by the impact if
the risk does occur? If the risk occurs, what could the
financial or time loss be to your project?
In the example below, this project has an EMV of
($58 250), this means that you need to put aside
$58 250 in your risk reserve account for potential risks.
Risk Probability Impact EMV
A 20% $ (100 000) $ (20 000)
B 90% $ 10 000 $ 9 000
C 5% $ 30 000 $ 1 500
D 65% $ (75 000) $ (48 750)
Total $ (58 250)
Outcome of Quantitative Risk Analysis

Risk Register Updates:


Prioritized list of quantified risks
Amount needed for contingency reserves for time and
cost
Confidence levels of completing the project on a certain
date for a certain amount of money
The probability of delivering the project objectives
Trends - risk management is an iterative process; as
you repeat the process you can track your overall
project risk and determine the trend (if you are
decreasing or increasing the level of risk on your
project).
Outcome of Quantitative Risk Analysis:
Examples

What are the risks that are most likely to cause trouble?
Can they affect the critical path? Which of them needs the
most contingency reserve?
The project requires another $50 000 and two months of
time to accommodate the risks on the project
We are 95 % confident that we can complete this project
on May 25th for $989 000 budget
We only have a 75 %chance of completing the project
within the $800 000 budget.
Plan Risk Responses

Eliminate the threats before they happen


Make sure opportunities happen
Decrease the probability and/or impact of threats
Increase the probability and/or impact of opportunities
For Residual Threats
Contingency Plans
Fallback Plans
Risk Response Strategies

RISK

Opportunities Threats

Accept Avoid
Exploit

Transfer
Enhance

Active Passive Mitigate


Share

Contingency
Fallback Plan Workaround
Plan
Strategies for Negative Risks or
Threats
Avoidance

Risk prevention
Changing the plan to eliminate a risk by avoiding the
cause/source of risk
Protect project from impact of risk

Examples:
Change the supplier / engineer
Do it ourselves (do not subcontract)
Reduce scope to avoid high risk deliverables
Adopt a familiar technology or product
Mitigation

Seeks to reduce the impact or probability of the risk


event to an acceptable threshold.
Be proactive: Take early actions to reduce
impact/probability and dont wait until the risk hits your
project.

Examples:
Staging - More testing - Prototype
Redundancy planning
Use more qualified resources
Transfer

Shift responsibility of risk consequence to another party


This does NOT eliminate the risk
Most effective in dealing with financial exposure.

Examples:
Buy/subcontract: move liabilities
Selecting type of procurement contracts: Fixed Price
Insurance: liabilities + bonds + warranties
Strategies for Positive Risks or
Opportunities
Strategies for Opportunities

Exploit: Ensure opportunity is realized.


Example: Assigning most talented resources of the
organization to the project to reduce cost lower than
originally planned.
Enhance: Increase the probability and/or the positive
impact of the opportunity.
Example: Adding more resources to finish early.
Share: Allocating some or all of the ownership to third
part best able to capture the opportunity
Example: Joint ventures, special-purpose companies
Acceptance
(both for threats & opportunities)

Active Acceptance
Develop a contingency plan to execute if the risk occur
Contingency plan - means be ready with Plan B
Fallback plan - means to have Plan C if Plan B fails
Passive Acceptance
Workarounds means to deal with the risks as they
occur. Usually is applied for low ranked risks.
Risk Response Matrix

Risk Event Response Contingency Trigger Who is


Plan responsible

Interface Mitigate: Test Workaround Not solved within Anna


Problems Prototype until help 24 hours
comes
System Mitigate: Test Reinstall OS Still frozen after 1 Lianna
freezing Prototype hour
User backlash Mitigate: Increase staff Cell from top Gagik
Prototype support management
demonstration
Equipment Mitigate: Select Order Equipment fails Hakob
malfunction reliable vendor replacement
Transfer:
Warranty
Some Terms related to
Risk Response Planning

Residual Risks risks that are left over after Plan Risk
Response.
Contingency Plans plans of action in case the risk
does occur.
Risk Response Owners the person on the team
responsible for monitoring the risk, risk triggers,
developing a response strategy, and implementing the
strategy should the risk occur.
Secondary Risks new risks that result from the
implementation of the contingency plans for the primary
risks.
Some Terms related to
Risk Response Planning (continued)
Risk Triggers early warning signs that there is a high
probability the risk will occur
Fallback Plans a secondary contingency plan, in case
the contingency plan does not work or is not effective
Reserves
Contingency reserves - covers the cost for known
unknowns discovered during risk management; covers
the residual risks. The contingency reserve is calculated
and made part of the baseline.
Management reserves these are estimated and
made part of the project budget, not the baseline.
Management approval is needed to use the
management reserve.
Some important points:

What do you do with non-critical risks?


