Construction Cost Analysis and Estimating

(0401448)

3 – Risk and Uncertainty

Dr. Khaled Hyari
Department of Civil Engineering
The Hashemite University
Zarqa, Jordan

Risk and Uncertainty

• Uncertainty: A number of different values can
exist for a quantity
– Inability to determine
• Value of a variable
• A future state
• Probability
• Risk: the possibility of loss as a result of
uncertainties
– Possibility of suffering a loss
• Actual
• Opportunity
• All risks involve uncertainties 3-2

1
 Risk and Uncertainty II

• Example: Risks in Construction Development

Firm
– Market risk
• Anticipated demand does not materialize
• Unanticipated supply increases competition
• Natural or other disaster causes failure or high
cost
– Project risk
• Delay in development
• Unanticipated development cost
• Poor building quality
• Legal problems (building code, environment
law)
Risk and Uncertainty 3-3

Risk and Uncertainty III

• Risk and Uncertainty lie at the very heart of

the capital investment decision

• How can we incorporate risk into the

analysis of the firm’s investment decisions?

• Investment decisions depends on

estimates of future cash flows
forecasting the future is at best a risky
business
Risk and Uncertainty 3-4

2
 Handling Risks

• Risks must be recognized

• Once the risk is identified, management must
make a decision as how to handle it. Some of
the options include:
– Avoiding the risk (eg. Not bidding a project
which is far larger and more complex than
any others in which the contractor has
experience)
– Pricing the risk (eg. increasing the
estimated labor cost on the remote project
where skilled craftsman are in short supply)
Risk and Uncertainty 3-5

Handling Risks II

•Options, cont’d:
– Managing the risk by intense pre-planning
and analysis so that additional cost can be
avoided
– Subcontracting high risk work to a qualified,
bonded subcontractor
– Insurance

Risk and Uncertainty 3-6

3
 States of Expectations

• Certainty
– We can calculate the exact return which
will be received upon redemption. Ex:
Short term treasury bills (War?,
Inflation?…)
• Uncertainty
– Option whose profit is not known in
advance with absolute certainty, but for
which an array of alternative outcomes
and their probabilities are known
Risk and Uncertainty 3-7

Frequency Distribution of Profits

Risk and Uncertainty 3-8

4
 Frequency Distribution of Profits II

• Is there any reason why the future

distribution of profits should resemble the
distribution in the past?
• How can we realize the high profit (right-
hand side of the histogram)?
• What if we don’t have past experience to
draw upon? Can we make a decision based
on subjective probabilities (personal
judgement regarding the chances of gain
and loss)?
Risk and Uncertainty 3-9

The Maximum Expected Return Criterion

• A and B Certainty
• C, D and E Uncertainty
• Once uncertainty is introduced, the
maximum return criterion is no longer
applicable
Risk and Uncertainty 3 - 10

5
 The Maximum Expected Return Criterion II

• Expected profit is defined as the mean of

the return distribution weighted by the
probabilities of occurrence
– Example: Project C
• 1/4 x (-8) + 1/2 x 16 + 1/4 x 24 = 12
– Project Expected Return
•A 8
•B 10
•C 12
•D 6
•E 13
Risk and Uncertainty 3 - 11

The Maximum Expected Return Criterion III

• Does it take risk explicitly into account?

I - Luxury products - very vulnerable to general

economic conditions
II - Basic food items
•Both have the same expected profit - $620
Risk and Uncertainty 3 - 12

6
 The Maximum Expected Return Criterion IV

• I - 20% chance of
loss
• II - 0% chance of
loss
• Expected profit
measures
profitability - does
not measures risk

Risk and Uncertainty 3 - 13

The Maximum Expected Return Criterion V

• Using Expected Values to make decision

means that the decision maker is
considering only the average payoff
• Expected value does not capture the risk
attitudes
• Taking decision based on expected values
is convenient, but it can lead to decision
that may not seem intuitively appealing

