Risk&Value Management: Decision Trees for Business Intelligence - Research Paper Example

Risk and Value Management Introduction As there is uncertainly all around us it is essential that we evaluate possible risks using quantitative methods of analysis (Ajjan, 2007). This would prove useful in arriving at suitable decisions that are based on objective analysis rather than subjective methods. Expected Monetary Value (EMV) method using the Decision Tree Analysis and Monte Carlo Analysis are very effective for quantifying risks. The decision tree is useful for making informed decisions regarding risks when there is uncertainty in the likely outcomes, especially in the area of project management. This risk analysis technique allows one to use estimations of expected results to arrive at a decision. The decision tree provides an opportunity to explore various options and choose from among these options, based on the possible outcomes (Mindtools, 2009, Para 1). It is used for making a strategic decision, especially in the case of selecting a project or an investment option. Since it is pictorial in structure, a decision tree is useful in providing a bird’s eye view of the risks and rewards associated with each outcome. As per the current scenario for risk and value management, a contractor has the opportunity to bid for three different projects. He needs to choose between an office complex, a shopping complex and a sports stadium. The contractor has limited resources and can only bid for one of these projects. During the preparation of the bid he has incurred certain costs which also need to be considered while he evaluates the most suitable decision. The contractor has decided to use the EMV method to arrive at his decision as he is taking into account future events where probability and impact have been estimated and there is a need for investment. According to Koller (2005, p. 5) when a risk model is well constructed it emulates the real world events, which is what is attempted here. The following report is submitted to the contractor. TECHNICAL REPORT As per the technical report submitted to the contractor, we have evaluated available alternatives and drawn up a decision tree. On the basis of the calculated EMV the most appropriate decision is provided to the contractor. Reasons for arriving at the same are also documented for further discussions. Risks and assumptions have been detailed. All calculations have been separately provided in tabular form for easier comprehension. Available Alternatives As per the available information there are a number of possible scenarios: At the outset, no bid maybe made considering the costs involved There is also a possibility of either bidding low or high to remain in the competition as other bidders is not known at this point In each case there is also a possibility of either losing the bid or winning it In case of no bid the outcome would be £0.0 as there would be no investment required. However, in case of losing a bid, the initial cost of preparing the tender would be a sunk cost Decision Tree Analysis The following decision tree has been arrived at, based on current information available and all the possible alternatives known. While preparing a decision tree, one is usually exposed to severe risks that can make the investment futile and can impact the decision taken by management (Ajjan, 2007). It is therefore important to consider all possible scenarios and identify all assumptions and risks. As per definition in Project Management Book of Knowledge (Project Management Institute [PMI], 2008, Ch.11), the decision tree follows certain notations. The squares represent decision nodes and circles represent uncertain outcomes or chance nodes. DECISION TREE In the above decision table all figures are in millions of pound. Figures in brackets indicate negative values and the decimals are mostly rounded to 2 or a maximum of 3 places. Thus the EMV of opportunities are expressed as positive values and those of threats as negative values. It is also ensured that all probability values add to a 100%. The values are derived statistically and average outcomes are obtained. The following section takes into account each scenario i.e. whether contractor will profit when investing in the office complex, the shopping complex or the sports stadium, to provide the final best choice. As per the final EMV, the highest return is possible from the low bid for the Sports Complex. We will evaluate how this conclusion was arrived at, while taking into consideration all risks and assumptions regarding the decision. Evaluation of Each Scenario In a decision tree the calculations are worked on from the right of the tree. Probability or percentage estimate of the outcomes have been considered along with the estimated cash values. The results of each calculation are recorded at the nodes, as shown in the circles. The final outcome or EMV is noted for each of the decisions. It is important to work out the option that is of greatest worth (Mindtools, 2009), while considering all the outcomes. Hence the option with the highest value should be considered as it will provide the maximum benefit to the contractor. The user should also choose the best alternative wisely (De Ville, 2006, Ch. 5). Tabular Representation of Values Before taking each project i.e. office complex, shopping complex and sports stadium separately for analysis and the best possible outcome, a table is provided that details the calculated values of each path. The final computed value is taken by considering payoffs minus costs along each path. Decision to be Made Decision Node Chance Node Probability Net Path Value Outcome Value Decision Value Office Complex High Bid WIN - p(0.35) p(0.25) 3,375,000 6,400,000 2,240,000 p(0.55) 4,125,000     p(0.2) (1,100,000)     LOSE - p(0.65)   0     Low Bid WIN - p(0.75) p(0.20) 2,100,000 3,650,000 2,737,500 p(0.60) 3,300,000     