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Project Risk Management and the application of Monte Carlo

Simulation
To ensure the successful completion of a project, it is of utmost importance for the project manager to find ways to
handle uncertainties that can pose potential risks for a project. Risk management is an iterative process. Risks
can relate to any aspect of the project be it the cost, schedule, or quality. The key to managing risks is to identify
them early on in the project and develop an appropriate risk response plan.
To develop a Risk Response Plan, you need to quantify the impact of risks on the project. This process is known
as quantitative risk analysis wherein risks are categorized as high or low priority risks depending on the quantum
of their impact on the project. The Project Management Body of Knowledge (PMBOK) advocates the use of Monte
Carlo analysis for performing quantitative risk analysis.

What is Monte Carlo Analysis?

Monte Carlo analysis involves determining the impact of the identified risks by running simulations to identify the
range of possible outcomes for a number of scenarios. A random sampling is performed by using uncertain risk
variable inputs to generate the range of outcomes with a confidence measure for each outcome. This is typically
done by establishing a mathematical model and then running simulations using this model to estimate the impact
of project risks. This technique helps in forecasting the likely outcome of an event and thereby helps in making
informed project decisions.
While managing a project, you would have faced numerous situations where you have a list of potential risks for
the project, but you have no clue of their possible impact on the project. To solve this problem, you can consider
the worst-case scenario by summing up the maximum expected values for all the variables. Similarly, you can
calculate the best-case scenario. You can now use the Monte Carlo analysis and run simulations to generate the
most likely outcome for the event. In most situations, you will come across a bell-shaped normal distribution
pattern for the possible outcomes.
Let us try to understand this with the help of an example. Suppose you are managing a project involving creation
of an eLearning module. The creation of the eLearning module comprises of three tasks: writing content, creating
graphics, and integrating the multimedia elements. Based on prior experience or other expert knowledge, you
determine the best case, most-likely, and worst-case estimates for each of these activities as given below:
Tasks

Best-case estimate

Most likely estimate

Worst-case estimate

Writing content

4 days

6 days

8 days

Creating graphics

5 days

7 days

9 days

Multimedia integration

2 days

4 days

6 days

Total duration

11 days

17 days

23 days

The Monte Carlo simulation randomly selects the input values for the different tasks to generate the possible
outcomes. Let us assume that the simulation is run 500 times. From the above table, we can see that the project
can be completed anywhere between 11 to 23 days. When the Monte Carlo simulation runs are performed, we can
analyse the percentage of times each duration outcome between 11 and 23 is obtained. The following table
depicts the outcome of a possible Monte Carlo simulation:

Total
Project
Duration

Number of times the simulation result was

less than or equal to the Total Project
Duration

Percentage of simulation runs where the result

was less than or equal to the Total Project
Duration

11

1%

12

20

4%

13

75

15%

14

90

18%

15

125

25%

16

140

28%

17

165

33%

18

275

55%

19

440

88%

20

475

95%

21

490

98%

22

495

99%

23

500

100%

This can be shown graphically in the following manner:

What the above table and chart suggest is, for example, that the likelihood of completing the project in 17 days or
less is 33%. Similarly, the likelihood of completing the project in 19 days or less is 88%, etc. Note the importance
of verifying the possibility of completing the project in 17 days, as this, according to the Most Likely estimates, was
the time you would expect the project to take. Given the above analysis, it looks much more likely that the project
will end up taking anywhere between 19 20 days.

Benefits of Using Monte Carlo Analysis

Whenever you face a complex estimation or forecasting situation that involves a high degree of complexity and
uncertainty, it is best advised to use the Monte Carlo simulation to analyze the likelihood of meeting your
objectives, given your project risk factors, as determined by your schedule risk profile. It is very effective as it is
based on evaluation of data numerically and there is no guesswork involved. The key benefits of using the Monte
Carlo analysis are listed below:
It is an easy method for arriving at the likely outcome for an uncertain event and an associated confidence
limit for the outcome. The only pre-requisites are that you should identify the range limits and the
correlation with other variables.
It is a useful technique for easing decision-making based on numerical data to back your decision.
Monte Carlo simulations are typically useful while analyzing cost and schedule. With the help of the Monte
Carlo analysis, you can add the cost and schedule risk event to your forecasting model with a greater level
of confidence.
You can also use the Monte Carlo analysis to find the likelihood of meeting your project milestones and
intermediate goals.
Now that you are aware of the Monte Carlo analysis and its benefits, let us look at the steps that need to be
performed while analysing data using the Monte Carlo simulation.

