Project Risk Analysis

Jørn Vatn

Norwegian University of Science and Technology

January 2008
2
Contents

1 Introduction 5
1.1 About this compendium . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.2 Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

2 Risk Management 9
2.1 Project objectives and criteria . . . . . . . . . . . . . . . . . . . . . . 9
2.2 Risk identification . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2.3 Structuring and modelling of risk . . . . . . . . . . . . . . . . . . . . 12
2.3.1 Model for project execution time/schedule modelling . . . . . 12
2.3.2 Cost modelling . . . . . . . . . . . . . . . . . . . . . . . . . 13
2.3.3 Uncertainty in schedule and cost modelling . . . . . . . . . . 13
2.4 Risk elements for follow up: Risk and opportunity register . . . . . . 14
2.5 Correction and controll . . . . . . . . . . . . . . . . . . . . . . . . . 15
2.6 Collection and analysis of experience - learning . . . . . . . . . . . . 15

3 Probability theory 25
3.1 Basic probability notation . . . . . . . . . . . . . . . . . . . . . . . . 25
3.1.1 Event . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
3.1.2 Probability . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
3.1.3 Probability and Kolmogorov’s axioms . . . . . . . . . . . . . 26
3.1.4 The law of total probability . . . . . . . . . . . . . . . . . . . 28
3.1.5 Bayes rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
3.1.6 Stochastic variables . . . . . . . . . . . . . . . . . . . . . . . 29
3.2 Common probability distributions . . . . . . . . . . . . . . . . . . . 33
3.2.1 The normal distribution . . . . . . . . . . . . . . . . . . . . . 33
3.2.2 The exponential distribution . . . . . . . . . . . . . . . . . . 34
3.2.3 The Weibull distribution . . . . . . . . . . . . . . . . . . . . 35
3.2.4 The gamma distribution . . . . . . . . . . . . . . . . . . . . 35
3.2.5 The inverted gamma distribution . . . . . . . . . . . . . . . . 35
3.2.6 The lognormal distribution . . . . . . . . . . . . . . . . . . . 36
3.2.7 The binomial distribution . . . . . . . . . . . . . . . . . . . . 36
3.2.8 The Poisson distribution . . . . . . . . . . . . . . . . . . . . 37
3.2.9 The inverse-Gauss distribution . . . . . . . . . . . . . . . . . 37
3.2.10 The triangular distribution . . . . . . . . . . . . . . . . . . . 38

3
4 CONTENTS

3.2.11 The PERT distribution . . . . . . . . . . . . . . . . . . . . . 38

3.3 Assessment of parameters in parametric distributions . . . . . . . . . 40
3.4 Distribution of sums, products and maximum values . . . . . . . . . . 40
3.4.1 Distribution of sums . . . . . . . . . . . . . . . . . . . . . . 40
3.4.2 Distribution of a product . . . . . . . . . . . . . . . . . . . . 42
3.4.3 Distribution of maximum values . . . . . . . . . . . . . . . . 42

4 Schedule 45
4.1 Critical Path Method (CPM) . . . . . . . . . . . . . . . . . . . . . . 47
4.2 Program Evaluation and Review Technique (PERT) . . . . . . . . . . 47
4.3 Successive schedule planning (SSP) . . . . . . . . . . . . . . . . . . 47
4.4 Monte Carlo simulation (MCS) . . . . . . . . . . . . . . . . . . . . . 50
4.5 Penalty for default . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
4.6 Event uncertainty in the schedule model . . . . . . . . . . . . . . . . 53
4.7 Updating the model as we get more information . . . . . . . . . . . . 54
4.8 Examples of advanced schedule modelling . . . . . . . . . . . . . . . 55

5 Decision under uncertainties 57

5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
5.1.1 Overview of the method . . . . . . . . . . . . . . . . . . . . 57
5.2 Basic concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
5.2.1 Discrete end consequences vs attribute vector . . . . . . . . . 59
5.2.2 Maximising expected utility . . . . . . . . . . . . . . . . . . 64
5.2.3 Examples with one decision node . . . . . . . . . . . . . . . 65
5.2.4 Decision trees . . . . . . . . . . . . . . . . . . . . . . . . . . 69

6 Life cycle cost and life cycle profit 77

6.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
6.2 Net present value calculation . . . . . . . . . . . . . . . . . . . . . . 78
6.2.1 Trend modelling . . . . . . . . . . . . . . . . . . . . . . . . 79
6.2.2 Example areas of LCC calculations . . . . . . . . . . . . . . 79
Chapter 1

Introduction

1.1 About this compendium

This course compendium is to be used in the course “Risikostyring i prosjekter”. The
focus will be on the following topics:
• Risk identification
• Risk structuring
• Risk modelling in the light of a time schedule and a cost model
• Risk follow up
We will also discuss elements related to decision analysis where risk is involved, and
use of life cycle cost and life cycle profit models.
The course compendium comprises a large number of exercises, and it is recom-
mended to do most of the exercises in order to get a good understanding of the topics
and methods described. A separate MS Excel program, [Link] has been developed
in order to assist numerical calculations and to conduct Monte Carlo simulation.

1.2 Definitions
Aleatory uncertainty
Variation of quantities in a population. We sometimes use the word variability rather
than aleatory uncertainty.

Epistemic uncertainty
Lack of knowledge about the “world”, and observable quantities in particular.

Dependency
The relation between the sequence of the activities in a project.

5
6 CHAPTER 1. INTRODUCTION

Observable quantity
A quantity expressing a state of the “world”, i.e. a quantity of the physical reality or
nature, that is unknown at the time of the analysis but will, if the system being analysed
is actually implemented, take some value in the future, and possibly become known.

Parameter
We use the term parameter in two ways in this report. The main use of a parameter is
that it is a quantity that is a part of the risk analysis models, and for which we assign
numerical values. The more academic definition of a parameter used in a probability
statement about an observable quantity, X, is that a parameter is a construct where the
value of the parameter is the limiting value where we are not able to saturate our un-
derstanding about the observable quantity X whatsoever new information we could get
hold of.

Parameter estimate
The numeric value we assess to a parameter.

Probability
A measure of uncertainty of an event.

Risk
Risk is defined as the answer to the three questions [14]: i) what can go wrong? ii) how
likely is it?, andn if it goes wrong,
o iii) what are the consequences? To describe the risk
we write R = < si , li , xqi > where si is a scenario and an answer to the first question,
q
li , is the likelihood for the scenario, and xi is the consequence.

Risk acceptance
A decision to accept a risk.

Risk acceptance criterion

A reference by which risk is assessed to be acceptable or unacceptable.

Schedule
A plan which specifies the start and finalisation point of times for the activities in a
project.

Stochastic dependency
Two or more stochastic variables are (stochastically) dependent if the expectation of
one stochastic variable depends on the value of one or more of the other stochastic
variables.

Stochastic variable
A stochastic variable, or random quantity, is a quantity for which we do not know the
value it will take. However, we could state statistical properties of the variable or make
probability statement about the value of the quantity.
1.2. DEFINITIONS 7

Uncertainty
Lack of knowledge about the performance of a system, and observable quantities in
particular.
8 CHAPTER 1. INTRODUCTION
Chapter 2

Risk Management

Generally, risk management is defined (IEC 60300-3-9) as a “systematic application

of management policies, procedures and practices to the tasks of analyzing, evaluating
and controlling risk”. It will comprise (IEC definitions in parentheses):

• Risk assessment, i.e.

– Risk analysis (“Systematic use of available information to identify hazards

and to estimate the risk to individuals or populations, property or the envi-
ronment”), and
– Risk evaluation (“Process in which judgments are made on the tolerability
of the risk on the basis of risk analysis and taking into account factors such
as socio-economic and environmental aspects”)

• Risk reduction/control (Decision making, implementation and risk monitoring).

There exists no common definition of risk, but for instance IEC 60300-3-9 [13] defines
risk as a “combination of the frequency, or probability, of occurrence and the conse-
quence of a specified hazardous events”. Most definitions comprise the elements of
probabilities and consequences. However, some as Klinke and Renn (2001) [15] sug-
gest a very wide definition, stating: “Risk refers to the possibility that human actions
or events lead to consequences that affect aspects of what humans value”. So the total
risk comprises the possibility of a number (“all”) unwanted/hazardous events. It is part
of the risk analysis to delimit which hazards to include. Further, risk usually refers to
threats in the future, involving a (high) degree of uncertainty.
In the following we will present the basic elements of risk management as it is
proposed to be an integral part of project management.

2.1 Project objectives and criteria

In classical risk analysis of industrial systems the use of so-called risk acceptance cri-
teria has played a central role in the last two or tree decades. Basically use of risk

9
10 CHAPTER 2. RISK MANAGEMENT

acceptance criteria means that some severe consequences are defined, e.g. accident
with fatalities. Then we try to set an upper limit for the probability of these conse-
quences that could be accepted, i.e. we could not accept higher probabilities in any
situations. Further these probabilities could only be accepted if risk reduction is not
possible, or the cost of risk reduction is very high.
In recent years it has been a discussion in the risk analysis society whether it is
fruitful or not to use risk acceptance criteria according to the principles above. It is
argued that very often risk acceptance criteria are set arbitrary, and these do not nec-
essarily support the overall best solutions. Therefore, it could be more fruitful to use
some kind of risk evaluation criteria, rather than strict acceptance criteria.
In project risk management we could establish acceptance criteria related to two
types of events:
• Events with severe consequences related to health, environment and safety.
• Events with severe consequences related to project costs, project quality, project
duration, or even termination of the project.
In this course we will have main focus on the project costs and the duration of the
project. Note that both project cost and project duration are stochastic variables and
not events. Thus it is not possible to establish acceptance criteria to project cost or
duration directly. Basically, there are three types of numeric values we could introduce
in relation to such stochastic variables describing the project:
1. Target. The target expresses our ambitions in the project. The target shall be
something we are striving at, and it should be possible to reach the target. It is
possible to introduce (internal) bonuses, or other rewards in order to reach the
targets in a project.
2. Expectation. The expectations are the value the stochastic variables will achieve
in the long run, or our expectation about the outcome. The expectation is less
ambitious than the target. The expectation will in a realistic way account for
hazards, and threats and conditions which often contribute to the fact that the
targets are not met.
3. Commitment. The commitments are values related to the stochastic variables
which are regulated in agreements and contracts. For example it could be stated
in the contract that a new bridge shall be completed within a given date. If we
are not able to fulfil the commitments, this will usually result in economical
consequences, for example penalties for defaults, or in the worst case canceling
of the contract.

Problem 2.1
Discuss targets, expectations and commitments related to a new railway track between
two big cities in Norway. 
We sometimes also want to discuss the uncertainty in e.g. the project costs. In Sec-
tion 2.3.3 we have discussed the uncertainty concept in relation to project duration and
costs.
2.2. RISK IDENTIFICATION 11

2.2 Risk identification

In order to establish a risk picture three important questions are put forward:
1. What could go wrong?
2. How likely is it?
3. And if it goes wrong, how serious is it (the consequences)?
With respect to risk identification it is the first question we will answer. The question
could be adressed from different angles:

• A listing of undesired events.

• A listing of scenarios.
• A listing of hazards.
• A listing of threats.

An undesired event is an event which might occur, e.g. a large water leakage in a tunnel.
A scenario is a description of a imagined sequence or chain of events, e.g. we have a
water leakage, and we are not able to stop this leakage with ordinary tightening medium
due to the possible environmental aspects which is not clarified at the moment. Further
the green movement is also likely to enter the scene in this case. A hazard is typically
related to energies, poisonous media etc, and if they are released this will result in
an accident or a severe event. A threat is a wider term than hazard, and we include
also aspects as “wrong” method applied, “lack of competence and experience”. The
term threat is also very often used in connection with security problems, e.g. sabotage,
terrorism, and vandalism.

Problem 2.2
List examples of “undesired events”, “scenarios”, “hazards” and “threats” in relation
to building a new railway track between two major cities in Norway. 
There exist several methods that could be used in order to identify undesired events and
threats, e.g.:
• Preliminary Hazard Analysis (PHA). PHA is used to establish threats in an early
phase of a project. The method will usually require some project breakdown, e.g
Work Breakdown Structure (WBS) or Cost Breakdown Structure (CBS), project
phases or similar. A detailed project description is usually not available at this
moment.
• Task analysis (TA) and Hazard and Operability Study (HAZOP) are used on a
more detailed level where we have knowledge about the various tasks.
• Use of experience data means that we try to identify events and threats based on
systematic analysis of experience from the past, i.e. what have gone wrong in
earlier projects.
12 CHAPTER 2. RISK MANAGEMENT

• Checklists. Checklists exist on different levels, and could either be used in a

separate analysis, or as an aid in another method, e.g. in a PHA. The checklists
should, however, be put a way initially since introducing checklists early will
often prevent the process of revealing project specific conditions. A checklist is
primarily a list to be used in the end of the process to ensure that the “obvious”
elements have not been overlooked. In Table 2.6 a such generic list of risk factors
is provided. For each risk factor in the list, also some “cues” are listed which
could be used to assess the significance of the risk factor in a given project. Note
that this list is on a very general level, and not specific to e.g. a construction
project, a tunnel project and so on.