Risk and Uncertainty 3 - 14

7
 Expected Return (Joint Probability)
• Electronics manufacturing firm evaluates a new
product
– Sale price = $650
– 3 estimates for annual sales volume
– 3 estimates for unit cost
– Cost is independent of volume
– Expected profit ?
Cost per Probability Annual Sales Probability
Unit, ($) Volume
*450 0.7 15,000 0.2
500 0.2
20,000 0.2
550 0.1
Risk and Uncertainty
*25,000 0.6 3 - 15

Expected Return (Joint Probability) II

• 1st Approach
– Expected sales volume = 15,000 x 0.2 +
20,000 x 0.2 + 25,000 x 0.6 = 22,000
– Expected cost = 450 x 0.7 + 500 x 0.2 +
550 x 0.1 = 470
– Expected profit = (650 – 470) x 22,000 =
$3.96 million
• 2nd Approach
– Calculate joint probability

Risk and Uncertainty 3 - 16

8
 Expected Return (Joint Probability) III
Joint probability for cost and volume of product
(650 – Cost) Volume, Joint Probability Expected
$ of Occurrence Value Profit, $
(650 – 450) 15,000 = 3,000,000 0.14 420,000
(650 – 450) 20,000 = 4,000,000 0.14 560,000
(650 – 450) 25,000 = 5,000,000 0.42 2,100,000
(650 – 500) 15,000 = 2,250,000 0.04 90,000
(650 – 500) 20,000 = 3,000,000 0.04 120,000
(650 – 500) 25,000 = 3,750,000 0.12 450,000
(650 – 550) 15,000 = 1,500,000 0.02 30,000
(650 – 550) 20,000 = 2,000,000 0.02 40,000
(650 – 550) 25,000 = 2,500,000 0.06 150,000
Profit =
Total 1.00
Risk and Uncertainty $3,960,000 3 - 17

Expected Return (Joint Probability) IV

• What is the estimated profit if uncertainty

was not considered?
– Estimated profit = (650 – 450 ) x 25,000 =
$5 millions

Risk and Uncertainty 3 - 18

9
 Alternatives Attitudes Toward Risk

• Classes of investors:
– “Risk Averse”

– “Risk Lover”

– “Risk Neutral”

• Typical investor is risk averse. They don’t

like wide distribution of outcomes

Risk and Uncertainty 3 - 19

Alternatives Attitudes Toward Risk II

• Example:
– Opportunity of purchasing for $10.00 the
following investment option:

End-of-Period Probability
Value
9 50%
11 50%
– Very short term - Don’t consider interest!
– Expected end-of-period value:
0.5 x 9 + 0.5 x 11 = 10 =purchase price

Risk and Uncertainty 3 - 20

10
 Alternatives Attitudes Toward Risk III

• Can an individual be expected to purchase

such an option?
• Depends on the individual’s attitude
toward risk - The degree to which he
“likes” or “dislikes” to trade a safe prospect
for an uncertain one.

Risk and Uncertainty 3 - 21

Utility Function

• The utility Function represents a way to

translate dollars into “Utility Units”
• Instead of maximizing expected value, the
decision maker should maximize expected
utility
• A utility function might be specified in terms of :
– Graph
– Tabular form
– Mathematical expression
• Utility Function is only a model of an
individual’s attitude toward risk
Risk and Uncertainty 3 - 22

11
 Utility Function II
• Three different shapes for utility functions:
– Risk-Lover
– Risk-Neutral
– Risk-Averse
• Risk neutrality is reflected by a utility curve that is
simply a straight line
• For Risk Neutral person , maximizing expected
value is the same as maximizing expected utility
• A convex (opening upward) utility curve indicates
risk-seeking behavior
• A concave (opening downward) utility curve
indicates risk-averse behavior 3 - 23

Utility Function III

3 - 24

12
 Utility Function IV

• Concave risk averse

– Marginal utility of money declines over the
entire relevant range - diminishing marginal
utility
• Convex risk lover
• In the example the risk averse will not
purchase the option because in term of
utility, the possible loss of $1 more than
offset the equal possible gain of $1