Monte Carlo Analysis: Steps

The series of steps followed in the Monte Carlo analysis are listed below:
1. Identify the key project risk variables.
2. Identify the range limits for these project variables.
3. Specify probability weights for this range of values.
4. Establish the relationships for the correlated variables.
5. Perform simulation runs based on the identified variables and the correlations.
6. Statistically analyze the results of the simulation run.
Each of the above listed steps of the Monte Carlo simulation is detailed below:
1. Identification of the key project risk variables: A risk variable is a parameter which is critical to the
success of the project and a slight variation in its outcome might have a negative impact on the project. The
project risk variables are typically isolated using the sensitivity and uncertainty analysis.
Sensitivity analysis is used for determining the most critical variables in a project. To identify the most
critical variables in the project, all the variables are subjected to a fixed deviation and the outcome is
analysed. The variables that have the greatest impact on the outcome of the project are isolated as the key
project risk variables. However, sensitivity analysis in itself might give some misleading results as it does
not take into consideration the realistic nature of the projected change on a specific variable. Therefore it is
important to perform uncertainty analysis in conjunction with the sensitivity analysis.
Uncertainty analysis involves establishing the suitability of a result and it helps in verifying the fitness or
validity of a particular variable. A project variable causing high impact on the overall project might be
insignificant if the probability of its occurrence is extremely low. Therefore it is important to perform
uncertainty analysis.

2. Identification of the range limits for the project variables : This process involves defining the maximum
and minimum values for each identified project risk variable. If you have historical data available with you,
this can be an easier task. You simply need to organize the available data in the form of a frequency
distribution by grouping the number of occurrences at consecutive value intervals. In situations where you
do not have exhaustive historical data, you need to rely on expert judgement to determine the most likely
values.
3. Specification of probability weights for the established range of values: The next step involves
allocating the probability of occurrence for the project risk variable. To do so, multi-value probability
distributions are deployed. Some commonly used probability distributions for analyzing risks are normal
distribution, uniform distribution, triangular distribution, and step distribution. The normal, uniform, and
triangular distributions are even distributions and establish the probability symmetrically within the defined
range with varying concentration towards the centre. Various types of commonly used probability
distributions are depicted in the diagrams below:

4. Establishing the relationships for the correlated

variables: The next step involves defining the correlation
between the project risk variables. Correlation is the
relationship between two or more variables wherein a
change in one variable induces a simultaneous change in
the other. In the Monte Carlo simulation, input values for the
project risk variables are randomly selected to execute the
simulation runs. Therefore, if certain risk variable inputs are
generated that violate the correlation between the variables,
the output is likely to be off the expected value. It is
therefore very important to establish the correlation
between variables and then accordingly apply constraints to
the simulation runs to ensure that the random selection of
the inputs does not violate the defined correlation. This is
done by specifying a correlation coefficient that defines the
relationship between two or more variables. When the
simulation rounds are performed by the computer, the
specification of a correlation coefficient ensures that the
relationship specified is adhered to without any violations.
5. Performing Simulation Runs: The next step involves
performing simulation runs. This is typically done using a
simulation software and ideally 500 1000 simulation runs
constitute a good sample size. While executing the
simulation runs, random values of risk variables are
selected with the specified probability distribution and
correlations.
6. Statistical Analysis of the Simulation Results : Each
simulation run represents the probability of occurrence of a
risk event. A cumulative probability distribution of all the
simulation runs is plotted and it can be used to interpret the probability for the result of the project being
above or below a specific value. This cumulative probability distribution can be used to assess the overall
project risk.

Summary
Monte Carlo simulation is a valuable technique for analyzing risks, specifically those related to cost and schedule.

The fact that it is based on numeric data gathered by running

multiple simulations adds even greater value to this technique. It
also helps in removing any kind of project bias regarding the
selection of alternatives while planning for risks. While running
the Monte Carlo simulation, it is advisable to seek active
participation of the key project decision-makers and
stakeholders, specifically while agreeing on the range values of
the project risk variables and the probability distribution patterns
to be used. This will go a long way in building stakeholder
confidence in your overall risk-handling capability for the project.
Moreover, this serves as a good opportunity to make them
aware of the entire risk management planning being done for the project.
Though there are numerous benefits of the Monte Carlo simulation, the reliability of the outputs depends on the
accuracy of the range values and the correlation patterns, if any, that you have specified during the simulation.
Therefore, you should practice extreme caution while identifying the correlations and specifying the range values.
Else, the entire effort will go waste and you will not get accurate results.