2.3 Structuring and modelling of risk

In Section 2.2 we have identified methods to identify events and threats. We now want
to relate these events and threats to the explicit models we have for project costs and
project duration.

2.3.1 Model for project execution time/schedule modelling

When analysing the execution time for a project we will have a project plan and typ-
ically a Gantt diagram as a starting point. The Gantt diagram is transformed into a
so-called flow network. where the connections between the activities are explicitly
described. Such a flow network also comprises description of duration of the activi-
ties in terms of probability statements. The duration of each activities are stochastic
variables, which we denote T i for activity i. In a flow network we might also have
uncertain activities which will be carried out only under special conditions. These con-
ditions could be describe in terms of events, and we need to describe the probability
of occurrence of such events. Thus, there is a set of quantities, i.e. time variables and
events in the model. The objective is now to link the undesired events and threats dis-
cussed in Section 2.2 to these time variables and events. Time variables are described
by a probability distribution function. Such a distribution function comprises param-
eters that characterise the time variable. Often a parametric probability distribution is
described by the three quantities L (low), M (most likely) and H high. If an undesired
event occur, it is likely that the values of L, M and H will be higher than in case this
event does not occur. A way to include the result from the risk identification process
is then to express the different values of L, M and H depending on whether the critical
event occurs or not. If we in addition are able to assess the probability of occurrence of
the critical event, the knowledge about this critical event has been completely included
into the risk model. Based on such an explicit modelling of the critical event, we could
also easily update the model in case of new information about the critical event is ob-
tained, for example new information could be available at a later stage in the process
and changes of the plan could still be possible in light of the new information.
2.3. STRUCTURING AND MODELLING OF RISK 13

2.3.2 Cost modelling

The cost model is usually based on the cost breakdown structure, and the cost elements
will again be functions of labor cost, overtime cost, purchase price, hour cost of renting
equipment, material cost, amount of material etc. The probabilistic modelling of cost
is usually easier than for modelling project execution time. The principle is just to add
a lot of cost terms, where each cost term is the product of the unit price and the number
of units. We introduce price and volume as stochastic variables to describe the unit
price and the number of units. The price and volume variables should also be linked to
the undesired events and threats we have identified in Section 2.2. Often it is necessary
to link the cost model to the schedule model. For example in case of delays it might be
necessary to put more effort into the project to catch up with the problems, and these
effort could be very costly. Also, if the project is delayed we may need to pay extra
cost to sub-contractors that have to postpone their support into the project.

2.3.3 Uncertainty in schedule and cost modelling

As indicated above we will establish probabilistic models to describe the duration and
cost of a project. The result of such a probabilistic modelling is that we treat the
duration and cost as stochastic variables. Since duration and costs are stochastic vari-
ables, this means that there is uncertainty regarding the values they will take in the
real project we are evaluating. Sometimes we split this uncertainty into three different
categories, i) aleatory uncertainty (variability due to e.g. weather conditions, labour
conflicts, breakdown of machines etc.), ii) parameter or epistemic uncertainty due to
lack of knowledge about “true” parameter values, and iii) model uncertainty due to lack
of detailed, or wrong modelling. Under such a thinking, the aleatory uncertainty could
not be reduced, it is believed to be the result of the variability in the world which we
cannot control. Uncertainty in the parameters is, however, believed to be reducible by
collecting more information. Also uncertainty in the models is believed to be reducible
by more detailed modelling, and decomposition of the various elements that go into the
model. It is appealing to have a mental model where the uncertainty could be split into
one part which we might not reduce (variability), and one part which we might reduce
by thorough analysis and more investigation (increased knowledge). If we are able to
demonstrate that the part of the uncertainty related to lack of knowledge and under-
standing has been reduced to a sufficient degree, we could then claim high confidence
in the analysis. In some situation the owner, or the authorities put forward require-
ments which could be interpreted as confidence regarding the quality of the analysis. It
is though not always clear what is meant by such a confidence level. As an example, let
E(C) be the expected cost of a project. A confidence statement could now be formu-
lated as “The probability that the actual project cost is within an interval E(C) ± 10%
should at least be 70%”. It is, however, not straight forward to document such a con-
fidence level in a real analysis. The “Succesive process (trinnvisprosessen)” [4] is an
attempt to demonstrate how to reduce the “uncertainty” in the result to a certain level
of confidence.
We also mention that Aven [12] has recently questioned such an approach where
there exist model uncertainty and parameter uncertainty, and emphasises that we in the
14 CHAPTER 2. RISK MANAGEMENT

analysis should focus on the observable quantities which will become evident for us if
the project is executed, e.g. the costs, and that uncertainty in these quantities represent
the lack of knowledge about which values they will take in the future. This discussion
is not pursuit any more in this presentation.

Problem 2.3 Discuss different type of uncertainties in a tunnel project. Propose a

classification, and identify uncertainty elements that could be reduced by i) further
physical investigation, and ii) by further analysis. Also list uncertainty elements that
could not be reduced before the project is actually executed. 

2.4 Risk elements for follow up: Risk and opportunity

register
As risk elements and threats are identified in Section 2.2 these have to be controlled as
far as possible. It is not sufficient to identify these conditions and model them in the
schedule and cost models, we also have to mitigate the risk elements and threats. In
order to ensure a systematic follow up of risk elements and threats it is recommended
to establish a so-called threat log. The terms ’Risk Register‘ and ’Risk & Opportunity
Register‘ (R&OR) is sometimes used rather than the term ’threat log.‘
A R&OR is best managed by a database solution, for example an MS-Access
database. Each row in the database represents one risk element or threat. The fields in
such a database could vary, but the following fields seems reasonable:
• ID. An identifier is required in order to keep track of the threat in relation to the
quantitative risk models, to follow up actions et.
• Description. A description of the threat is necessary in order to understand the
content of the the problem. It could be necessary to state the immediate conse-
quences (e.g. occupational accident), but also consequences in terms of the main
objectives of the project, e.g time and costs.
• Likelihood or probability. A judgment regarding how probable it is that the threat
or the risk condition will be released in terms of e.g. undesired or critical events.
• Impact. If possilbe, give a direct impact on cost and schedule if the event occurs,
either by an expected impact, or by L, M and H values.
• References to cost and schedule. In order to update the schedule and cost models
it is convenient to give an explicit reference from the R&OR into the schedule
and cost models.
• Manageability. Here it is descried how the threat could be influenced, either by
implementing measures to eliminate the threat prior to it reveals it self, or mea-
sures in order to reduce the consequences in case of the threat will materialize.
• Alert information. It is important to be aware of information that could indicate
the development of the threat before it eventually will materialize. If such in-
formation is available we could implement relevant measures if necessary. For
2.5. CORRECTION AND CONTROLL 15

example it could be possible to take ground samples at a certain cost, but util-
ising the information from such samples could enable us to choose appropriate
methods for tunnel penetration.

• Measures. List of measures that could be implemented to reduce the risk.

• Deadline and responsible. Identification of who is responsible for implementing

and follow up of the measure or threat, and any deadlines.

• Status. Both with respect to the threat and any measure it is valuable to spec-
ify the development, i.e. did the treat reveal it self into undesired events with
unwanted consequences, did the measure play any positive effect etc.

Problem 2.4
Consider threats and risk conditions in Problem 2.2 and discuss the possibilities to
mitigate the threats, and if any prior information could be available. 

2.5 Correction and controll

As the project develops the R&OR is the primary controll tool for risk follow up.
By following the status of the various threats, risk elements and measures we could
monitor the risk in the project. This information should of course be linked to the time
and cost plans. If a given threat does not reveal in terms of undesired events, the time
and cost estimates could be lowered and this gain could be utilised in other part of the
project, or in other projects. In the opposite situation it is necessary to increase the time
and cost estimates, and we need to consider new measures, and maybe spend some of
the reserves to catch up in case of an expected delay.
During the life cycle of a project it will occur new threats and risk elements which
we did not foresee in the initial risk identification process. Such threats must continu-
ously be entered into the R&OR, and measures need to be considered.

2.6 Collection and analysis of experience - learning

After project execution it is valuable to systemise the information and knowledge we
have achieved during the project. The most important data sources will be

• The risk and opportunity register (R&OR).

• Schedule plans, and the relation between plans and reality.

• Cost plans, and account numbers

Problem 2.5
Identify other sources of information that could be relevant. 

It is especially two types of analyses we will conduct:

 16 CHAPTER 2. RISK MANAGEMENT

Project objectives,
requirements etc.

Learning
Experience
Risk identification
data

Risk structuring Project

and modelling debriefing

Identify threats and risks Regular update of

to include in R&OR R&OR

Project execution,
correction and controll

Project Project Project Operating

initiation start-up finalisation phase

Figure 2.1: Project risk management

• Systemising of what went wrong, and which measures that proved to be efficient.
• Estimation of parameters which we could include in later probabilistic schedule
and cost models.
The main elements of the project risk management process is shown in Figure 2.1.
2.6. COLLECTION AND ANALYSIS OF EXPERIENCE - LEARNING 17

Table 2.1: Risk factors, adapted from State of Texas: Department of Information Re-
sources, [Link]

Risk Factors Low Risk Cues Medium Risk Cues High Risk Cues
Project Fit to Cus- directly supports indirectly impacts does not support or
tomer Organization customer organiza- one or more goals of relate to customer
tion mission and/or customer organization mission
goals or goals
Project Fit to directly supports indirectly impacts does not support or
Provider Organiza- provider organiza- one or more goals of relate to provider
tion tion mission and/or provider organization mission
goals or goals
Customer Percep- customer expects organization is project is mismatch
tion this organization to working on project with prior products
provide this product in area not expected or services of this or-
by customer ganization
Work Flow little or no change to will change some as- significantly
work flow pect or have small changes the work
affect on work flow flow or method of
organization
Goals Conflict goals of projects goals of projects do goals of projects are
within the program not conflict, but pro- in conflict, either di-
are supportive of or vide little direct sup- rectly or indirectly
complimentary to port
each other
Resource Conflict projects within the projects within the projects within the
program share re- program schedule program often need
sources without any resources carefully the same resources
conflict to avoid conflict at the same time
(or compete for the
same budget)
Customer Conflict multiple customers multiple customers multiple customers
of the program have of the program have of the program are
common needs different needs, but trying to drive it
do not conflict in very different
directions
Leadership program has active program has person program has no
program manager or team responsible leader, or program
who coordinates for program, but un- manager concept is
projects able to spend enough not in use
time to lead effec-
tively
continued on next page
18 CHAPTER 2. RISK MANAGEMENT

continued from previous page

Risk Factors Low Risk Cues Medium Risk Cues High Risk Cues
Program Manager program manager program manager program manager is
Experience has deep experience has some experience new to the domain
in the domain in domain, is able
to leverage subject
matter experts
Definition of the program is well- program is well- program is not
Program defined, with a defined, but unlikely well-defined or
scope that is man- to be handled by this carries conflicting
ageable by this organization objectives in the
organization scope
Political Influences no particular project has several project has a vari-
politically-driven politically motivated ety of political influ-
choices being made decisions, such as ences or most deci-
using a vendor se- sions are made be-
lected for political hind closed doors
reasons, rather than
qualifications
Convenient Date date for delivery has date is being par- date is being totally
been set by reason- tially driven by need driven by need to
able project commit- to meet marketing meet marketing
ment process demo, trade show, demo, trade show,
or other mandate not or other mandate;
related to technical little consideration
estimate of project team
estimates
Use of Attractive technology selected project is being done project is being done
Technology has been in use for in a sub-optimal as a way to show a
some time way, to leverage new technology or as
the purchase or an excuse to bring a
development of new new technology into
technology the organization
Short Term Solution project meets short project is focused on project team has
term need without short-term solution been explicitly di-
serious compromise to a problem, with rected to ignore the
to long term outlook little understanding long term outlook
of what is needed in and focus on com-
the long term pleting the short
term deliverable
continued on next page
2.6. COLLECTION AND ANALYSIS OF EXPERIENCE - LEARNING 19

