McKinsey & Company delve into how to logistics of risk and how to capture the benefit. Any project has an associated risk—delays, cost overruns, unexpected government interventions, market dynamics, etc. For large projects involving significant operational commitment, these risks can turn into considerable and unexpected financial costs. Having seen overruns hit tens and hundreds of millions of euros/dollars or more.
Despite these significant financial penalties, companies rarely give risk its due when it comes to pricing. In many cases, companies still treat risk as an afterthought. Large construction projects, for example, often simply add a standard “contingency cost” of 5 or 10 percent to cover the risks. Here’s how to capture the benefits:
- Know the risk
With the wide availability of data and advanced analytics, companies now can develop risk models that weren’t possible before. They can scale the complexity of the analysis up and down, but the deeper the analysis, the better the information for making decisions. Most companies, however, start with almost nothing, so even putting together a set of “orders of magnitude” estimates based on hypotheses lays a useful foundation for creating awareness of risk and factoring it into the process.
- Develop a risk pricing plan
Once the risks have been identified, the company has to price and come up with an approach for each (or at least for the most important ones). Generally this is a choice between pricing the risk into the contract, mitigating it, managing it during implementation, or simply walking away from it. Each option, of course, comes with a trade-off and cost. Almost any risk, for example, can be mitigated. Locking in the price of a basic material needed for a project can reduce the risk of price volatility though it may increase costs. Understanding these trade-offs helps in deciding on which risks to take. Risk review should be both systematic and flexible enough to respond to changing situations.
- Negotiate the risk
Risk has a cost and a value. In many cases, however, the customer has little idea of the risks and therefore has a limited appreciation of what it’s worth. For this reason, contract negotiation has to include a clear articulation of risks and their value, which is why prior risk analysis is particularly valuable. Negotiators need to understand both the risk and the rationale for pricing it, and be able to defend it when speaking with the customer.