Risk and Uncertainty 3 - 25

Utility Function V

• Risk premium is the discount required to

induce the risk-averse individual to
purchase the option
• At prices lower than M the investment
option is attractive - It represents gain in
the utility

Risk and Uncertainty 3 - 26

13
 Utility Function VI

• The expected utility rule is not operational:

– Assessing a utility function is a matter of
subjective judgment, just like assessing
subjective probability
– Cannot calculate expected utilities
– We do not know the precise shape of the utility
function
– Different people have different risk attitudes and
thus are willing to accept different level of risk.
– Companies have many partners or stockholders,
each with a different utility function
Risk and Uncertainty 3 - 27

Measuring Risks by the Variability of Returns

• Simplest and most used way to measure

risk
• Utilizes the expected (mean) profit as an
indication of the investment’s anticipated
profitability and the variance (or standard
deviation) as an indication of risk.

Risk and Uncertainty 3 - 28

14
 Measuring Risks by the Variability of Returns II

• Example:
Profit in $ Probability
80 50%
100 25%
200 25%
• Expected Profit
0.5 x 80 + 0.25 x 100 + 0.25 x 200 =$115

Risk and Uncertainty 3 - 29

Measuring Risks by the Variability of Returns III

• Variance

= 0.5 x 802 +0.25 x 1002 +0.25 x 2002 -1152

=2,475

• Standard Deviation
σ(x) = √ 2,475 = 49.75
Risk and Uncertainty 3 - 30

15
 Range Estimating

• Based on PERT method

• Three estimates for each major cost item
– Lowest cost, or best-case estimate of cost
(optimistic estimate)
– Most likely estimate of cost
– Highest cost, or worst-case estimate of cost
(Pessimistic estimate)

Risk and Uncertainty 3 - 31

Range Estimating II

• Those estimates are assumed to correspond

to beta distribution
– Only positive costs are allowed
– It can be symmetric, Skewed right, skewed left

3 - 32

16
 Range Estimating III

• E(Ci) = Expected cost of cost item i

• L = Lowest cost, best-case estimate
• M = Most likely estimate
• H = Highest cost, worst-case estimate
• Var(Ci) = Variance of cost distribution of cost
item i 3 - 33

Range Estimating IV
• For total cost, the new distribution of the total
project cost is approximately normal (Central
limit theorem)

Risk and Uncertainty 3 - 34

17
 Range Estimating V

• E(CT) = E(C1) + E(C2) + ………+ E(Cn)

• Var (CT) = Var (C1) + Var (C2) + ………+ Var (Cn)

• E(CT) = Expected total cost

• Var (CT) = Variance of total cost

Risk and Uncertainty 3 - 35

Range Estimating VI

• What is the probability that a certain cost (x)

will be exceeded?

Risk and Uncertainty 3 - 36

18
 Range Estimating VII

• Probability of exceeding x value = 0.5 - Pr(Z)

x − E (C T )
z=
Var (C T )
• Pr [cost > E(CT) = 0.5 (50%)
• Pr [cost < E(CT) = 0.5 (50%)
• Example: E(CT) =$10,610, Var (CT) = 22,301
• Pr [cost > $10,850]? 10850 − 10610
z= = 1.607
22,301 3 - 37
Risk and Uncertainty

Range Estimation IV

3 - 38

19
 Range Estimating IX

• Using Z =1.607, Pr [cost > $10,850] = 0.5 –

0.4463 = 0.0537 = 5%

• Pr [cost < $10,850] = 0.5 +0.4463 = 0.9463 =

95%

• Pr [$10,500<cost < $10,850]?

– Pr [cost<10,500]
10500 − 10610
z= = −0.74
22,301
– Pr [cost<10,500] =0.5 - 0.2704 = 0.2296 3 - 39

Range Estimation X

•Pr [cost < $10,850] = 0.9463

Pr [$10,500<cost < $10,850] = 0.9463-0.2296 =

0.712 = 71.2%

• Advantages:
– Considering uncertainty
– Ability to identify elements of cost that have great
uncertainty

Risk and Uncertainty 3 - 40

20