continued from previous page

Risk Factors Low Risk Cues Medium Risk Cues High Risk Cues
Organization Stabil- little or no change some management management or or-
ity in management or change or reorgani- ganization structure
structure expected zation expected is continually or
rapidly changing
Organization Roles individuals through- individuals under- many in the organi-
and Responsibilities out the organization stand their own roles zation are unsure or
understand their own and responsibilities, unaware of who is
roles and responsi- but are unsure who responsible for many
bilities and those of is responsible for of the activities of
others work outside their the organization
immediate group
Policies and Stan- development poli- development poli- no policies or stan-
dards cies and standards cies and standards dards, or they are ill-
are defined and are in place, but defined and unused
carefully followed are weak or not
carefully followed
Management Sup- strongly committed some commitment, little or no support
port to success of project not total
Executive Involve- visible and strong occasional support, no visible support;
ment support provides help on is- no help on unre-
sues when asked solved issues
Project Objectives verifiable project ob- some project objec- no established
jectives, reasonable tives, measures may project objectives or
requirements be questionable objectives are not
measurable
User Involvement users highly in- users play minor minimal or no user
volved with project roles, moderate involvement; little
team, provide impact on system user input
significant input
User Experience users highly expe- users have experi- users have no previ-
rienced in similar ence with similar ous experience with
projects; have spe- projects and have similar projects; un-
cific ideas of how needs in mind sure of how needs
needs can be met can be met
User Acceptance users accept con- users accept most of users do not accept
cepts and details concepts and details any concepts or de-
of system; process of system; process sign details of sys-
is in place for user in place for user ap- tem
approvals provals
User Training Needs user training needs user training needs requirements not
considered; training considered; no train- identified or not
in progress or plan in ing yet or training addressed
place plan is in develop-
ment
continued on next page
20 CHAPTER 2. RISK MANAGEMENT

continued from previous page

Risk Factors Low Risk Cues Medium Risk Cues High Risk Cues
User Justification user justification user justification no satisfactory justi-
complete, accurate, provided, complete fication for system
sound with some questions
about applicability
Project Size small, non-complex, medium, moder- large, highly com-
or easily decom- ate complexity, plex, or not decom-
posed decomposable posable
Reusable Compo- components avail- components avail- components identi-
nents able and compatible able, but need some fied, need serious
with approach revision modification for use
Supplied Compo- components avail- components work components known
nents able and directly under most circum- to fail in certain
usable stances cases, likely to be
late, or incompat-
ible with parts of
approach
Budget Size sufficient budget al- questionable budget doubtful budget is
located allocated sufficient
Budget Constraints funds allocated with- some questions allocation in doubt
out constraints about availability of or subject to change
funds without notice
Cost Controls well established, in system in place, system lacking or
place weak in areas nonexistent
Delivery Commit- stable commitment some uncertain com- unstable, fluctuating
ment dates mitments commitments
Development Sched- team agrees that team finds one phase team agrees that
ule schedule is accept- of the plan to have a two or more phases
able and can be schedule that is too of schedule are
met aggressive unlikely to be met
Requirements Sta- little or no change some change ex- rapidly changing
bility expected to ap- pected against or no agreed-upon
proved set (baseline) approved set baseline
Requirements Com- all completely speci- some requirements some requirements
pleteness and Clarity fied and clearly writ- incomplete or only in the head of
ten unclear the customer
Testability product require- parts of product hard most of product hard
ments easy to test, to test, or minimal to test, or no test
plans underway planning being done plans being made
Design Difficulty well defined inter- unclear how to de- interfaces not well
faces; design well sign, or aspects of defined or con-
understood design yet to be de- trolled; subject to
cided change
continued on next page
2.6. COLLECTION AND ANALYSIS OF EXPERIENCE - LEARNING 21

continued from previous page

Risk Factors Low Risk Cues Medium Risk Cues High Risk Cues
Implementation Dif- content is reasonable content has elements content has compo-
ficulty for this team to im- somewhat difficult nents this team will
plement for this team to find very difficult to
implement implement
System Dependen- clearly defined de- some elements no clear plan or
cies pendencies of the of the system are schedule for how the
project and other well understood whole system will
parts of system and planned; oth- come together
ers are not yet
comprehended
Response or other readily fits bound- operates occasion- operates continu-
Performance Factors aries needed; analy- ally at boundaries ously at boundary
sis has been done levels
Customer Service requires little change requires minor requires major
Impact to customer service changes to customer changes to customer
service service approach or
offerings
Data Migration Re- little or no data to much data to mi- much data to mi-
quired migrate grate, but good de- grate; several types
scriptions available of data or no good
of structure and use descriptions of what
is where
Pilot Approach pilot site (or team) pilot needs to be only available pilot
available and inter- done with several sites are uncoopera-
ested in participating sites (who are will- tive or in crisis mode
ing) or with one who already
needs much help
Alternatives Analy- analysis of alterna- analysis of alter- analysis not com-
sis tives complete, all natives complete, pleted, not all
considered, assump- some assumptions alternatives consid-
tions verifiable questionable or ered, or assumptions
alternatives not fully faulty
considered
Commitment Pro- changes to com- changes to commit- changes to com-
cess mitments in scope, ments are communi- mitments are made
content, schedule cated to all involved without review or
are reviewed and involvement of the
approved by all team
involved
continued on next page
22 CHAPTER 2. RISK MANAGEMENT

continued from previous page

Risk Factors Low Risk Cues Medium Risk Cues High Risk Cues
Quality Assurance QA system estab- procedures estab- no QA process or es-
Approach lished, followed, ef- lished, but not well tablished procedures
fective followed or effective
Development Docu- correct and available some deficiencies, nonexistent
mentation but available
Use of Defined De- development process process established, no formal process
velopment Process in place, established, but not followed or is used
effective, followed ineffective
by team
Early Identification peer reviews are in- peer reviews are team expects to find
of Defects corporated through- used sporadically all defects with test-
out ing
Defect Tracking defect tracking de- defect tracking pro- no process in place
fined, consistent, ef- cess defined, but in- to track defects
fective consistently used
Change Control for formal change con- change control pro- no change control
Work Products trol process in place, cess in place, not fol- process used
followed, effective lowed or is ineffec-
tive
Physical Facilities little or no modifica- some modifications major modifications
tion needed needed; some exis- needed, or facilities
tent nonexistent
Tools Availability in place, docu- available, validated, unvalidated, propri-
mented, validated some development etary or major devel-
needed (or minimal opment needed; no
documentation) documentation
Vendor Support complete support at adequate support little or no support,
reasonable price and at contracted price, high cost, and/or
in needed time frame reasonable response poor response time
time
Contract Fit contract with cus- contract has some contract has burden-
tomer has good open issues which some document re-
terms, communi- could interrupt team quirements or causes
cation with team is work efforts extra work to com-
good ply
Disaster Recovery all areas following some security mea- no security measures
security guidelines; sures in place; back- in place; backup
data backed up; dis- ups done; disaster lacking; disas-
aster recovery sys- recovery considered, ter recovery not
tem in place; proce- but procedures lack- considered
dures followed ing or not followed
continued on next page
2.6. COLLECTION AND ANALYSIS OF EXPERIENCE - LEARNING 23

continued from previous page

Risk Factors Low Risk Cues Medium Risk Cues High Risk Cues
PM Approach product and process planning and moni- weak or nonexistent
planning and moni- toring need enhance- planning and moni-
toring in place ment toring
PM Experience PM very experi- PM has moderate ex- PM has no experi-
enced with similar perience or has expe- ence with this type
projects rience with different of project or is new
types of projects to project manage-
ment
PM Authority has line management is able to influence has little author-
or official authority those elsewhere in ity from location
that enables project the organization, in the organiza-
leadership effective- based on personal tion structure and
ness relationships little personal
power to influence
decision-making and
resources
Support of the PM complete support by support by most of no visible support;
team and of manage- team, with some manager in name
ment reservations only
Team Member in place, little available, some high turnover, not
Availability turnover expected; turnover expected; available; team
few interrupts for some fire fighting spends most of time
fire fighting fighting fires
Mix of Team Skills good mix of disci- some disciplines some disciplines not
plines inadequately repre- represented at all
sented
Team Communica- clearly commu- team communicates rarely communicates
tion nicates goals and some of the informa- clearly within team
status between the tion some of the time or to others who
team and rest of need to be informed
organization
Application Experi- extensive experience some experience little or no expe-
ence in team with projects with similar projects rience with similar
like this projects
Expertise with Ap- good background some experience no expertise in do-
plication Area (Do- with application with domain in team main in team, no
main) domain within or able to call on availability of ex-
development team experts as needed perts
Experience with high experience average experience low experience
Project Tools
Experience with high experience average experience low experience
Project Process
Training of Team training plan in training for some ar- no training plan or
place, training eas not available or training not readily
ongoing training planned for available
future
continued on next page
24 CHAPTER 2. RISK MANAGEMENT

continued from previous page

Risk Factors Low Risk Cues Medium Risk Cues High Risk Cues
Team Spirit and At- strongly committed willing to do what it little or no commit-
titude to success of project; takes to get the job ment to the project;
cooperative done not a cohesive team
Team Productivity all milestones met, milestones met, productivity low,
deliverables on time, some delays in milestones not met,
productivity high deliverables, pro- delays in deliver-
ductivity acceptable ables
Technology Match technology planned some of the planned selected technology
to Project for project is good technology is not is a poor match to
match to customers well-suited to the the problem or cus-
and problem problem or customer tomer
Technology Experi- good level of expe- some experience no experience with
ence of Project Team rience with technol- with the technology the technology
ogy
Availability of Tech- technology experts experts available will need to acquire
nology Expertise readily available elsewhere in organi- help from outside
zation the organization
Maturity of Technol- technology has been technology is well technology is lead-
ogy in use in the industry understood in the in- ing edge, if not
for quite some time dustry "bleeding edge" in
nature
Design Complexity easily maintained certain aspects diffi- extremely difficult to
cult to maintain maintain
Support Personnel in place, experi- missing some areas significant discipline
enced, sufficient in of expertise or expertise missing
number
Vendor Support complete support at adequate support little or no support,
reasonable price and at contracted price, high cost, and/or
in needed time frame reasonable response poor response time
time
Chapter 3

Probability theory

3.1 Basic probability notation

In this chapter basic elements of probability theory are reviewed. Readers familiar with
probability theory can skip this chappter. Readers which are very unfamiliar with this
topic are advised to read an introductionary textbook in probability theory.

3.1.1 Event
In order to define probability, we need to work with events. Let as an example A be the
event that there is an operator error in a control room. This is written:

A = {operator error}

An event may occur, or not. We do not know the outcome in advance prior to the
experiment or a situation in the “real life”. We also use the word event to denote a set
of distinct events. For example the event that we get an even number when tossing a
dice.

3.1.2 Probability
When events are defined, the probability that the event occurs is of interest. Probability
is denoted by Pr(·), i.e.

Pr(A) = Probability that A occur

The numeric value of Pr(A) may be found by:

• Studying the sample space.

• Analysing collected data.

• Look up the value in data hand books.

25
 26 CHAPTER 3. PROBABILITY THEORY

• “Expert judgement” [11].

The sample space defines all possible events. As an example let A = {It is Sunday},
B = {It is Monday}, .. , G = {It is Saturday}. The sample space is then given by S =
{A, B, C, D, E, F, G}.
So-called Venn diagrams are useful when we want to analyse a subset of the sample
space S . A rectangle represents the entire sample space, and closed curves such as a
circle are used to represent subsets of the sample space as illustrated in Figure 3.1. In

Figure 3.1: Venn diagram

the following we will illustrate frequently used combinations of events:

Union. We write A ∪ B to denote the union of A and B, i.e. the occurrence of A or B

or (A and B). Let A be the event that tossing a die results in a “six”, and B be the event
S AB
that we get an odd number of eyes. We then have A ∪ B = {1, 3, 5, 6}.

Intersection. We write A ∩ B to denote the intersection of A and B, i.e. the occurrence

of both A and B. As an example, let A be the event that a project is not completed in due
time, and let B be the event that the budget limits are exceeded. A ∩ B then represent
the situation that the project is not completed in due time and the budget limits are
S AB
exceeded.

Disjoint events. A and B are said to be disjoint if they can not occur simultaneously,
i.e. A ∩ B = Ø = the empty set. Let A be the event that tossing a die results in a “six”,
and B be the event that we get an odd number of eyes. A and B are disjoint since they
S A B
cannot occur simultaneously, and we have A ∩ B = Ø.