Would you choose only one risk response strategy?
What risk management activities are done during
execution of the project?
What is the most important item to be discussed in
project team meetings?
How would risk be addressed in project meetings?
Some important points:

What do you do with non-critical risks?


Put them in a watch-list and revisit them periodically.
Would you choose only one risk response strategy?
You may select a combination of strategies.
Response of one risk might address another risk as
well!
What risk management activities are done during
execution of the project?
Watch-out risks on watch-list and looking for new risks.
Some important points:

What is the most important item to be discussed in


project team meetings?
Off course, Risk!
How would risk be addressed in project meetings?
Asking, what is the status of the risks?
Is their any new risk?
Is the rank of any risk goes up and down?
Decision Tree for Risk Management

A decision tree is a method you can use to help


make good choices, especially decisions that involve
high costs and risks.
Decision trees use a graphic approach to compare
competing alternatives and assign values to those
alternatives by combining uncertainties, costs, and
payoffs into specific numerical values.
Advantages of Using Decision Trees
Decision trees offer advantages over other methods of
analyzing alternatives. They are:
Graphic. You can represent decision alternatives,
possible outcomes and chance events schematically.
Efficient. You can quickly express complex alternatives
clearly. You can easily modify a decision tree as new
information becomes available.
Revealing. You can compare competing alternatives
even without complete information in terms of risk and
probable value.
Complementary. You can use decision trees in
conjunction with other project management tools. For
example, the decision tree method can help evaluate
project schedules.
Advantages of Using Decision Trees
Decision trees offer advantages over other methods of
analyzing alternatives. They are:
Graphic. You can represent decision alternatives,
possible outcomes and chance events schematically.
Efficient. You can quickly express complex alternatives
clearly. You can easily modify a decision tree as new
information becomes available.
Revealing. You can compare competing alternatives
even without complete information in terms of risk and
probable value.
Complementary. You can use decision trees in
conjunction with other project management tools. For
example, the decision tree method can help evaluate
project schedules.
Decision Tree
Decision Node
Chance Node

Root Node

Chance Branch
Decision Branch

End Point
Outcome
Exercise No. 1

It is the average amount of money one can expect to


receive from a project when multiple outcomes (with
different probabilities) are taken into account.
Define 3 possibilities:
The very best reasonable outcome
The most likely outcome
The very worst reasonable outcome
What are the Expected Return and Expected
Probability for each outcome?

EXPECTED PROBABILITY
RETURN
BEST CASE
MOST LIKELY
CASE
WORST CASE
What are the Expected Return and Probability
for each outcome?

EXPECTED PROBABILITY WEIGHTED


RETURN RETURN
BEST CASE $200K 0.25
MOST LIKELY $50K 0.60
CASE
WORST CASE $5K 0.15
Multiply the expected return of each scenario by the
probability of its occurrence to come up with a
weighted return.

EXPECTED PROBABILITY WEIGHTED


RETURN RETURN
BEST CASE $200K 0.25 $50K
MOST LIKELY $50K 0.60 $30K
CASE
WORST CASE $5K 0.15 $750
The sum of the weighted expected returns is the EMV -
expected monetary value, of the project.
This number is not a prediction or a guarantee for what the
return of a project will be. Rather, it is an average of the
many possible outcomes. It is a simple way to summarize
the expected range of returns with a single figure.

WEIGHTED
RETURN
$50K
$80 750 = $30K
$750
Best Case
$200K
25%
Project
A Most Likely Case
EMV:
$50K
$80.75 60%

Worst Case
$5K
15%
Besides the project A we have another project B
with the following parameters:

EXPECTED PROBABILITY WEIGHTED


RETURN RETURN
BEST CASE $100K 0.35
MOST LIKELY $90K 0.45
CASE
WORST CASE $70K 0.20

Compare these projects and make your choice.


Best Case
$100K
35%
Project

EMV: B Most Likely Case


$90K
$89 500 45%

Worst Case
$70K
20%
Decision Tree Analysis
Project Best Case
$200K
25%
A

EMV: Most Likely Case $50K


$80 750 60%

Which is the Worst Case $5K


Preferred 15%
Alternative ?

Best Case $100K


Project
35%
B

EMV: Most Likely Case


$90K
$89 500 45%

Worst Case
20% $70K
Exercise No. 2

You have to select between two projects with the same


budget cost.
Project 1 has 20% chance of an opportunity that will provide
you a profit of $300 K, and 60% chance of a threat with
impact costing you $40K.
Project 2 has 60% chance of an opportunity that will provide
you a profit of $60K, 20% chance of a negative risk with
impact costing $50K and also another threat with probability
10% and impact $20K.

