Project Reality Check #5: The Devil is in the Details

by Gary Monti on January 19, 2011

Expected Monetary Value (EMV) connects the customer with the team, as we saw in the previous blog. This tool is very powerful. The numbers are as serious as a heart attack (the reason will be shown later). This blog addresses the mechanics of the EMV model providing a whirlwind tour of the associated calculations.

Remember, the goal is getting the team more power to help the client by tying risk with quality and projecting changes in performance corresponding to changes in the risk terrain.

Probabilities and Closed Systems

At the core, an EMV calculation comprises probability times impact to get a weighted number:

10% (probability) x $1000(impact) = $100(EMV)

Let’s put it to use in a closed system.

CLOSED SYSTEMS. In closed systems the probabilities add up to 100% (summation rule) and options are mutually exclusive which is also referred to as being mutually dependent. For example, if you toss a die there is a 1 in 6 chance of getting a “1.” If you get a “1” that also means you did not get 2, 3, 4, 5, or 6.

EMV calculation. Here’s an example that also brings in financial consequences. A vendor has a 70% chance of needing to do rework and it will cost you $1000 extra. The other 30% of the time the work is as expected with $0 added cost. The total probabilities for this system are 100% (70 + 30). Now, the expected value for this system is;

(.7 x $1000) + (.3 x $0) = $700.

Let’s make it a little more complicated. Say there’s a 70% chance the vendor needs to do rework costing $1000, 20% chance the work is as expected at $0 cost, and a 10% chance the vendor design exceeds customer expectations and you get a $2000 bonus (cost reduction). The percentages for this system add up to 100% (70+20+10). The expected value for the additional cost to this system is now:

(.7 x $1000) + (.2 x $0) + (.1 x -$2000) = $600 + $0 – $200 = $500.

Open Systems And The EMV Model

An open system has a set of four calculations providing context for making decisions:

  • Baseline
  • Total Project EMV
  • Worst Case
  • Best Case

These provide a range of numbers with the Best- and Worst Case being the bookends and the Baseline and Total Project EMV lying in between. Let’s define an open system and jump into the calculations.

OPEN SYSTEMS. Imagine 3 dice. The summation rule applies for each die but the dice are independent of each other and move freely. In other words, you can still get a “1” on dies B and C even when there is a “1” on die A. Substitute “subcontractors” for “dice” and the stage is set to continue on to the calculations!

Baseline. The baseline sums the costs across the WBS (work breakdown structure). Here’s an example:

You are to provide a circuit board for your client using three subcontractors using the following estimates:

The firmware contractor, Dewey, Cheatum, and Howe, estimates $50,000.

The software contractor, Karen Sympathy, estimates $100,000.

The board manufacturer, Flyby Knight, estimates $80,000.

The Baseline simply sums the estimates:

($50,000 + $100,000 + $80,000) = $230,000

Total Project Expected Monetary Value (TPEMV). The TPEMV combines the baseline with any needed reserves to achieve the desired quality and delivery date. Imagine you are trying to determine what your risk reserves should be in order to protect the margin on the project while meeting the desired quality:

  • The firmware contractor, Dewey, Cheatum, and Howe, has a 50% chance of needing $5,000 extra to achieve the desired quality;
  • The software contractor, Karen Sympathy, has a 90% chance of performing adequately for $10,000 less than the estimate;
  • The board manufacturer, Flyby Knight, has a 70% chance of trying to squeeze you for and additional $10,000 to get the desired quality and delivery date.

The question is, “How much extra money should you add to your fix fee bid to make sure the margin is protected?” Here’s how to do it:

For Dewey, Cheatum, and Howe there is a need for an extra (.5 x $5000) or $2500.

For Karen Sympathy there is some cushion to the tune of (.9 x $10,000) or -$9,000.

For Flyby Knight these is need for an extra (.7 x 10) or $7,000

The net of this is $2,500 – $9,000 + $7,000 = $500 in risk reserve.

TPEMV = Baseline + risk reserves = $230,000 + $500 = $230,500.

Worst Case. But what if everything bad that could happen actually did? In that case you need to do a Worst Case calculation and do 100% calculations for the threat and 0% for the opportunity, i.e., leave Karen Sympathy out and assume the worst for Dewey, Cheatum, and Howe and Flyby Knight.

Increase your bid by (100% x $5,000) + (100% x $10,000) or an extra $15,000.

Worst Case = Baseline + 100% threats = $230,000 + $15,000 = $245,000

Best Case. The Best Case leaves out the threats and adds in the opportunities at 100% or (100% x -$10,000) = -$10,000 for Karen Sympathy. The bid then changes to:

Best Case = $230,000 – $10,000 = $220,000

This has been brief. If you have any questions feel free to contact me. The EMV model is a great way to connect with stakeholders and work rationally while keeping relationships intact.

Oh, about that heart attack. The Securities and Exchange Commission (SEC) was founded during the Great Depression because people offering stock for sale only showed the Baseline and Best Case numbers and a more robust model was needed – the EMV model. Risks and reserves have to be reported. Unfortunately, we are climbing out of a repeat of the same situation caused by ignoring the model.

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