Complementary events. The complement of an event A is all events in the sample

A space S except for A. The complement of an event is denoted by AC . Let A be the event
that tossing a die results in an odd number of eyes. AC is then the event that we get an
S AC even number of eyes.

3.1.3 Probability and Kolmogorov’s axioms

Probability is a set function Pr() which maps events A1 , A2, ... in the sample space S
to real numbers. The function Pr(·) can only take values in the interval from 0 to 1,
i.e. probabilities are greater or equal than 0, and less or equal than 1. Kolmogorov
3.1. BASIC PROBABILITY NOTATION 27

B
A

0 Pr(A) Pr(B) 1

Figure 3.2: Mapping of events on the interval [0,1]

established the following axioms which all probability rules could be derived from:
1. 0 ≤ Pr(A)

2. Pr(S ) = 1
3. If A1 , A2 , A3 ,... is a sequence of disjoint events we shall then have:
Pr(A1 ∪ A2 ∪ . . .) = Pr(A1 ) + Pr(A2 ) + . . .

The axioms are the basis for establishing calculation rules when dealing with probabil-
ities, but they do not help us in establishing numerical values for the basic probabilities
Pr(A1 ), Pr(A2 ), etc. Historically two lines of thoughts have been established, the classi-
cal (frequentiest) and the Bayesian approach. In the classical thinking we introduce the
concept of a random experiment, where Pr(Ai ) is the relative frequency with which the
event Ai occurs. The probability could then be interpreted as a property of the experi-
ment, or a property of the world. By letting nature reveal itself by doing experiments,
we could in principle establish all probabilities that are of interest. Within the Bayesian
framework probabilities are interpreted as subjective believe about whether Ai will oc-
cur or not. Probabilities is then not a property of the world, but rather a measure of the
knowledge and understanding we have about a phenomenon.
Before we set up the basic rules for probability theory that we will need, we intro-
duce the concepts of conditional probability and independent events.
Conditional probability. Pr(A|B) denotes the conditional probability that A will occur
given that B has occurred.
Independent events. A and B are said to be independent if information about whether
B has occurred does not influence the probability that A will occur, i.e. Pr(A|B) = Pr(A).
Basic rules for probability. The following calculation rules for probability apply:

Pr(A ∪ B) = Pr(A) + Pr(B) − Pr(A ∩ B) (3.1)

Pr(A ∩ B) = Pr(A) · Pr(B) if A and B are independent (3.2)
Pr(AC ) = Pr(A does not occur) = 1 − Pr(A) (3.3)
Pr(A ∩ B)
Pr(A|B) = (3.4)
Pr(B)

Example 3.1
28 CHAPTER 3. PROBABILITY THEORY

Let the two events A and B be defined by A = {It is Sunday} and B = {It is between 6
and 8 pm).
First we note that A and B are independent but not disjoint. We will find Pr(A ∩ B),
Pr(A ∪ B) and Pr(A|B)

1 2 1
Pr(A ∩ B) = Pr(A) · Pr(B) =
· =
7 24 84
1 2 1 9
Pr(A ∪ B) = Pr(A) + Pr(B) − Pr(A ∩ B) = + − =
7 24 84 42
Pr(A ∩ B) 1/84 1
Pr(A|B) = = =
Pr(B) 2/24 7


3.1.4 The law of total probability

In many situations it is easier to assess the probability of an event B conditionally on
some other events, say A1 , A2 , . . ., Ar , than unconditionally. The law of total proba-
bility could then be used to assess the unconditional probability. Now, we say that
A1 , A2 , . . ., Ar is a division of the sample space if the union of all Ai ’s covers the entire
sample space, i.e. A1 ∪ A2 ∪ . . . ∪ Ar = S and the Ai ’s are pair wise disjoint, i.e. Ai ∩
A j = Ø for i , j. An example is shown in Figure 3.3.

A2
A4

A1
A3
S

Figure 3.3: Division of the sample space

Let A1 , A2 , . . ., Ar represent a division of the sample space S , and let B be an arbitrary

event in S . The law of total probability now states:
r
X
Pr(B) = Pr(Ai ) · Pr(B|Ai ) (3.5)
i=1

Example 3.2
A special component type is ordered from two suppliers A1 and A2 . Experience has
shown that components from supplier A1 has a defect probability of 1%, whereas com-
ponents from supplier A2 has a defect probability of 2%. In average 70% of the com-
ponents are provided by supplier A1 . Assume that all components are put on a common
stock, and we are not able to trace the supplier for a component in the stock. A compo-
nent is now fetched from the stock, and we will calculate the defect probability, Pr(B):
3.1. BASIC PROBABILITY NOTATION 29

r
X
Pr(B) = Pr(Ai ) · Pr(B|Ai) = Pr(A1 ) · Pr(B|A1) + Pr(A2 ) · Pr(B|A2) =
i=1
0.7 · 0.01 + 0.3 · 0.02 = 1.3%

3.1.5 Bayes rule

Now consider the example above, and assume that we have got a defect component
from the stock (event B). We will derive the probability that the component originates
from supplier A1 . We then use Bayes formula that states if A1 , A2 , . . ., Ar represent a
division of the sample space, and B is an arbitrary event then:

Pr(B|A j) · Pr(A j )
Pr(A j |B) = r (3.6)
P
Pr(Ai ) · Pr(B|Ai )
i=1

Example 3.3
We have
Pr(B|A1) · Pr(A1 ) 0.01 · 0.7
Pr(A1 |B) = r = = 0.54
P 0.013
Pr(Ai ) · Pr(B|Ai)
i=1

Thus, the probability of A1 is reduced from 0.7 to 0.54 when we know that the com-
ponent is defect. The reason for this is that components from supplier A1 are the best
ones, and hence when we know that the component was defect, it is less likely that it
was from supplier A1 . 

3.1.6 Stochastic variables

Stochastic variables are used to describe quantities which can not be predicted exactly.
Note that the term ‘random quantity’ is often used to denote a stochastic variable.

X is stochastic ⇔ Impossible to predict the value of X

To be more precise, a stochastic variable X is a real valued function that assigns a

quantitative measure to each event ei in the sample space S . Often the underlying
events, ei are of little interest. We are only interested in the stochastic variable X
measured by some means. Examples of stochastic variables are given below:

• X = Life time of a component (continuous)

• R = Repair time after a failure (continuous)

• T = Duration of a construction project (continuous)

30 CHAPTER 3. PROBABILITY THEORY

• C = Total cost of a renewal project (continuous)

• N = Number of delayed trains next month (discrete)

• W = Maintenance and operational cost next year (continuous)

Remark: We differentiate between continuous and discrete stochastic variables.

Continuous stochastic variables can take any value among the real numbers, whereas
discrete variables can take only a finite (or countable finite) number of values. 
Cumulative distribution function. A stochastic variable X is characterized by it’s
cumulative distribution function

F X (x) = Pr(X ≤ x) (3.7)

We use subscript X to emphasise the relation to the cumulative distribution function of

the quantity X. The argument (lowercase x) states which values the random quantity X
could take, or is of our interest. From the expression we observe that F X (x) states the
probability that the random quantity X is less or equal than (the numeric value of) x. A
typical distribution function is shown in Figure 3.4. Note that the distribution function
is strictly increasing, and 0 ≤ F X (x) ≤ 1. From F X (x) we can obtain the probability
that X will be within a specified interval, [a,b):

Pr(a < X ≤ b) = F X (b) − F X (a) (3.8)

F X (x)

x
Figure 3.4: Cumulative distribution function, F X (x)

Example 3.4
2
Assume that the probability distribution function of X is given by F X (x) = 1 − e−(0.01x) ,
and we will find the probability that X is in the interval (100,200]. From Equation (3.8)
we have:

Pr(100 < X ≤ 200) = F X (200) − F X (100) =

−(0.01·200)2 2
h i h i
1−e − 1 − e−(0.01·100) = e−1 − e−4 ≈ 0.35


3.1. BASIC PROBABILITY NOTATION 31

Probability density function. For a continuous stochastic variable, the probability

density function is given by
d
fX (x) = F X (x) (3.9)
dx
The probability density function expresses how likely the various x-values are. Note

fX (x)

x
Figure 3.5: Probability density function, fX (x)

that for continuous random variables the probability that X will take a specific value
vanishes. However, the probability that X will fall into a small interval around a specific
value is positive. For each x-value given in Figure 3.5 fX (x) could be interpreted as the
probability that X will fall within a small interval around x divided by the length of this
interval. Especially we have:
Zx
F X (x) = fX (u)du (3.10)
−∞

and
Zb
Pr(a < X ≤ b) = fX (x)dx (3.11)
a
The last expression is illustrated in Figure 3.6.

fX (x)

x
a b
Figure 3.6: The shadded area equals Pr(a < X ≤ b)

Random quantities that take discrete values are said to be discretely distributed. For
such quantities we introduce the point probability for X in the point x j :
p(x j ) = Pr(X = x j ) (3.12)
32 CHAPTER 3. PROBABILITY THEORY

where x1 , x2 , . . . are possible values X could take.

Expectation. The expectation (mean) of X is given by
 R∞

x · fX (x) dx if X is continuous




E(X) =  (3.13)

−∞
P
 j x j · p(x j ) if X is discrete





The expectation can be interpreted as the long time run average of X, if an infinite
amount of observations are available.
Median. The median of a distribution is the value m0 of the stochastic variable X such
that Pr(X ≤ m0 ) ≥ 1/2 and Pr(X ≥ m0 ) ≥ 1/2. In other words, the probability at or
below m0 is at least 1/2, and the probability at or above m0 is at least 1/2.
Mode. The mode of a distribution is the value M of the stochastic variable X such that
the probability density function, or point probability at M is higher or equal than for
any other value of the stochastic variable. We sometimes used the term ‘most likely
value’ rather than mode.
Variance. The variance of a random quantity expresses the variation in the value X
will take in the long run. We denote the variance of X by:
 ∞
R
[x − E(X)]2 · fX (x) dx if X is continuous






Var(X) =  (3.14)
 −∞
 Ph i2
 j (x j − E(X) · p(x j ) if X is discrete





Standard deviation. The standard deviation of X is given by

p
SD(X) = + Var(X) (3.15)
The standard deviation defines an interval which observations are likely to fall into, i.e.
if 100 observations are available, we expect that approximate1 67 of these observations
fall in the interval [E(X) − SD(X), E(X) + SD(X)].
Precision. The precision, P, is the reciprocate of the variance, i.e. P = Var1 (X) .
α-percentiles. The upper α-percentile, xα , in a distribution F X (x) is the value satisfying
α = Pr(X > xα ) = 1 − F X (xα ).
We end this section by giving some results regarding expectation and variances.
These results apply when it is easier to express the expectation and variance of one
variable if we condition on the value of another variable.

Result 3.1 Double expectation

Let X and Y be stochastic variables. We then have:
E(X) = E(E(XY)) (3.16)

Var(X) = E(Var(XY)) + Var(E(XY)) (3.17)


1 This result is valid for the normal distribution. For other distributions there may be deviation from this
result.
3.2. COMMON PROBABILITY DISTRIBUTIONS 33

It follows easily that

E(X) = E(X B) Pr(B) + E(X BC ) Pr(BC ) (3.18)

Var(X) = Var(X|B) Pr(B) + Var(X|BC ) Pr(BC )

h i2
+ [E(X|B) − E(X)]2 Pr(B) + E(X|BC ) − E(X) Pr(BC ) (3.19)

3.2 Common probability distributions

In this section we will present some common probability distributions. We write X ∼
<Name of distribution>(<parameters>) to express that X belongs to <Name of distri-
bution>, and with parameters <parameters>. Sometimes we also use an abbreviation
for the distribution, for example we write X ∼ N(3, 4) to express that X is normally
distributed with expectation 3, and variance 4.

3.2.1 The normal distribution

X is said to be normally distributed if the probability density function of X is given by:

1 1 − (x−µ)22
fX (x) = √ e 2σ (3.20)
2π σ
where µ and σ are parameters that characterise the distribution. The mean and variance
are given by:

E(X) = µ
Var(X) = σ2 (3.21)

The distribution function for X could not be written on closed from. Numerical meth-
ods are required to find F X (x). It is convenient to introduce a standardised normal
distribution for this purpose. We say that U is standard normally distributed if it’s
probability density function is given by:

1 u2
fU (u) = φ(u) = √ e− 2 (3.22)
2π
We then have
Zu Zu
1 t2
FU (u) = Φ(u) = φ(t)dt = √ e− 2 dt (3.23)
2π
−∞ −∞

and we observe that the distribution function of U does not contain any parameters.
We therefore only need one look-up table or function representing Φ(u). A look-up
table is given in Table 3.1. To calculate probabilities in the non-standardised normal
distribution we use the following result:
34 CHAPTER 3. PROBABILITY THEORY

Result 3.2 If X is normally distributed with parameters µ and σ, then

X−µ
U= (3.24)
σ
is standard normally distributed. 

