Remember Russian roulette, the lethal game of chance found in the story, “The Fatalist”, by Russian poet Mikhail Lermontov? You take a revolver which has six empty chambers, insert a single cartridge, and then give the cylinder a good spin. When the cylinder stops spinning (presumably in a random position), you point the barrel at your temple and pull the trigger. The likelihood of the risk occurring (death) is an easy to calculate, but very unhealthy, 16.7%.
Contractor Russian Roulette
Contractors play Russian roulette every time they enter into a new contract. If they calculate that they have an 83.3% chance of avoiding the risks they identify in a new project, they always pull the trigger and sign the contract. They deem an 83.3% chance of success pretty good odds.
But That’s Only Half the Story
Would those same contractors play Russian roulette with a loaded weapon? During my seminars over the years, I have actually asked contractors that very question, and they all gave me that same quizzical look as if to say, “Do you think I’m crazy?”
Without realizing it, they had instinctively factored in the second fundamental element of risk evaluation; thedegree of the penalty if the risk occurs.
The True Measure of Risk
The measurement of risk is easier than you may thing. It involves only two factors; the likelihood that the event being considered will occur (the odds), and the penalty or reward if it occurs. What is critical to understand is that a change in either the odds or the penalty changes the risk. Example: If I offer you a bet on the flip of a coin (50/50 odds) for $10 you may be interested. If I suggest the bet be $1,000 it is not nearly as attractive unless you can afford to lose $1,000. Note that only the penalty changed, the odds remain the same, but the measurement or degree of risk changed considerably. If we discuss the same bet of $1,000 at 6 to 1 odds in your favor, is becomes much more attractive. Note only the odds changed as the penalty remained the same. Let’s take the same 6 to 1 odds in your favor and switch the penalty as in Russian Roulette. Same great odds in your favor, but the penalty is acute, life threatening and a totally unacceptable risk. Great odds, sever penalty—extreme high risk measurement—”off the chart.”
Let’s not pull any punches; construction is very risky for many reasons:
- A poor record of completion as to cost and time.
- High levels of disputes and litigation.
- Intense competition for work.
- Low margins and profit risk.
- Poor safety and occupational health record.
- Pressure to produce a high return on funds invested.
- Pressure to save time and money.
- Pressure on health and safety provisions.
Historically, contractors have ignored risk or dealt with it in an arbitrary way. For example, it is still common practice to simply add a contingency to manage risk, but how is it measured?
Better risk management in construction is to plan in advance for possible risks, measure the likelihood of the risk occurring, evaluate the true cost if the risk occurs, and make a decision to accept it or not based on the data.
- Identify the hazard.
- Assess the likelihood of the risk occurring.
- Measure the cost if the risk does occur.
- Decide to – Goor No Go.
Risk mitigation is accomplished in advance during the planning stage. It begins with realistically recognizing risk factors like project size, type, and location, then accurately assessing the cost that the risk factors represent and weighing one against the other to make a go/no go decision.
- If a risk event has a 90% chance of occurring but represents a minimal cost to your company, you will most likely go ahead with a contract.
- If a risk event has only a 16% chance of occurring but could put you out of business if it does occur, you might pass on the project.
- You weigh the likelihood against the severity of the penalty and then make your choice.
Self-evident but Rare
Although the Russian roulette mental exercise is self-evident, you would be amazed at how rarely contractors go through the exercise in advance of signing a contract. I believe that this negligence is the main cause of contractor failure. It is not the presence of risk elements (weather, market conditions, labor shortages, material inflation, legal entanglements) that make our industry so risky, but rather our unwillingness to realistically recognize risk and plan mitigation measures in advance.
Even with only a 16% likelihood of risk occurrence, you wouldn’t play Russian roulette because you’re not crazy!
Read More: Indicators of Financial Distress and Original R Score Research