Including Schedule Risk in an NPV Risk Model
Schedule risk may have least two effects on project NPV. First, the materialisation of schedule risk causes delays to the associated cash flows. This often impacts on benefits to a greater extent than costs. If the commencement of benefits realisation is delayed, its value will be lost from the period during which discounting has the least effect. If, in addition, the model terminates at a set date, early lost benefits will, in effect, be lost altogether. Schedule risk may also have the secondary effect of causing cost escalation. Schedule and cost risk are often correlated in models for this reason.
A Method for Including Schedule Risk in an NPV Risk Model
If a project is vulnerable to schedule risk, its effects may be one of the earliest features that should be built into an NPV risk model. The following method can help to do so.
- Identify a small number of schedule milestones that can be used to flex the start and finish dates of cost and/or benefits components in the model. The simplest approach is to select just one milestone, typically the completion of the project implementation phase.
- Develop a simple structure of activities that underpins these milestones for the purposes of constructing a simple schedule risk model.
- Make risk estimates for the activities in the schedule risk model such that it forecasts appropriate variation in the milestone dates when the NPV risk simulation is run.
- Align the phasing of costs and benefits in the model with milestone dates.
- Where costs or benefits vary in proportion to activity duration, ensure that the risk estimates for these components are entered on a pro rata basis e.g. cost per year.
- Review the model's correlation inputs, removing inputs made unnecessary by the previous step and introducing other inputs to correlate schedule and cost components as appropriate.
- Add a calculation method to the model whereby cost and benefits can be apportioned correctly between cash flow periods as milestone dates fluctuate during the simulation.
The last step requires a cash flow apportionment algorithm that handles schedule fluctuations one iteration in the Monte Carlo simulation to the next. This page includes links to two models (Models 6.1 and 6.2) that contain such an algorithm. The book Net Present Value and Risk Modelling for Projects provides a full explanation of the method used, including the relevant conditions and equations.