Example 3.5 Calculation in the normal distribution

Let X be normally distributed with parameters µ = 5 and σ = 3. We will find Pr(3 <
X ≤ 6). We have:
3−µ X−µ 6−µ 3−5 6−5
Pr(3 < X ≤ 6) = Pr( < ≤ ) = Pr( <U≤ )
! ! σ σ σ 3 3
1 −2
=Φ −Φ = Φ(0.33) − (1 − Φ(0.67)) = 0.629 − 1 + 0.749 = 0.378
3 3


Problem 3.1 Consider the example in Example 3.5, and carry out the calculation by
means of the [Link] program. 

Problem 3.2 Let X be the height of men in a population, and assume X is normally
distributed with parameters µ = 181 and σ = 4. How large percentage of the population
is more than 190 cm? 

3.2.2 The exponential distribution

X is said to be exponentially distributed if the probability density function of X is given
by:

fX (x) = λe−λx (3.25)

The cumulative distribution function is given by:

F X (x) = 1 − e−λx (3.26)

and the mean and variance are given by:

E(X) = 1/λ
Var(X) = 1/λ2 (3.27)

Note that for the exponential distribution, X will always be greater than 0. The
parameter λ is often denoted the intensity in the distribution

Example 3.6
We will obtain the probability that X is greater than it’s expected value. We then have:

Pr(X > E(X)) = 1 − Pr(X ≤ E(X)) = 1 − F X (E(X)) = e−λE(X) = e−1 ≈ 0.37


3.2. COMMON PROBABILITY DISTRIBUTIONS 35

3.2.3 The Weibull distribution

X is said to be Weibull distributed if the probability density function of X is given by:
α
fX (x) = αλ(λx)α−1 e−(λx) (3.28)
The cumulative distribution function is given by:
α
F X (x) = 1 − e−(λx) (3.29)
and the mean and variance are given by:
" !
1 1
E(X) = Γ +1
λ α
! !#
1 2 1
Var(X) = 2 Γ + 1 − Γ2 +1 (3.30)
λ α α
where Γ(·) is the gamma function. Note that in the Weibull distribution X will also
always be positive.

3.2.4 The gamma distribution

X is said to be gamma distributed if the probability density function of X is given by:
λα
fX (x) = (x)α−1 e−λx (3.31)
Γ(α)
For integer values of α the gamma distribution is often denoted the Erlang distribution.
The cumulative distribution function could then be found on closed form:
α−1
X (λx)α
F X (x) = 1 − e−(λx) (3.32)
n=0
n!

For non-integer values of α numerical methods are required to obtain the cumulative
distribution function. The mean and variance are given by:
α
E(X) =
λ
α
Var(X) = 2 (3.33)
λ
If we know the expectation, E and the variance, V, in the gamma distribution we could
obtain the parameters α and λ by: λ = E/V, and α = λ · E. The gamma distribution is
often used as a prior distribution in a Bayesian approach.

3.2.5 The inverted gamma distribution

X is said to be inverted gamma distributed if the probability density function of X is
given by:
!α+1
λα 1
fX (x) = e−λ/x (3.34)
Γ(α) x
36 CHAPTER 3. PROBABILITY THEORY

The mean and variance are given by:

E(X) = λ/(α − 1)
2
Var(X) = λ (α − 1)−2 (α − 2)−1 (3.35)
Note that if X is gamma distributed with parameters α and λ, then Y = X −1 has an
inverted gamma distribution with parameters α and 1/λ. If we know the expectation,
E and the variance, V, of an inverted gamma distribution we could obtain α and λ by
α = E 2 /V + 2, and λ = E · (α − 1).

3.2.6 The lognormal distribution

X is said to be lognormal distributed if the probability density function of X is given
by:
1 1 1 − 12 (log x−ν )2
fX (x) = √ e 2τ (3.36)
2π τ x
We write X ∼ LN(v,τ). The mean and variance of X is given by
1 2
E(X) = eν+ 2 τ
2 2
Var(X) = e2ν (e2 τ − eτ ) (3.37)
The following result could be utilised:

Result 3.3 If X is lognormally distributed with parameters ν and τ, then Y = ln X is

normally distributed2 with expected value ν and variance τ2 . 

3.2.7 The binomial distribution

Before the binomial distribution is defined, binomial trials are defined. Let A be an
event, and assume that the following holds:
i) n trials are performed, and in each trial we record whether A occurrs or not.
ii) The trials are stochastic independent of each other.
iii) For each trial Pr(A) = p
When i)-iii) is satisfied, we say that we have binomial trials. Now let X be the number
of times event A occurs in such a binomial trial. X is then a stochastic variable with a
binomial distribution. This is written X ∼ Bin(n, p).
The probability function is given by
!
n px
P(X = x) = (1 − p )n−x for x = 1, 2, .., n (3.38)
x
The cumulative distribution function Pr(X ≤ x) is given in statistical tables. For the
binomial distribution, expectation and variance are given by:
E(X) = np
Var(X) = np(1 − p) (3.39)
2 ln(·) is the natural logarithm function
3.2. COMMON PROBABILITY DISTRIBUTIONS 37

3.2.8 The Poisson distribution

The Poisson distribution is often appropriate in the situation where the stochastic vari-
able may take the values 0,1,2,. . ., and where the expected number of occurrences is
proportional to an exposure measure such as time or space. For the Poisson distribution
we have the following point distribution:

λ x −λ
p(x) = Pr(X = x) = e (3.40)
x!
For the poison distribution, expectation and variance are given by:

E(X) = λ
Var(X) = λ (3.41)

It can be proved that the Poisson distribution is appropriate if the following situation
applies: Consider the occurrence of a certain event (e.g. a component failure) in an
interval (a, b), and assume the following:

1. A could occur anywhere in (a,b), and the probability that A occurs in (t, t + ∆t)
is approximately equal to λ∆t, and is independent of t (∆t should be small).

2. The probability that A occurs several times in (t, t + ∆t) is approximately 0 for
small values of ∆t.

3. Let I1 og I2 be disjoint intervals in (a, b). The event A occurs within I1 is then
independent of the event A occurs in I2 .

When the criteria above are fulfilled we say we have a Poisson point process with
intensity λ. The number of occurrences (X) of A in (a, b) is then Poisson distributed
with parameter λ(b − a), i.e.

[λ(b − a)]x −λ(b−a)

p(x) = Pr(X = x) = e (3.42)
x!
It may also be proved that the times between occurrence of A in a Poisson point process
are exponentially distributed with parameter λ.

3.2.9 The inverse-Gauss distribution

The inverse-Gauss distribution is often used when we have an “under laying” deterio-
ration process. If this deterioration process follows a Wiener process with drift η and
diffusion constant δ2 , the time T , until the first time the process reaches the value ω
will be Inverse-Gauss distributed with parameters µ = ω/η, and λ = ω2 /δ2 .
If the failure progression Ω(t) follows a Wiener process it could be proven that Ω(t)
- Ω(s) is normally distributed with expected value η(t − s) and variance δ2 (t - s). That is
η is the average growth rate in the curve, whereas δ2 is an expression for the variation
around the average value.
38 CHAPTER 3. PROBABILITY THEORY

For the inverse-Gauss distribution we have:

λ√ √ 1 λ√ √ 1
! !
FT (t) = Φ t− λ √ +Φ − t − λ √ e2λ/µ (3.43)
µ t µ t
and

E(T ) = µ (3.44)
Var(T ) = µ3 /λ (3.45)

3.2.10 The triangular distribution

The triangular distribution has a probability density function that comprises a triangle.
The lover left corner points out the lowest value (L), the upper right corner points out
the highest value (H). Finally, the x-value of the third corner points out the most prob-
able value, or mode (M).The probability density function for the triangular distribution
is given by:
 2(x−L)
 (M−L)(H−L) if L ≤ x ≤ M


fX (x) =  2(H−x) (3.46)
 (H−M)(H−L) if M ≤ x ≤ H


The cumulative distribution function is given by:

(x−L)2

 (M−L)(H−L) if L ≤ x ≤ M


F X (x) =  (3.47)
 1 − (H−x)2
 if M ≤ x ≤ H
(H−M)(H−L)

and the mean and variance are given by:

L+M+H
E(X) =
3
L2 + M 2 + H 2 + LM + LH + MH
Var(X) = (3.48)
6
Problem 3.3 Assume that the completion of a project is triangular distributed with
parameters L = 200, M = 240 and H = 350. In our contract we have committed our
selves to finish the project within 220 days. After 220 days we have to pay a penalty of
100 Euro per day in penalty for default. Find the total expected penalty for default in
this project. 

Problem 3.4 Consider Problem 3.3 and assume that a special building method could
reduce H from 350 to 300, leaving L and M unchanged. This will cost 2,000 Euro
extra. Do a cost benefit analysis of this option. 

3.2.11 The PERT distribution

The PERT distribution has as the triangular distribution three parameters, L (lowest
value), M (most likely value), and H (highest value). To give the probability density
3.2. COMMON PROBABILITY DISTRIBUTIONS 39

function for the triangular distribution we first define:

4M + H − 5L
α1 =
H−L
5H − 4M − L
α2 =
H−L
x−L
z= (3.49)
H−L
The probability density function is now given by:

(x − L)α1 −1 (H − x)α2 −1
fX (x) = (3.50)
B(α1 , α2 )(H − L)α1 +α2 −1

where B(·, ·) is the beta function. The cumulative distribution function is given by:

Bz(α1 , α2 )
F X (x) = (3.51)
B(α1 , α2 )

where Bz (·, ·) is the incomplete beta function. The mean and variance are given by:

L + 4M + H
E(X) =
6
(E(X) − L)(H − E(X))
Var(X) = (3.52)
7

Problem 3.5 Use the [Link] program to find Pr(X ≤ 7) if X ∼ PERT(L = 3, M =

6, H = 10). 

Problem 3.6 Consider a situation where the unconditional distribution of the duration
of a project groundwork activity is PERT distributed with parameters L = 0.5, M = 1.5
and H = 3.5 days. By a detailed analysis into the uncertainty of the situation we
recognize that frozen soil is a major factor to the long duration. Let B represent the
event that it is frozen soil. We now make the following assessment: Given frozen soil,
the duration of the activity, T B, is PERT distributed with parameters L = 2, M = 2.5
and H = 3.5, and if the soil is not frozen the duration of the activity, T BC , is PERT
distributed with parameters L = 0.5, M = 1 and H = 2.5. Find p = Pr(B) such that the
expectation in the conditional situation is the same as in the unconditional situation.
Hint: You may use that E(T ) = E(T B) Pr(B) + E(T BC) Pr(BC ), see Equation ( 3.18). 

Problem 3.7 Make a sketch of the unconditional probability distribution function in

the situation in Problem 3.6 when the consideration of frozen soil is taken into account.


Problem 3.8 Find the unconditional variance of the duration in Problem 3.6. Hint:
You may use Equation (3.19) 
40 CHAPTER 3. PROBABILITY THEORY

Problem 3.9 Consider again the situation in Problem 3.6, i.e. we let in the first place
T ∼ PERT(L = 0.5, M = 1.5, H = 3). Also Let B represent frozen soil and Pr(B) = 0.2.
We now introduce three factors, fB , fBC and fV that relate the conditional situation to the
original situation. The parameters relevant in the conditional situation are {LB , MB , HB }
and {LBC , MBC , HBC } in the situation where B occurs, and B does not occur respectively.
We now let MB = fB · M, LB = MB − fV ·(M −L), HB = MB + fV ·(H − M), MBC = fBC · M,
LBC = MBC − fV · (M − L), and HBC = MBC + fV · (H − M). Let fB = 1.5 and fV = 0.5.
Find by an iterative procedure the value of fBC such that the expectation of T is equal
to the original expectation. Next find fV by a similar iterative procedure such that the
variance of T is equal to the original variance. 