p(0.20) (1,750,000)     LOSE - p(0.25)   0     Shopping Complex High Bid WIN - p(0.20) p(0.40) 6,000,000 9,000,000 1,800,000 p(0.50) 3,250,000     p(0.10) (250,000)     LOSE - p(0.80)   0     Low Bid WIN - p(0.70) p(0.20) 2,700,000 4,280,000 2,996,000 p(0.50) 2,750,000     p(0.30) (1,170,000)     LOSE - p(0.30)   0     Sports Stadium High Bid WIN - p(0.25) p(0.30 4,200,000 8,487,500 2,121,875 p(0.65) 4,550,000     p(0.15) (262,500)     LOSE - p(0.75)   0     Low Bid WIN - p(0.70) p(0.20) 2,200,000 4,950,000 3,465,000 p(0.60) 3,300,000     p(0.20) (550,000)     LOSE - p(0.30)   0     Office Complex: If a high bid is placed for the office complex there is a 35% chance of winning the same as against a 65% chance of losing the bid. The high bid produces a value of £2,240,000 when the weighted average is considered. This is arrived at considering the possible risk or pessimistic scenario of losing £1,100,000, which is almost 15% of the opportunity cost for optimistic and most likely scenarios. The lower bid provides a better return of £2,737,500 and there is a higher chance of winning this bid i.e. 75%. The quantum of loss is however higher during the low bid almost 35% of the estimated opportunity cost. Since the high bid in this case cannot be considered for the final EMV, as the value returned is lower than for low bid, it is struck out and the low bid scenario evaluated. The overall EMV of 0.738 i.e. £738,000 is arrived at after considering the investment cost (PMI, Ch. 11) of £2 million. This is lower than the value returned while evaluating the other scenarios i.e. Shopping Complex and the Sports Stadium. Shopping Complex: In the case of the shopping complex, a high bid shows only a 20% chance of winning as against a 70% chance of winning a low bid. On computing the value for high bid we arrive at a very low return of £1,800,000 even though the estimated loss is only £250,000. However, if the contractor believes in placing a low bid for this complex it would provide a better return of £2,996,000 which is higher than the low bid return expected for an office complex. However, in this scenario too, the quantum of loss is high i.e. approximately 22% of the opportunity cost. As far as the shopping complex is concerned the high bid scenario is a very risky proposition with low returns, so it is outright rejected. On evaluating the payoffs minus the costs (of 1.3 million pounds) for the low bid scenario we arrive at an overall EMV of 1.696 i.e. £1,696,000. This will need to be evaluated against the Sports stadium to take the final decision. Sports Stadium: The sports stadium provides a higher return and seems the least risky option, though as more data is obtained from various stakeholders the risks would be further exposed. A high bid for the sports stadium only has a 25% chance of winning as against a 70% chance on a low bid. Probably most of the competitors will also bid low, so the contractor needs to be cautious. On computing the value for high bid we arrive at a return of £2,121,875 and the probability of losing money here is also very low, at 15%. It appears from the decision tree analysis that on bidding low for the sports stadium, the contractor would have a very high chance of good returns of £3,465,000 which is higher than the other outcome. For the sports stadium too, the high bid cannot be considered as the return is lower than for low bid. On evaluating the payoffs minus the costs we arrive at an overall EMV of 1.965 i.e. £1,965,000 which is higher than for office or shopping complexes. Final Suggested Decision Decision to be Made Value Costs Final EMV Office Complex 2,737,500 2,000,000 £738,000 Shopping Complex 2,996,000 1,300,000 £1,696,000 Sports Stadium 3,465,000 1,500,000 £1,965,000 As per the above evaluation, the contractor is advised to go for a low bidding of the sports stadium as he has a 70% chance of winning the same and the expected return is the best of all the possible outcomes. Finally the contractor could also consider the idea of not bidding for any of the projects. That would mean dropping the idea altogether, but there would be no return for him. However, some amount of risk has to be taken in a business scenario if one needs to meet organization’s business objectives and expand the portfolio. It is important too, to consider the quantum of loss as one would not like to suffer losses due to a bad business decision. Assumptions: A number of assumptions have been made in the above computations and scenarios. These could impact the final decision as further assumptions are clarified by the contractor and other team members or decision makers, as the project progresses. The estimates regarding probability and impact value of each case would have been provided by experts, probably during a Delphi analysis or using brainstorming and other creativity techniques. The candidate scenarios selected are the entire possible ones. Selecting the different branches of the decision tree is also a difficult task (De Ville, 2006, Ch. 3) and requires experts in the area of risk identification and qualitative analysis. It is essential to identify all potential events or situations that may have a negative impact on some objective of the project. It is also assumed that the qualitative analysis has been conducted in an expert way. In case a matrix was used for judging the impact and probability, this would be based on the risk tolerance of the contractor’s organization. It is assumed that these outcomes are defined after considering relevant mitigation strategies and associated costs In certain cases the contingency costs would also need to be considered (PMI, Ch. 11) A situation of no bidding has also been considered where the contractor could move out of the entire process of decision making It is also assumed that the contractor has the possible funds to bear the loss of preparing the tenders in case he loses all the