What is the EMV for each project?


Which project would you recommend?
Exercise No. 2: Solution

Project 1: EMV = $300K * 0.2 - $40K * 0.6 = $36K


Project 2: EMV = $60K * 0.6 - $50K * 0.2 - $20 * 0.1 = $24K

Project 1 is preferable because of higher positive EMV.


Exercise No. 3

Your company is the primary contractor and in your contract is


penalty $1000 for each day you deliver late. As a project manager
you need to decide which subcontractor to use for a critical
activity. Your aim is to minimize your expected cost.
You have to choose between two candidate companies:
One subcontractor company has offered lower cost ($110
000). You estimate that there is 50% chance that this
subcontractor can delay the delivery for 90 days.
Second subcontractor company has offered higher cost ($140
000). You estimate that there is 10% chance that this
subcontractor can delay the delivery for 30 days.

Use decision tree and EMV calculation define which


subcontractor has to be selected for your project. Draw decision
tree diagram and calculate EMV for this case.
50% In time: no penalty

Company 1
(contract cost
50%
$ 110K) 90 days delay:
Penalty $90K
$ 110K + 0.5 * $ 90K = $155K

Company 2
is
preferable 90%
$ 140K + 0.1 * $ 30K = $143K In time: no penalty

Company 2
(contract cost
$ 140K) 10%
30 days delay:
Penalty $30K
Exercise No. 4: Build or Upgrade
You have to make decision between two options: to build a new plant or
reconstruct the existing one. Cost of new plant is $120Mln, cost of
reconstruction is $50 Mln.
Marketing department forecasted 60% probability high demand for
your product and 40% probability low demand.
The new plant will give you $200Mln profit in case of high demand and
only $90Mln in case of low demand.
The upgraded plant will give you $120Mln profit in case of high
demand and only $60Mln in case of low demand.

Use decision tree and EMV calculation define which option has to be
selected for your project. Draw decision tree diagram and calculate
EMV.
60% High Demand
$200M

Build new plant


(invest $ 120M)
40%
Low Demand
$90M

Build
or
Upgrade 60% High Demand
$120M

Upgrade plant
(invest $ 50M)
40%
Low Demand
$60M

Chance node

Decision node
60% Strong Demand
$200M $80

$ 200M - $120M = $ 80M


Build new plant
(invest $ 120M)
40%
Week Demand - $30
$ 36M = 0.6*($80M) + 0.4*(-$30M) $90M

$ 90M - $120M = - $ 30M


Build
or Upgrade existing plant
Upgrade 60% Strong Demand
$120M $70

$ 120M - $50M = $ 70M


Upgrade plant
(invest $ 50M)
40%
Week Demand $10
$ 46M = 0.6*($70M) + 0.4*($10M) $60M

$ 60M - $50M = $ 10M


Chance node

Decision node
Exercise No. 5: New or Old Farm

You have to make decision between two options:


Option 1: to sell your farm and buy a new farm with positive
difference $55K, also you need upgrade the new farm to make it
profitable.
Option 2: to upgrade the old farm up to the same level
profitability as in Option 1.
Your consultant analysed the both farms conditions, market
prices for new equipment etc and provided you with the following
information:
- there is 40% probability that the upgrade of the new farm will
cost $75K and 60% probability for upgrade cost $55K.
- there is 50% probability that the upgrade of the old farm will
cost $45K and 50% probability for upgrade cost $65K.
Use decision tree, make calculations and select between two
options.
60%

Best case: $55K

Buy new farm


(difference from
sell - buy $ 55K) 40%

Worst case: $75K

Buy
or 50%
Upgrade
Best case: $45K

Upgrade existing
farm
50%

Worst case: $65K

Chance node

Decision node
60%
- $33K
Best case (- $55K)

0.6*(- $55K) = - $ 33K


Buy new farm
(difference from
sell - buy $ 55K) 40%
- $30K
- $ 8 K = $55K - $33K - $30K Worst case (- $75K)

0.4*(- $75K) = - $ 30K


Buy
or 50%
Upgrade Equipment available -$22.5K
$45K

0.5*(- $45K) = - $ 22.5K


Upgrade existing
farm
50%
Import equipment -$32.5K
- $55K = - $22.5K - $32.5K $65K

0.5*(-$65K) = - $ 32.5K
Chance node

Decision node
Exercise No. 6: Law case

You have to make decision between two options:


Option 1:
to take your client to the court claiming $ 50 000
compensation for your losses. According to your lawyer's
opinion you have only 25% chance to win the case. The lose
of the case will cost you $10 000.
Option 2:
to accept the clients proposal settle the case for $5 000
compensation.