3.3 Assessment of parameters in parametric distribu-

tions
We have in the previous section discussed parametric probability distributions. Com-
mon for all these distributions is that they involve parameters. When using a parametric
distribution, we also need to assess the parameters. In this presentation we will not dis-
cuss in detail how this could be done. If we have access to experience data, we could
estimate these parameters by e.g. the maximum likelihood principle. In other situa-
tions where we have no, or very little data we would use expert judgment to assess the
parameters, see e.g. [11] for further discussion on expert judgment. In this presenta-
tion we will very often assume that the uncertainty in a quantity, e.g. the duration of
an activity could be described by a so-called triple estimate {L, M, H}. We will then
as a general rule assume that the corresponding parametric distribution is the PERT
distribution. We will further assume that the L value is the absolute minimum, and that
the H value is the absolute maximum the quantity could take. It is, however, important
to realise that in other presentation the L and H values are treated as lower and upper
quantiles in the distribution, and often a 90% interval is assumed. This is even the
situation for the PERT distribution which is defined for a finite domain. So if we for
a given triple estimate should establish the expected value, and the standard deviation
we should be carefull regarding the interpretation of the triple estimate.

3.4 Distribution of sums, products and maximum val-

ues
3.4.1 Distribution of sums
If X1 , X2 ,. . . ,Xn are random variables we might obtain the expected value, the variance
and the standard deviation of the sum of the x-es:
 Xn  Xn
E(X1 + X2 + . . . + Xn ) = E Xi = E(Xi ) (3.53)
i=1 i=1

 Xn  Xn
Var(X1 + X2 + . . . + Xn ) = Var Xi = Var(Xi ) (3.54)
i=1 i=1
3.4. DISTRIBUTION OF SUMS, PRODUCTS AND MAXIMUM VALUES 41
rX
 Xn  n
SD Xi = [SD(Xi )]2 (3.55)
i=1 i=1

Note that Equations (3.54) and (3.55) are only valid if the x-es are stochastically inde-
pendent. If there is dependency between the x-es we need to include a covariance term,
e.g. if we only have two variables X1 and X2 we have:

Var(X1 + X2 ) = Var(X1 ) + Var(X2 ) + 2Cov(X1 , X2 ) (3.56)

where Cov(X1 , X2 ) is the covariance between X1 and X2 .

The results above help us in determine the expectation and variance of a sum of
stochastic variables, but the results could not be used to establish the probability dis-
tribution of the sum. In the following we refer some results we could utilise in many
situations.

Result 3.4 Sum of normally distributed stochastic variables

Let X1 , X2 ,. . . ,Xn be independent normally distributed. Let Y be the sum of the x-
es, i.e. Y = ni=1 Xi . Y is then normally distributed with E(Y) = ni=1 E(Xi ) and
P P
Pn
Var(Y) = i=1 Var(Xi ). 

Result 3.5 Sum of exponentially distributed stochastic variables

Let X1 , X2 ,. . . ,Xn independent exponentially distributed with parameter λ. Let Y be the
sum of the x-es, i.e. Y = ni=1 Xi . Y is then gamma distributed with parameters n and
P
λ. 

Result 3.6 Sum of gamma distributed stochastic variables

Let X1 , X2 ,. . . ,Xn independent gamma distributed with parameters α and λ. Let Y be
the sum of the x-es, i.e. Y = ni=1 Xi . Y is then gamma distributed with parameters nα
P
and λ. 

Result 3.7 Central limit theorem

Let X1 , X2 ,. . . ,Xn be a sequence of identical independent distributed stochastic variables
with expected value µ and standard deviation σ. As n approaches infinity, the average
value of the x-es will asymptotically
√ have a normal distribution with expected value µ
and standard deviation σ/ n. Similarly, the sum of the x-es will asymptotically
√ have
a normal distribution with expected value nµ and standard deviation σ n. 

Several generalizations for finite variance exist which do not require identical distribu-
tion but incorporate some conditions which guarantee that none of the variables exert a
much larger influence than the others. Two such conditions are the Lindeberg condition
and the Lyapunov condition. Now, as n approaches infinity, the sum of the x-es will
asymptotically have a normal distribution with expected value ni=1 E(Xi ) and variance
P
Pn
i=1 Var(Xi ).

Problem 3.10 Consider a project consisting of n activities that follow each other in
time. Let each activity have a PERT distribution with parameters L = 3, M = 5 and
H = 10. Use the Monte Carlo simulation procedure in the [Link] program to find
42 CHAPTER 3. PROBABILITY THEORY

the cumulative distribution function for the total duration of the project. Compare the
result with using the Central Limit Theorem for various values of n. How large should
n be in order to give a reasonable approximation by using the normal distribution? 

3.4.2 Distribution of a product

If X1 , X2 ,. . . ,Xn are independent stochastic variables we might obtain the expected
value, the variance and the standard deviation of the product of the x-es:
 n  n
Y  Y
E(X1 · X2 · . . . · Xn ) = E   Xi  = E(Xi ) (3.57)
i=1 i=1

The results for the variance and standard deviation is more complicated, and we only
present the results for n=2.

Var(X1 X2 ) = Var(X1 )Var(X2 ) + Var(X1 ) [E(X2 )]2 + Var(X2 ) [E(X1 )]2 (3.58)
q
SD(X1 X2 ) = Var(X1 )Var(X2 ) + Var(X1 )[E(X2 )]2 + Var(X2 )[E(X1 )]2 (3.59)

Problem 3.11 Show that Equation (3.58) is correct by using the fact that Var(X) =
E(X 2 ) − [E(X)]2. 

Problem 3.12 Use the program [Link] to simulate the mean and standard deviation
of the product X1 X2 if both X1 and X2 are independent and normally distributed with
expected value 10 and standard deviation 2. Compare the result with the exact result.


3.4.3 Distribution of maximum values

Let X1 og X2 be independent stochastic variables, and let Y = max(X1 , X2 ). The cumu-
lative distribution function of Y is given by:

FY (x) = Pr(Y ≤ x) = Pr(X1 ≤ x ∩ X2 ≤ x)

= Pr(X1 ≤ x) Pr(X2 ≤ x) = F X1 (x)F X2 (x) (3.60)

In this situation we could easily obtain the distribution of the maximum of two stochas-
tic variables, but it is not so easy to obtain the expectation and variance. However, since
the probability density function, fY (x) is the derivative of FY (x) we find:
Z∞ Z∞
 
E(Y) = x · fY (x) dx = x · fX1 (x)F X2 (x) + fX2 (x)F X1 (x) dx (3.61)
−∞ −∞

Z∞
[x − E(Y)]2 · fX1 (x)F X2 (x) + fX2 (x)F X1 (x) dx
 
Var(Y) = (3.62)
−∞
3.4. DISTRIBUTION OF SUMS, PRODUCTS AND MAXIMUM VALUES 43

Problem 3.13 Find the expectation and standard deviation of Y = max(X1 , X2 ) if X1

and X2 are independent and normally distributed with µ1 = E(X1 ) = 10, µ2 = E(X2 ) =
7, σ1 = SD(X1 ) = 2, and σ2 = SD(X2 ) = 3. Hint: You might use the routine for
numerical integration implemented in the [Link] program. 

Problem 3.14 Consider the problem above, but now find the result by using the Monte
Carlo simulation procedure in the [Link] program. 

Problem 3.15 Consider the problem above, but now find the result by using the EMax
and VarMax functions in the [Link] program. 
44 CHAPTER 3. PROBABILITY THEORY

Table 3.1: The Cumulative Standard Normal Distribution

Zz
1 u2
Φ(z) = Pr(Z ≤ z) = √ e− 2 du
2π
−∞

z .00 .01 .02 .03 .04 .05 .06 .07 .08 .09
0.0 .500 .504 .508 .512 .516 .520 .524 .528 .532 .536
0.1 .540 .544 .548 .552 .556 .560 .564 .567 .571 .575
0.2 .579 .583 .587 .591 .595 .599 .603 .606 .610 .614
0.3 .618 .622 .626 .629 .633 .637 .641 .644 .648 .652
0.4 .655 .659 .663 .666 .670 .674 .677 .681 .684 .688
0.5 .691 .695 .698 .702 .705 .709 .712 .716 .719 .722
0.6 .726 .729 .732 .732 .739 .742 .745 .749 .752 .755
0.7 .758 .761 .764 .767 .770 .773 .776 .779 .782 .785
0.8 .788 .791 .794 .797 .800 .802 .805 .808 .811 .813
0.9 .816 .819 .821 .824 .826 .829 .831 .834 .836 .839
1.0 .841 .844 .846 .849 .851 .853 .855 .858 .860 .862
1.1 .864 .867 .869 .871 .873 .875 .877 .879 .881 .883
1.2 .885 .887 .889 .891 .893 .894 .896 .898 .900 .901
1.3 .903 .905 .907 .908 .910 .911 .913 .915 .916 .918
1.4 .919 .921 .922 .924 .925 .926 .928 .929 .931 .932
1.5 .933 .934 .936 .937 .938 .939 .941 .942 .943 .944
1.6 .945 .946 .947 .948 .949 .951 .952 .953 .954 .954
1.7 .955 .956 .957 .958 .959 .960 .961 .962 .962 .963
1.8 .964 .965 .966 .966 .967 .968 .969 .969 .970 .971
1.9 .971 .972 .973 .973 .974 .974 .975 .976 .976 .977
2.0 .977 .978 .978 .979 .979 .980 .980 .981 .981 .982
2.1 .982 .983 .983 .983 .984 .984 .985 .985 .985 .986
2.2 .986 .986 .987 .987 .987 .988 .988 .988 .989 .989
2.3 .989 .990 .990 .990 .990 .991 .991 .991 .991 .992
2.4 .992 .992 .992 .992 .993 .993 .993 .993 .993 .994
2.5 .994 .994 .994 .994 .994 .995 .995 .995 .995 .995
2.6 .995 .995 .996 .996 .996 .996 .996 .996 .996 .996
2.7 .997 .997 .997 .997 .997 .997 .997 .997 .997 .997
2.8 .997 .998 .998 .998 .998 .998 .998 .998 .998 .998
2.9 .998 .998 .998 .998 .998 .998 .999 .999 .999 .999
3.0 .999 .999 .999 .999 .999 .999 .999 .999 .999 .999

Φ(-z) = 1 - Φ(z)
Chapter 4

Schedule

In order to analyse the duration of a project, or a project activity we use flow network
models. Visually, a flow network model is similar to a bar chart, or a gantt diagram.
However, we usually indicate dependencies between activities with arrows, and the y
and x axes are usually not labeled. The symbols used in a flow network used in this
presentation are shown in Figure 4.1. An example flow network diagram is shown in
Figure 4.2.

Activity

Uncertain activity

Milestone

S Start point

F End point, finish

Coupling between activities or nodes

Figure 4.1: Symbols used in flow network diagrams

There exist several methods for analysing flow networks. All these models requires
that the flow network is described completely in terms of dependencies between the
activities. Further the duration of the activities should be described by probability
distribution functions with numeric values for the parameters. When analysing such
flow network we differentiate between:

• Analytical methods.

45
46 CHAPTER 4. SCHEDULE

S A B E F H F

C G
Figure 4.2: Example flow network from [3]

• Monte Carlo simulation methods.

Generally we let T denote the duration of the project we are analysing, or a part of
the project, e.g. a work package. If the project comprises n activities, we often denote
these activities Ai , and the duration of activity Ai is denoted T i . Sometimes in this
presentation we also use the more simplified notation where each activity is described
by a letter, e.g. A, B etc. The main purpose of the schedule analysis is to establish the
cumulative distribution function for the entire project duration. We might also want to
establish the cumulative distribution function for parts of the project, milestones etc.
Another important measure of interest is the probability that an activity will delay the
project, i.e. the criticality index. The methods we will investigate are:

• Critical Path Method (CPM)

• Program Evaluation and Review Technique (PERT)

• Successive schedule planning (SSP)

• Monte Carlo simulation

The example diagram shown in Figure 4.2 will be used to demonstrate the various
methods. This example is adapted from [3]. The parameters to describe the duration of
each activity are given in Table 4.2. Fundamental for all methods is to understand the
term ’path’. A path in a flow network is a set of activities from the the starting point

Activity L (Lowest) M (Most likely) H (Highest)

A 2 5 9
B 4 6 9
C 7 12 21
D 5 7 10
E 4 7 11
F 2 3 6
G 3 5 9
H 5 7 10

Table 4.1: Data for the schedule demonstration example

4.1. CRITICAL PATH METHOD (CPM) 47

to the end point in the network, where each activity in the set follows another activity
in the set except the first activity that follows the starting point. This means that all
activities in a path have to be executed in order to complete the project. Usually there
are several paths in a flow network. Formally, we also include uncertain activities in a
path, even if they might not be necessary to execute.

