Quantitative Risk Analysis

Quantitative risk analysis refers to a numeric projection of the total impact of risk on a project's goals, for example, schedule and cost objectives. It helps organizations determine whether a project can be successful. Moreover, businesses can use the numeric estimate to develop project management plans and contingency reserves.

This type of risk analysis is most effective when one uses it at a portfolio or business level. However, it is the least effective when individuals use it to analyze project-specific risks. It gives them an idea of what could go wrong and why helping managers establish a course of action that can fulfill the set objectives more efficiently.

• Quantitative risk analysis is a systematic method that uses objective, quantifiable data to assess the impact and probability of risks.
• There are various advantages of quantitative risk analysis. For instance, it enables clients to be more confident when making decisions. Moreover, it allows companies to make prudent decisions regarding projects.
• Quantitative risk analysis involves mathematical calculations, unlike qualitative risk analysis.
• Businesses can utilize multiple quantitative risk analysis techniques, for example, decision tree, Monte Carlo, and sensitivity risk analysis, to evaluate the likelihood and effect of risks.

Quantitative risk analysis definition refers to an objective and numeric risk analysis tool that offers extensive details concerning the impact and probability of a certain risk. It helps business owners and project managers establish the right course of action and make improved cost and duration estimates. This is crucial because if the projections are incorrect, it will lead to wrong decisions, thus affecting a company's ability to achieve the set goals.

If individuals want to determine whether pursuing a project is worthwhile, they can follow these steps to conduct this type of risk analysis before making a decision:

#1 - Spot The Areas Of Uncertainty

Irrespective of what type of risk analysis one conducts, identifying the potential risks associated with a project is the first step. A prudent way of looking for areas of uncertainty involves breaking the project into small segments by using a management plan or project outline and examining every section. Then, individuals must note down every area of uncertainty identified and how the potential risks can impact their project's execution. A few common effects are delays, a surge in making costs, and diminished product quality.

#2 - Evaluate The Cost Of Every Risk

After identifying the uncertainty areas, individuals can compute each risk's relative cost. Then, they must determine the estimated cost when a potential risk occurs to calculate it. In the case of basic risks, individuals must record the projected cost of eliminating the risk. On the other hand, for complicated risks with variable costs, one has two methods to determine the number. Out of them, the more convenient option involves deciding an average cost for every potential response to risk. The other option is more accurate; it involves breaking down the variable risks into different items.

#3 - Determine The Probability Of The Risks Occurring 

Individuals must determine the likelihood of every risk occurring to understand the risk associated with a project. When computing probabilities, the two most crucial elements are experience and research. The more individuals know about every scenario, the more accurately they can project the likelihood of an issue occurring at the time of execution. One must note that seeking outside help can be useful, especially if one lacks experience.

The following are some popular quantitative risk analysis techniques:

#1 - Monte Carlo Analysis

This method utilizes most likely, pessimistic, and optimistic projections to compute the overall project cost and determine the completion dates. It establishes a range of possible outcomes and is most effective for the risks associated with a project's yield or duration.

#2 - Scenario Analysis

The scenario analysis technique computes multiple project outcomes' likelihood and possible range. This method is extremely useful to determine if a company can achieve its desired result without exceeding its risk tolerance level. In addition, it can help businesses figure out how many resources they might require and when.

#3 - Decision Tree Analysis

The decision tree analysis technique helps organizations evaluate the risk associated with one or multiple choices. Every tree represents a choice and its associated costs. First, individuals must assign costs and probabilities at every point. Then, they must follow a chain and add up every cost. Once done, they can determine which choice has the lowest risk.

#4 - Sensitivity Risk Analysis

Businesses can use the sensitivity risk analysis method to identify the risks that most likely impact a project. It examines how a project element's vagueness impacts the objective when every other indefinite element is held to minimum standards.

#5 - Expected Monetary Value or EMV Analysis

In this case, individuals require the probability or likelihood of a risk occurring and the estimated cost of that risk. Then, they can determine the total estimated risk amount by calculating the sum of the results obtained after multiplying each risk's cost and the probability.

Let us look at a few quantitative risk analysis examples to understand the concept better.

Example #1

Suppose TBZ Infrastructure, a manufacturing company, uses the expected monetary value (EMV) method to analyze a project's risk exposure and develop a contingency reserve. The following table shows the calculation.

Therefore, the overall EMV is $5,490. It denotes TBZ's contingency reserve and the project's risk exposure.

Example #2

Suppose Pixel, a t-shirt manufacturer, purchased off-the-rack equipment required for production. However, there is a risk associated with customization. There is a 70% chance that the organization will only have to do a few customizations, increasing the overall cost to $80,000.

That said, there is a 30% chance that Pixel would have to do a lot of customization, raising the cost to $120,000. The company can compute the expected monetary value or risk exposure by adding the alternatives' values.

Therefore,

EMV = Cost Impact x Probability = (80,000 x 70%) + (120,000 x 30%), i.e., $92,000

There are various benefits and limitations of this type of risk analysis. Let us look at them.

Advantages

#1 - Objective Evaluation

Since a quantitative evaluation involves allocating numerical values to every risk, it offers objective results. The objective projections help ensure that every party has an identical understanding of the estimated risks.

#2 - Client Confidence

When individuals present a project evaluation to a prospective client, a quantitative evaluation's specificity may offer more confidence as there is little scope for misinterpretation. Clients can make their decision regarding a proposal more confidently when they get a specific value concerning the potential risk.

#3 - Extensive Details

This risk analysis approach involves breaking down a project or proposal by the estimated cost of every potential financial risk. This allows an organization to focus on reducing its efforts on risks considered highly probable or most costly.

Another key advantage of quantitative risk analysis is it helps companies make better decisions regarding proposals. This is because individuals involved in the decision-making process can accurately assess potential risks by creating risk evaluations with objective measures.

Disadvantages

#1 - Lack Of Precision

The analysis's results may not be precise; it might lead to confusion.

#2 - Qualitative Descriptions

Individuals might need to enrich this analysis with qualitative descriptions.

#3 - Expensive

Analysis conducted using the above-mentioned quantitative risk analysis methods is usually expensive as it requires greater experience and advanced tools.

The concept of qualitative and quantitative risk analyses can be confusing for individuals who are new to risk management. However, one can eliminate such confusion by knowing how they differ. So, let us look at this tabular representation of their distinct characteristics.

This article has been a guide to what is Quantitative Risk Analysis. We explain its comparison with qualitative risk analysis, examples, methods, and advantages. You may also find some useful articles here -

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