(Calculation EMV) What is the business purpose of product value calculated by multiplying the probability of an event by the cost of the impact?

Question

Lets say you are going on a geological survey up on a mountain in the rural areas.

( Page 576, Head First PMP 3rd Edition, Jennifer Greene, PMP & Andrew Stellman, PMP ) Expected Monetary Value (EMV)

Risk: High Winds Probability: 35% Impact: cost $48 to replace equipment

Risk: Mudslide Probability: 5% Impact: lose $750 in damage costs

Risk: Wind generator is usable Probability: 15% Impact: save $800 in battery costs

Risk: Truck rental Unavailable Probability: 10% Impact: cost $350 last-minute rental

Calculating EMV for each Risk High Winds: 35% x -$48 = -$16.80 Mudslide: 5% x -$750 = -$37.50 Wind Generator: 15% x $800 = $120 Truck Rental: 10% x -$350 = -$35

EMV = -$16.80 + (-$37.50) + $120 + (-$35) = -$30.70

I am confused about the business significance of multiplying the percentage probability by the cost impact.

To elaborate, what does the probability of the risk event occurring have to do with the cost of the impact, and vice versa?

what is the business purpose of product value calculated by multiplying the probability of an risk event by the cost of the impact? ( Page 576, Head First PMP 3rd Edition, Jennifer Greene, PMP & Andrew Stellman, PMP )

Answer 1

Expected Monetary Value (EMV) is an important part of risk management, usually used in large and complex projects to perform quantitative risks analysis.

Probability is the measurement of the likelihood of the occurrence of any event. Impact is the amount that you will have to spend if any identified risk occurs.

According to the PMBOK Guide 5th edition, “Expected monetary value analysis is a statistical concept that calculates the average outcomes when the future includes the scenarios that may or may not happen.”

EMV is therefore a statistical technique in risk management that is used to convert the risk into a number, which in turn assists the project manager calculate the contingency reserve, and helps compare a risk with other risks.

EMV = Probability * Impact

Since you usually have multiple risks (like in your example), you will calculate the EMV of those risks separately and add them all. As you have noted you calculate the EMV of all risks, regardless of whether they are positive risks or negative risks.

Once you calculate the EMV of the project, you will be able to calculate the contingency reserve. From you example you could be tempted to say that you need $348 (that is to say, $48+$750-$800+$350) to manage all risks. Anyway, you would do a big mistake by doing so. The probability is used in the calculation to take into account the fact that not all risks are going to happen. So, in your example you only need to add $30.70 to your budget to cover all identified risks.

Answer 2

The business purpose behind using weighted values is to normalize the data you have for many alternatives that have varying degrees of risk and impact. It equalizes a set of alternatives with objective values that will help the business decision maker cut through biases and make more reliable and accurate decisions.

It is important to note that, while you can use EMV to help arrive at contingency and reserve values, you need critical mass to adequately insure yourself. If the volume of risks are low, such as in this example, you will not be covered adequately by the stats.