bids An assumption made is that expertise is available in all the possible scenarios. That the contractor has experts or team members who are able to provide valid inputs whether for building a sports stadium or an office or shopping complex. Since each building has its own features and construction risks and constraints, the contractor would need relevant experts in the field. That all related costs, both direct and indirect have been considered while arriving at the outcomes. Sometimes support costs may be neglected or overlooked. Risk Implications based on assumptions If proper techniques were not used for arriving at probability and impact values and there is a lack of available expertise, then the returns may not be as computed and could totally differ from the given values. There could also be a possibility that the EMV would return no money In case all potential events or situations are not identified, then certain threats or opportunities may not have been taken into consideration In case the contract is awarded, the contractor would also face the risk of ensuring that capability exists within his organization to handle any of the possible outcomes. Or else he would need funds for acquiring the same. Suggested Refinements Some of the assumptions can be refined if the following are taken into consideration by the contractor: As part of the analysis requirements, the contractor should provide details as to whether experts have helped him arrive at the probability and impact values He should also provide a basis for the estimated profits and associated probabilities of each scheme The possible situation of a no bid or loss should also be mentioned A detail of the related costs both direct and indirect can be provided as this would help in evaluating the risks and assumptions further The contractor could also provide inputs regarding availability of experts in various construction techniques. This would help in refining the assumptions and reducing risks to any of the possible outcomes All best guesses should be mentioned and elaborated (Mindtools, 2008) with proper basis for arriving at the same Risk Implications The Contractor would need to ensure that capability exists within his organization to handle the construction of a sports stadium. In case of lack of expertise in the area of stadium construction, the project could suffer huge losses. In case all costs direct and indirect have not have been taken into account, then this would result in an error in the computations. If proper techniques were not used for arriving at probability and values of stadium construction, then the returns may not be as computed and could totally differ from the given values. Since this is a sports stadium, experts in the area of sports are also needed. The contractor would need to include sportsmen in his panel or need their expert judgement. This would also involve investment. It is not known whether such costs have been catered for The contractor would also need to consider the type of contract that he would be signing. This would impact the risk that he would need to take as a seller. It could either be a financial risk or a risk of quality, cost, etc. The capacity of the stadium is also a consideration and costs would vary immensely based on the required capacity Also unknown in this situation is the type of events that will be held. This could result in changes or requirements for various types of turf, etc. This could again impact costs as it is not known whether these have been factored in The other bidders may have quoted better prices for the same bid Suggestions to reduce Risk Profile Following are some suggestions to reduce the risk profile: The contractor can reduce risks by ensuring that he has an expert panel and always arrives at scenarios based on valid tools and techniques He could discuss the scenarios with sportsmen and other experts in the field to ensure that all his assumptions are covered and constraints have been considered The decision tree is a very robust method for arriving at a decision and if used along with sensitivity analysis would provide better results. The analysis would help at arriving at worst case scenarios and cost per case decrease. By use of data on past events or similar past projects from the industry, the contractor can reduce risk biases and make rigorous estimates of the probabilities. Probability distribution could provide more comprehensive analysis and a better idea on what decision needs to be taken. Conclusion As a conclusion of the report one can say that all projected outcomes have been evaluated and basis for evaluation provided. Finally it is the contractor choice and discretion regarding which decision to choose. According to Koller (2005, p. 3) risk models are very useful when we need to communicate decisions to customers and public, etc. Hence the decision tree model can provide a very comprehensive and objective evaluation of the possible scenarios, taking uncertainly into consideration. It is always useful to support decisions as above by additional methods like sensitivity analysis (e.g. tornado diagrams) or probability distributions (PMI, 2008). References Ajjan Associates, LLC (2007). How can you mathematically evaluate risks of new investments? Retrieved Nov 10, 2009 from http://consulting.ajjan.com/risk.htm De Ville, Barry (Oct 2006). Decision Trees for Business Intelligence and Data Mining. Publisher SAS Publishing. Mindtools (2009). Decision Tree Analysis, Choosing Between Options by Projecting Likely Outcomes. Retrieved Nov 09, 2009 from http://www.mindtools.com/dectree.html Project Management Institute. (2008). A Guide to the Project Management Book of Knowledge PMBOK (4th Edition). Project Management Institute Inc. Koller, Glenn (March, 2005). Risk Assessment and Decision Making In Business and Industry: A Practical Guide - Second Edition. Publisher Chapman & Hall/crc Read More