Determining Acceptable Risk

Author: Joe H., Inflow Engineer

In our last post, we talked about the basics of risk assessment. If you haven’t read the post, I recommend doing so now, since this post will build on that content. In our post titled Risk Assessment, we talked about how to determine the overall risk value for a project, and today we’ll look at how we can use that value to guide our decision making process. The key to this is determining our level of acceptable risk. Acceptable risk is the threshold above which your project is no longer worth pursuing. If you’ve ever looked at the side effects of a drug for headaches and decided that you’d rather have a headache than risk the possibility of suffering one of those effects, then you’re already familiar with the concept of acceptable risk. For professional purposes, however, we need to base our threshold value on something more than gut feelings or personal preference.

Determining acceptable risk is actually very simple. The first step is to determine the projected payout of the project in the same units that you will be calculating risk in, typically dollars. This gives you a value for your maximum risk. Next, you need to account for any profit margin you might need to generate with the project. Subtracting this number from the maximum risk value will give you the acceptable risk for your project. So now that we have this value, let’s take a look at how it can be used as a decision making tool.

The power of calculating an acceptable risk for a project is that it remains the same regardless of the approach used to complete the project. This allows us to look at multiple potential solutions, calculate the risk involved in each one, and compare them not just to each other, but to an objective standard. This in turn allows you to compare multiple projects. For example, if you needed to build a bridge, and wanted to determine whether you should use a suspension bridge, an arch bridge, or a truss bridge, you could simply calculate the overall risk of each approach and choose the lowest one. However, if you have to choose between building a bridge and building a subway somewhere else, looking at relative risk may not be accurate. If the subway is a high risk project, but has a much higher payout, you may still want to build the subway instead of the bridge. Looking at risk versus acceptable risk normalizes everything into one metric, allowing for an accurate comparison between highly complex options.

As some of you have probably realized, this type of risk analysis is essentially a cost-benefit analysis. The real value of approach from a risk perspective, rather than a cost perspective, is that it gives you an added level of granularity should you need to choose between two approaches with similar cost-benefit ratios. Maybe one project has a lot of low impact, high probability risks, and the other one has a few high impact, low probability risks, but the same cost-benefit ratio. Depending on your situation, this could make a huge impact on which option is most suitable.

Hopefully, these posts have given non-engineering readers a glimpse into the engineering mindset, and given engineering readers a look at how their training and methods can be applied in way that they may not have considered before. Next post, we’re going to look at some tips for communicating technical topics to a non-technical audience, so be sure to check back! 

 

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