4.1 Critical Path Method (CPM)

The idea of the CPM method is to find all paths in the flow network. Next, we assume
that the duration of all activities are deterministic, and typically equal to the most likely
duration (M). The duration of each path is given as the sum of duration of all activities
in the path. The path with the longest duration is denoted a critical path, and the
duration of the project is found by the duration of the critical path (or all critical paths
in case of several critical paths). In Figure 4.2 we have the following paths: P1 =
{A,B,D,F,H}, P2 = {A,B,E,F,H} and P3 = {A,C,G,H}. Inserting the duration of each
activity, we get the following durations T P1 = 5 + 6 + 7 + 3 + 7 = 28, T P2 = 5 + 6 +
7 + 3 + 7 = 28 and T P3 = 5 + 12 + 5 + 7 = 29 for P1 , P2 and P3 respectively. Since
P3 has the longest duration, P3 is a critical path, and the project duration is found to be
29. A disadvantage of the CPM method is that it cannot handle the uncertainty in the
duration of each activity, i.e. it is a deterministic approach.

4.2 Program Evaluation and Review Technique (PERT)

The PERT method is similar to the CPM method when finding the project duration.
We also here find the critical path, i.e. P3 . But rather than using the deterministic
value for the duration, we now treat uncertainties in the activities in the critical path.
The expectation and variance of a sum are given by Equations (3.53) and (3.54). If the
expectations and variances are given for the various activities, we can proseed directly.
However, very often the activities are described by a low (L), most likely (M), and high
value (H) as in Table 4.2. If we now assume that these parameters are describing the
PERT distribution, we recall that the expected value is given by µ = (L + 4M + H)/6
and the variance is given by σ2 = (µ − L)(H − µ)/7.
Note that the PERT method only includes one critical path. In case of more than
one critical path, it will be appropriate to use the path with the highest variance. A
weakness in the PERT method is that the project duration will be underestimated in
case of many paths with expected duration in the same range as the critical path.

4.3 Successive schedule planning (SSP)

The idea behind the SSP-method is that we need to consider more than the critical
path. To motivate for the algorithm we are going to present, consider a project with
two activities A and B executed in parallel. In this situation it is reasonable to assume
that the project duration will be the maximum of the duration of the two activities, and
we might apply Equations (3.61) and (3.62). In this example A and B are both paths
48 CHAPTER 4. SCHEDULE

in the network, and the two paths have no common activities. In a general situation,
the various paths might have common activities which complicates the calculation.
Now, consider a situation with two activities B and C in parallel, where the startup of
these two activities will be immediate after the finialisation of activity A. We might
now establish the two paths {A, B} and {A, C}, but we realise that the two paths have a
common activity, A. For each path we could find the expectation and variance similar
to what we did in the PERT method, but since the two paths share a common activity,
they will not be independent, and the result for the maximum of the two paths will not
be correct. In order to overcome this problem, we could in this situation first find the
expectation and variance of activity A, and next add the expectation and variance for
the maximum of activity B and C.

Problem 4.1 Consider the situation above with activities B and C in parallel following
activity A. Further let the expectation and variance of the activity durations be given
by: µA = 10, µB = 7, µC = 8, σ2A = 22 , σ2B = 32 and σC2 = 22 . Find the expectation and
duration of the project by first treating the two paths {A, B} and {A, C} as independent.
Next, carry out an exact calculation and compare the result with the first result. 

To structure the analysis we need some definitions. We define a meeting point where
two or more arrows join before or into an activity or the endpoint. For example in
Figure 4.2 the activities D and E join into a meeting point just before activity F. A
branching point is a point where one activity is followed by two or more activities in
parallel, i.e. one branch splits into two or more branches. For example in Figure 4.2
the activities B and C follow in parallel after activity A, and the branching point is
just right to activity A. We also need some numerical routines for solving the inte-
grals in Equations (3.61) and (3.62). Assume that we have access to the following
routines EMax=EMax(µ1 , σ21 , µ2 , σ22 ) and VarMax=VarMax(µ1 , σ21 , µ2 , σ22 ) for solving Equa-
tions (3.61) and (3.62) respectively. Here µ1 , σ21 , µ2 and σ22 are expectations and vari-
ances for the two variables we are taking the maximum of. We will only consider the
situation where EMax and VarMax are implemented under the assumption of indepen-
dent and normally distributed variables. See [Link] for such an implementation.

Problem 4.2 Show that EMax(µ1 , σ21 , µ2 , σ22 ) = ∆µ+ EMax(µ1 − ∆µ, σ21 , µ2 − ∆µ, σ22 )
and VarMax(µ1 , σ21 , µ2 , σ22 ) = VarMax(µ1 − ∆µ, σ21 , µ2 − ∆µ, σ22 ) 

The procedure for successive schedule planning with respect to describing the project
duration is now as follows1 :

1. For each activity i, establish the expectation, µi and variance σ2i for the duration
of activity i.

2. Identify all meeting points, i.e. where one or more branches join into one arrow.

3. Repeat and follow all activities from left to right in the flow network. This pro-
cess is iterative since each activity to the left of the current activity has to be
processed before we can proceed.
1 The presentation is slightly different from the original presentation by Lichtenberg (1990).
4.3. SUCCESSIVE SCHEDULE PLANNING (SSP) 49

4. For each activity i establish the expected start (EiS ), and expected finalisation
(EiF ). The expected start is equal to the expected finalisation of the preceding
activity (or meeting point in case of branches are joining just before activity i).
The expected finalisation is given by the expected start plus the expected duration
of activity i, i.e. EiF = EiS + µi . Note that this step cannot be executed if one or
more of the activities to the left have not been processed.

5. For each activity i establish the accumulative variance, ViF . Here ViF is the accu-
mulative variance of the activity (or meeting point) preceding activity i plus σ2i ,
i.e. ViF = VkF + σ2i where k is the activity preceding activity i.

6. If there is a meeting point in the network just before the entry into an activity,
we have to process this meeting point. Note that this means that two or more
branches join together and the succeeding activity cannot start before all the
branches, or paths up to this point, have been finalised (completed). Technically,
we now introduce a virtual node at the meeting point, representing the finali-
sation of the two (or more) branches going into the meeting point. The virtual
nodes are enumerated V1 , V2 , . . .. If three or more branches join into one meeting
point, we first process two branches into one virtual node, then this virtual node
represent one branch which is then processed together with the third branch into
another virtual node etc.

7. Let Vk be the virtual node we are processing, and assume that it is activities i and
j that are joining into Vk . If one of the activities (or virtual nodes) immediate to
the left of Vk has not been processed, we have to go to the left in the network
until we meet processed activities or nodes. The expectation and variance for
the finalisation of activity i are now given by EiF and ViF respectively. Similar
we have E Fj and V Fj for termination of activity j. If the two paths up to activity
i and j were disjoint, we could easily find the expectation and variance of the
finalisation of the virtual node Vk by Equations (3.61) and (3.62), or numerically
by EMax and VarMax. Typically, the two branches that join together after activity
i and j did split up into two branches from one single branch prior to a branching
point. Let l be the activity at which the branches did split up before joining again
at the virtual node k. When finding the expectation and variance up to the virtual
node k we then first find the expectation and variance up to the branching point l,
and then add the expectation and variance of the maximum of the two branches
from the branching point l to the virtual node k. The accumulated variance along
the path from branching point l to the end of activity i is found by Vi∆F = ViF −VlF .
We get similar results for the other branch, i.e. the one with activity j preceding
the virtual node k. The expectation and variance for the finalisation of the virtual
node k is now given by EiF = EMax( EiF , ViF − VlF , E Fj , V Fj − VlF ) and ViF = VlF +
VarMax( E iF , ViF − VlF , E Fj , V Fj − VlF ).

8. If there are more branches not processed into the meeting point, repeat until all
branches are processed by creating new virtual nodes.

9. When we reach the end node, we are done.

50 CHAPTER 4. SCHEDULE

Example 4.1
We want to demonstrate the calculation process by the flow network shown in Fig-
ure 4.2. We further assume that we have a spread sheet program available. The result
of the calculations are shown in Table 4.2. In addition to the activity row, and the
three rows for the low, most likely and high row, we add four rows for µi , σ2i , EiF
and ViF respectively. For each row corresponding to normal activities we calculate
µi = (L + 4m + H)/6 and σ2i = (µi − L)(H − µi )/7. Then we calculate the expected
finalisation of each activity, EiF as the expected finalisation of the previous activity (or
virtual node) plus the expected duration of activity i, µi . Similarly the variance of the
finalisation of activity i, ViF is the variance of the finilisation of the previous activity
(or virtual node) plus the variance of activity i, σ2i . For activity A the expected final-
isation and variance of the finalisation is equal to the expectation and variance of the
duration of activity A since it is the first activity. We note that after activity A we have
a branching point that meets again after activities F and G. For Activity B we see that
E BF = E AF + µB = 5.17 + 6.17 = 11.3, and VBF = VAF + σ2B = 1.73 + 0.88 = 2.61.
We note that after activity A we have a branching point that meets again after activ-
ities E and [Link] proceed similarly with activities C, D and E. We now proceed to
the virtual node V1 . It is convenient to insert a new row in the spread sheet program
just afer activity F. In order to find the expectation and variance for this node we take
advantage of the functions EMax and VarMax. The arguments to these functions are the
expectation of the finalisation of each of the preceding activities, and the accumulated
variance through the branches from the branching point which in this case is after activ-
ity B. EVF1 = EMax(18.5,3.49-2.69,18.5,4.35-2.69)=19.14. In order to obtain the variance
we use the VarMax function but we have to remember to add the accumulate variance
up to finialisation of activity B, VVF1 = VarMax(18.5,3.49-2.69,18.5,4.35-2.69)+2.69=3.5.
We complete the sheet for the remaining activities, including the virtual node V2 . The
expectation and variance of the duration of the entire project is now given by E HF and
VHF respectively. 
Note that we in the SSP-method have used the PERT distribution as a basis. The
method could be used for any distribution for the activities, the essential point is to
assess the expectation and variance of each activity duration.

Problem 4.3 Consider Example 4.1 and carry out the calculations by your self in a
spread sheet program. 

Problem 4.4 Find the cumulative distribution function for the entire project duration
(T ) based on the calculation in Problem 4.3, and especially find Pr(T > 35). 

4.4 Monte Carlo simulation (MCS)

The analytical models for project duration evaluation is often not flexible enough to
capture relevant aspects of a project. The use of Monte Carlo simulation techniques
is a supplement to analytical methods when we the situation is to complex to be anal-
ysed by analytical models. The idea of Monte Carlo simulation is that we establish
4.4. MONTE CARLO SIMULATION (MCS) 51

S A B E V1 F V2 H F

C G
Figure 4.3: Example flow network with virutal nodes, adapted from [3]

a set of stochastic variables and events. Then we establish deterministic relations be-
tween these variables and the events, e.g. the order of which activities are executed,
which activities that could be executed in parallel etc. It is important to realise that
the model that describes these relations is a deterministic model. Such a model could
be implemented in e.g. an MS Excel spreadsheet. The next idea in the Monte Carlo
simulation is to generate the stochastic variables and the events (indicator variables).
Most computer codes or program systems have a function that generate uniform dis-
tributed stochastic variables on the interval from 0 to 1. Given a such function it is also
in principle straight forward to generate the stochastic variables we need. By inserting
these stochastic variables into the deterministic model (e.g. an MS Excel model) we
now get one realisation of the system, or more specific the project duration. Let t1
be the numeric value when this process is done the first time. Now, we might repeat
the process by generating another set of random quantities and insert these into the
deterministic model to yield another value, say t2 . By repeating this process we could
think of the generated values t1 , t2 . . . as realisations of the project, and use the values
to obtain statistical properties such as the mean, the standard deviation, the cumulative
distribution function etc.
We will now illustrate how this process could be carried out with the [Link] pro-
gram.