Use decision tree, make calculations and select between


two options.
25%

Win $ 50 000

0.25*($50K) = $ 12.5K
Court
$ 5K = $12.5 K - $ 7.5 K

Response strategy 1 75%

Loss $ 10 000

0.75*(- $10K) = - $ 7.5K

Lawsuit

Take settlement
$ 5K
100%
Response strategy 2
Gain $5K

Chance node

Decision node
Exercise No. 8: Project Risks

Project Risks 1 - Weather: There is a 25% chance of


excessive snow fall thatll delay the construction for two
weeks which will, in turn, cost the project $80,000.
Project Risks 2 - Cost of Construction Material: There is
a 10% probability of the price of construction material
dropping, which will save the project $100,000.
Project Risks 3 - Delivery Delay: There is a 5% probability
of construction coming to a halt if the delivery from a vendor
will be late . The impact would lead to a loss of $150,000.
The Expected Monetary Value for the project risks:

Weather: 25/100 * (-$80,000) = - $ 20,000

Cost of construction material: 10/100 * ($100,000) =


$ 10,000

Late delivery: 5/100 * (-$150,000) = - $7,500

The projects EMV based on these project risks is:


-($20,000) + ($10,000) ($7,500) = - $17,500
Exercise No.9: Software Development

In this scenario, you can either:


Develop the new software: To develop the new
software, the associated cost is $500 000.
Buy the new software: To buy the new software, the
associated cost is $750 000.
Stay with the legacy software: If the company decides
to stay with the legacy software, the associated cost is
mainly maintenance and will amount to $100 000.
In this scenario, you can either:
Build the new software: To build the new software, the
associated cost is $500 000.
Buy the new software: To buy the new software, the
associated cost is $750 000.
Stay with the legacy software: If the company decides
to stay with the legacy software, the associated cost is
mainly maintenance and will amount to $100 000.
The Buy the New Software and Develop the New
Software options will lead to either a successful
deployment or an unsuccessful one. If the deployment
is successful then the impact is zero, because the risk
will not have materialized. However, if the deployment
is unsuccessful, then the risk will materialize and the
impact is $2 million.
The Stay with the Legacy Software option will lead to
only one impact, which is $2 million, because the
legacy software is not currently meeting the needs of
the company. Nor, will it meet the needs should there
be growth. In this example, we have assumed that the
company will have growth.
Successful
deployment
Impact $0
Build new
software
Cost $500K
40% Unsuccessful
deployment
Impact $2 Mln
Successful
deployment
Impact $0
Stay, Buy new
Buy, software
Build
Cost $750K
Decision Unsuccessful
5%
deployment
Impact $2 Mln

Stay with Growth in


legacy 100% business
software
Impact $2
Cost $100K Mln
Calculate EVM connected with each decision.
Build the new software: $ 2 Mln * 0.4 = $ 800 K
Buy the new software: $ 2 Mln * 0.05 = $ 100 K
Staying with the legacy software: $ 2 Mln * 1 = $ 2 Mln.

Now, add the setup costs to each Expected Monetary Value:


Build the new software: $ 500 K + $ 800 K = $ 1,3 Mln.
Buy the new software: $ 750 K + $ 100 K = $ 850 K
Staying with the legacy software: $ 100 K + $ 2 Mln =
$ 2,1 Mln.
Looking at the Expected Monetary Values computed in
this Decision Trees example, we can see that buying
the new software is actually the most cost efficient
option, even though its initial setup cost is the highest.
Staying with the legacy software is by far the most
expensive option.
Payoff

(0.5) Success
$900 000
- $100 000
EMV = $400 000
Raspberries (0.5) Failure
- $100 000

(0.8) Success
$390 000
- $10 000
EMV = $310 000
Strawberries (0.2) Failure
- $10 000
EMV = $0 (1.0)
$0
Neither
(0.3) 1st grade
$895 000
EMV = $268 500
(0.6) 2nd grade
$695 000
EMV = $417 000
- $5 000
EMV = $675 000
(0.5) Success Submit (0.1) No certification
application - $105 000
EMV = - $10 500
- $100 000
- $100 000
EMV = $287 500 Dont submit application
Raspberries
(0.5) Failure
- $100 000

(0.8) Success
$390 000
- $10 000
EMV = $310 000
Strawberries (0.2) Failure
- $10 000

EMV =$0
$0
Neither

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