A Short Guide To Expected Monetary Value
A Short Guide To Expected Monetary Value
A Short Guide To Expected Monetary Value
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I am writing this blog post on expected monetary value (EMV) upon receiving a request
from a visitor of my blog named Mohammad Anjum.
This technique is an important part of risk management, and is usually used in
medium, large and complex projects. Expected monetary value is used in the
Perform Quantitative Risks Analysis process, and is one of the few techniques in
the PMBOK Guide which involves mathematical calculations. Because of this
many aspirants leave this topic and try to avoid the whole concept.
On the surface this technique may look complex, however, it is a very simple
technique, involving relatively light mathematical calculations. Once you
understand the concept, it will be like a piece of cake.
Moreover, this concept is also important from a PMP, and PMI-RMP, exam point
of view. In your PMP, and/or PMI-RMP test, you are going to see a few questions
from the expected monetary value analysis.
Before we start discussing the expected monetary value concept, we will briefly
talk about probability and impact, because in the EMV calculation we are going to
use them. If you understand probability, you should not have any difficulty in
understanding the expected monetary value properly.
Probability
Probability is the measurement of the likelihood of the occurrence of any event.
For example, if you toss a coin, it will either show heads or the tails. There is a
50% chance of showing heads, and a 50% chance of showing tails. So in this
case you will say that the probability of showing heads (or tails) is 50% (or 1/2).
Now lets see how the above formula fits into tossing the coin.
Total number of events = 2 (because the coin can either show heads or the tails)
= 50%
Got it?
Suppose you are throwing a die, what is the probability of the number 5 coming
up?
If you throw the die it will show you one of the following: 1, 2, 3, 4, 5, or 6.
= 1/6
= 16.67%
So, if you throw the die, the probability of the number 5 showing is 16.67%.
=1/3
= 33.33%
So, if you throw the die, the probability of getting either 5 or 3 is 33.33%.
Impact
The impact is the amount that you will have to spend if any identified risk occurs.
For example, you have identified that during the peak of your project, some
equipment may break down and you may need to buy new equipment that will
cost you 2,000 USD.
I hope that probability and impact are clear to you. If they are, we can move on to
our topic, i.e. expected monetary value (EMV).
Once you calculate this data, you will multiply the probability by the impact, and
the result will be the expected monetary value.
If you have multiple risks, you will calculate the EMV of those risks separately
and add them all.
Please note that you will calculate the EMV of all risks, regardless of whether
they are positive risks or negative risks.
If they are negative risks the EMV will be negative, and if they are positive risks
the EMV will be positive. (This will become clearer when I will show you the
examples for calculating the EMV.)
Once you calculate the expected monetary value of the project, you will add this
amount to your work package costs estimate and generate the project baseline.
The amount you added to the work package costs estimate is known as the
contingency reserve.
For example, lets say you have four risks with probabilities and impacts as
follows:
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From the above table you can that you may need 4,500 USD to manage all risks,
but this would not be correct. Not all risks are going to happen, some of them
may happen and some of them may not. The risks that will not occur will add
their EMV to the pool and the risks that will occur will utilize the money from the
pool.
So, in the above case you may need to add 1,100 USD to your budget to cover
all identified risks.
The expected monetary value concepts works well to calculate the contingency
reserve when you expect a lot of risks, because the more risks you identify, the
spread of the contingency reserve will be better among all risks.
If you have identified fewer risks, you will not get enough spread and your
reserve may dry up too soon, or may not be large enough to cover a single large
risk.
Positive risks also play an important role in calculating the contingency reserve.
You should identify and include the positive risks in expected value calculations.
Expected monetary value also helps you with selecting the best decision.
For example, you have a risk and you have identified two risk response
strategies to manage this risk. So how will you select the best strategy?
You will use the expected monetary value to select the best risk response
strategy to manage the risk.
How?
You will calculate the expected monetary value for each response and select the
one which has the lowest value.
Example-I
You have identified a risk with a 30% chance of occurring. However, if this risk
occurs it may cost you 500 USD. Calculate the expected monetary value (EMV)
for this risk event.
We know that:
= 0.3 * -500
= -150
The expected monetary value (EMV) of the risk event is -150 USD.
Example-II
You have identified an opportunity with a 40% chance of happening. However, if
this positive risk occurs it may help you gain 2,000 USD. Calculate the expected
monetary value (EMV) for this risk event.
We know that:
= 0.4 * 2,000
= 800
Hence, the expected monetary value (EMV) of the risk event is 800 USD.
Example-III
In your project you have identified two risks with a 20% and 15 % chance of
occurring. If both of these risks occur they will cost you 1,000 USD and 2,000
USD respectively. What is the expected monetary value of these risk events?
In the above question, you have two negative risks; therefore, the expected
monetary value of these two risks will be the sum of the expected monetary value
of these risks individually.
Expected monetary value of two risk events = EMV of the first event + EMV of
the second event
= -200
= -300
= -500
The expected monetary value (EMV) of these two events is -500 USD.
Example-IV
During risk management planning your team has identified three risks with
probabilities of 10%, 50%, and 35%. If the first two risks occur, they will cost you
5,000 USD and 8,000 USD; however, if the third risk occurs it will give you
benefit of 10,000 USD.
Expected monetary value of three events = EMV of the first event + EMV of the
second event + EMV of the third event
= -500
EMV of the second event = 0.50 * (-8,000)
= -4,000
= 3,500
EMV of all three events = EMV of the first event + EMV of the second event +
EMV of the third event
= -1,000
The expected monetary value (EMV) of all three events is -1,000 USD.
These are four relatively simple types of examples on expected monetary value
analysis chosen to show you the EMV calculation in different scenarios. In the
real PMP exam you will see the question based on these four basic types.
I believe if you understand the above examples, you should not face any
problems in solving the questions based on the expected monetary value.
This technique is usually not used in small and small-medium sized projects.
This technique involves expert opinions to finalize the probability and impact
of the risk. Therefore, personal bias may affect the result.
This technique works well when you have a large number of risks because it
helps spread the impact of the risks.
Sometimes you may miss the inclusion of positive risks, which may affect the
final outcome.
While doing the expected monetary value your risk attitude should be neutral,
otherwise it may affect the calculation.
The reliability of this analysis is based on the data provided as input to this
technique. Therefore the data quality assessment should be thoroughly
performed.
Summary
If you have a large project and you want to complete it successfully within your
budget and schedule, there is no escape from the expected monetary value
analysis. You should perform this risk management technique as it helps you
develop the decision tree and the contingency reserve. This helps increase the
confidence level in achieving the project objectives.
Here is where this blog post on expected monetary value (EMV) ends. If you
have something to say, you can do so through the comments section.