Act. L M H µi σ2i EiF ViF Comment

A 2 5 9 5.17 1.73 5.17 1.73 Branching point for V2
B 4 6 9 6.17 0.94 11.33 2.61 Branching point for V1
C 7 12 21 12.67 2.60 17.83 8.48
D 5 7 10 7.17 0.94 18.50 3.49
E 4 7 11 7.17 1.32 18.50 4.35
V1 19.14 3.50 E & F joins, branches after B
F 2 3 6 3.33 0.71 22.48 4.01
G 3 5 9 5.33 1.22 23.17 9.70
V2 24.13 5.75 G & F joins, branches after A
H 5 7 10 7.17 0.88 31.30 6.63

Table 4.2: Data for the successive schedule planning demonstration in Example 4.1
52 CHAPTER 4. SCHEDULE

Example 4.2
It will be convenient to establish one row in MS Excel for each activity. The first
column (A) could contain the activity number, the second, third and forth (B, C and
D) could then contain the parameters in the PERT distribution, similar to Table 4.2.
Now we introduce three new columns (E, F and G) to contain the duration, start and
finalisation of each activity respectively. We start to enter the duration of each activity.
Assume that activity A is described in row 2 in the Excel sheet. In cell E2 we now enter
the following expression for the duration:
=RndPert(Rand(),B2,C2,D2)

Here the RndPert() function is a [Link] specific function, whereas the Rand() function
is a standard Excel function. The procedure is repeated for all activities, and we simply
copy the formula in cell E2 into the cells E3, E4 etc. We will now proceed to the
start and finalisation of each activity. It will be convenient to give the cells containing
the start and finalisation names in Excel. For activity A we give the following names
D_A, S_A and F_A for the duration, start and finalisation respectively. Similarly we
give the names S_B, D_B and F_B for the start, duration and finalisation of activity B
respectively, and so on for the remaining activities. By giving name to the activities, it
is easy to access them in formulas in other cells. We now use the convention cell name =
expression where the cell name is the name of the cell we want to assign an expression.
By inspecting the network in Figure 4.2 we easily verify the following statements for
the start of the various activities:
S_A = 0
S_B = F_A
S_C = F_A
S_D = F_B
S_E = F_B
S_F = Max(F_D, F_E)
S_G = F_C
S_H = Max(F_F, F_G)

The finalisation of the activities is given as the start point plus th duration, e.g., for
activity A we enter:
F_A = S_A + D_A

and similar for the other activities.

We have now specified the model and are prepared to simulate several runs. First
we note that each time we press the F9 key Excel updates the model by generating new
random numbers since we used the RAND() function in the cells containing the duration
of each activity. Next we switch to the RunSimul sheet and press the Run button. 

Problem 4.5 Consider the example in Figure 4.2. We will now consider an alternative
execution method for the last part of the project. Rather than executing activity H
as one activity, it is possible to split this activity into two parallel activities H and I.
Each of these activities could be described by the PERT distribution with parameters
L = 3, M = 5 and H = 8. Set up the flow network for this situation, and use the
4.5. PENALTY FOR DEFAULT 53

[Link] program to find the expectation and standard deviation of the project duration
by Monte Carlo Simulation. 

4.5 Penalty for default

The contracting party might issue penalties for default to ensure that the contractor put
necessary resources and effort into project execution. Penalties for default could be
linked to milestones and finalisation of the entire project. In the following discussion
we only consider the situation when there is defined penalty for default if the project as
such is delayed. Let T be the duration of the project measured from a defined startup
date. Let D be the number of days (from the startup date) before penalty for default is
initiated. Finally, let PD be the size of the penalty per day. The total penalty for default
is then max(0, (T − D)PD). The expected total penalty for default in a project is thus:
Z ∞
PDTot = (t − D)PD fT (t) dt (4.1)
D

where fT (t) is the probability density function for the project duration.
In principal we have to perform the integration in Equation 4.1 to find the expected
total penalty for default in a project. In most cases we also need to carry out numeri-
cal integration. However, if we have a Monte Carlo simulation model for the project,
we might utilise that for a given project duration T the total penalty for default is
max(0, (T − D)PD), and in e.g. [Link] we could specify in the “Cell to analyse”:
=max(0,PD*( T_End- D_Start )

where D_Start is the name of the cell where we have specified when penalty for default
is initiated, and T_End is the name of the cell where the total project duration could be
found.

Problem 4.6 Consider the example in Figure 4.2. Assume that D = 34, and PD =
1, 000 Euro. Find the total expected penalty for default in this project. 

4.6 Event uncertainty in the schedule model

When we describe the uncertainty about the duration of an activity by parameters such
as L, M and H these parameters account for all factors and conditions that influence the
duration. In some situations we might want to describe and model some important fac-
tors explicit. For example if the event W denote extremely bad weather conditions, we
might describe two set of parameters {L, M, H}; one if W occurs, and one if W does not
occur. That is, the duration of the activity is described by the parameters {LW , MW , HW }
if W occurs, and {LW C , MW C , HW C } if W does not occur. Next we describe the probabil-
ity that W occurs by a probability statement, pW = Pr(W).
We might now include the uncertainty about the weather (event uncertainty) explicit
into the schedule model. The easiest way to include such event uncertainty is to use
the Monte Carlo simulation approach. We have to do the following:
54 CHAPTER 4. SCHEDULE

• Describe the event we want to condition on, e.g. W

• Describe the probability of the occurrence of this event, e.g. pW = Pr(W)

• Define conditional parameter statements, e.g.{LW , MW , HW } if W occurs, and

{LW C , MW C , HW C } if W does not occur for each activity duration influenced by
W

• Define the event W in the [Link] model

• The duration for each activity influenced by W is now entered as one expression
if W occurs, and another if W does not occur.

Now, assume that it is activity A which is influenced by the event W. The following
information could then be specified to [Link]:
p_W = 0.1
Event_W = IF(Rand() < p_W,1,0)
D_A = IF(Event_W,RndPert(Rand(),5,8,12) ,RndPert(Rand(),2,5,8))

where the probability of bad weather conditions were set to 0.1, and we defined a cell
with cell name Event_W. Finally we have used the following set of parameter values:
{LW , MW , HW } = {5, 8, 12} and {LW C , MW C , HW C } = {2, 5, 8}.

Problem 4.7 Consider the example in Figure 4.2. Let W be the event {Bad weather}.
Assume that this event influences primarily the activities B and C. Let Pr(W) = 0.1.
The parameters describing the duration of activity B and C is now similar to the situa-
tion in Problem 3.9. The transformation factors now read fW , fW C and fV . Let fW = 1.5
and find fW C and fV similar to the procedure in Problem 3.9. Follow this procedure both
for activity B and C. Now update the Monte Carlo simulation model for the example
in Figure 4.2 when the event W is introduced in the model, and compare the simulation
results with the original results. 

4.7 Updating the model as we get more information

As we proceed with the project execution new information might be available, and we
will know the status of activities that have been completed. At regular intervals we
should therefore update the schedule model in order to optimise the effort we spend
on the different activities. To update the schedule model we take the following into
account

• Activities that are completed are replaced with deterministic quantities in the
schedule model.

• If new activities were necessary to add to the project, these are added to the
schedule model.

• If some activities were canceled these are removed from the schedule model.
4.8. EXAMPLES OF ADVANCED SCHEDULE MODELLING 55

• If the status of events and other risk factors that were included in the schedule
model is known, we replace the probabilistic statements about these with deter-
ministic statements.
• Other parameters (typically L, M and H) are revised in light of the knowledge
available at this moment, e.g. related to resources available.

Problem 4.8 Consider the example in Figure 4.2 and the penalty for default structure
as defined in Problem 4.6. assume that we now are in the project phase, and activity A
has just been completed. Due to special circumstances the duration of activity A was
tA = 10 which is even higher than the most pessimistic assessment. First calculate the
expected project duration, and total penalty for default. Next we will consider alterna-
tive production methods to increase the speed in the project. A major sub activity in
activity H is to produce an element on the construction site. It is, however, possible to
have this element prefabricated in advanced. The extra cost of such a prefabrication is
1,500 Euro. The gain of such a prefabrication is seen in the new distribution of the du-
ration of activity H, i.e. we now judge T H ∼ PERT(3, 5, 7). Update the [Link] model
and find the expected total cost with and without prefabrication. 

4.8 Examples of advanced schedule modelling

We will in the following present some situations where we need some more advanced
modelling to capture the situation. This will typically require to use the Monte Carlo
simulation approach, and we will use [Link] to modell the situation.

Example 4.3 Moving resources between activities

We consider again the example in Figure 4.2 and will investigate the activities F and
G. In expectation activity G will start slightly before activity F, whereas activity G
has longer duration than H in expectation. If the situation in the project is such that
activity G is not ready for start-up when activity F starts, it seems reasonable to move
resources from activity F to activity G. If this is the situation, we will assume that
the distributions for F and G are PERT(3,4,8) and PERT(3,4,8) respectively. To model
such an operative measure in [Link] we use the following statements:
D_F = IF(S_F>S_G,RndPert(Rand(),2,3,6),RndPert(Rand(),3,4,8))
D_G = IF(S_F>S_G,RndPert(Rand(),3,5,9),RndPert(Rand(),3,4,8))

When we run this model we get a slightly lower expected value for the project duration.


Problem 4.9 Use [Link] to perform the calculations in Example 4.3. 

Example 4.4 Time window

We consider again the example in Figure 4.2 and event B which represents an activity
that could only be executed within certain time windows. We will assume that if activ-
ity A is not completed before time t = 8, we could not start up activity B before time
t = 20. To model the effect of such a time window in [Link] we use the following
56 CHAPTER 4. SCHEDULE

statement:
S_B = IF(F_A>8,20,F_A)


Problem 4.10 Use [Link] to perform the calculations in Example 4.4. 

Chapter 5

Decision under uncertainties

5.1 Introduction
In this section we will give a general introduction to the field of decision theory where
uncertainties are involved. Examples are related to project risk management. As a
motivation consider the following situation where we have to choose between two or
more alternatives:
• Choice of sub contractor.
• Choice of concept for an oil production platform.
• Choice between double track and single track for a new railway line.
• Choice of tunnel trace now, or perform more investigation into the ground.
We could also have decisions related to continuous variables:
• When to make an agreement with one of the sub contractors.
• When to start preparing for a major shut-down.
• Choice of diameter for a gas pipeline towards Skogn.
• Dimension of a critical part in a new construction.

5.1.1 Overview of the method

We will first consider situations where one and only one decision is to be made. We
will denote the decision with the letter d. The decision alternatives will be denoted
a1 , a2 , . . . , am . The decision, d, could then be which sub contractor to choose, and
the alternative ai is the decision that we choose sub contractor i. The result of our
choice will be a set of end consequences Y. The end consequences could occur at
different times in the future, but we will simplify and assume that the effect will be
immediate after the decision is made. In more complex situations we have to consider

57
58 CHAPTER 5. DECISION UNDER UNCERTAINTIES

that the effect will come some time in the future, and discounting is an issue. Y =
[Y1 , Y2 , . . . , Yr ] is an attribute vector and comprises many dimensions. For example Y1
could be the project duration, Y2 could be the project costs etc. Further we note that
the Yi ’s are stochastic variables and the values will depend on our decision [Link] will
seek the decision that gives the “best” value of the attribute vector Y. It is common to
differentiate between the following four situations:
1. Decision under certainty. In this situation all the outcomes are known, and we
will know for sure what the outcome will be for the different decision alterna-
tives.
2. Decision under risk. In this situation all the possible outcomes are known, but
we do not know which outcome will be the result of our decision. We are able to
state probabilities for the various outcomes.
3. Decision under uncertainty. In this situation all the possible outcomes are known,
and we are unsure about the probabilities for the various outcomes.
4. Decision under ignorance. In this situation we do not know all the possible
outcomes, and we are also unsure about the probabilities of those outcomes we
know about.
In this presentation we will only consider decisions under risk and uncertainties. We
also note that many authors claim that it is not meaningful to state uncertainty about
the probabilities, it is the outcome which is uncertain, not the probabilities. When it
comes to the final outcome, i.e. related to the attribute vector Y we agree that there
is no uncertainty in the probability distribution of Y, i.e. the probability distribution
contains all the uncertainty about Y. We will therefore not differentiate between the
situation of decisions under risk, and decisions under uncertainty. Most frequently we
will use the term ‘decision under uncertainty’.
As indicated above we will seek the decision d that gives the best “value” of the
attribute vector Y, for example the lowest cost and the shortest execution time of a
project. There are, however, some difficulties in this approach:
• We will not be neutral to the risk. Very often we are willing to make a decision
that do not give the maximum expected revenue, but rather choose an option with
a lower expected revenue but with a lower probability of big losses. We are what
is called risk averse.
• The attribute vector Y comprises several dimensions, and it is not straight for-
ward how to weight these dimensions. For example how should we treat a project
with low cost, but a higher risk of accidents during project execution?
In order to treat such decision situations we introduced the concept of utility theory,
and utility functions. We will only briefly mention the major aspects, and refer to [9]
for further discussions. First we will treat situations where we make only one decision,
and the end consequences are assumed to take effect immediately after our decision.
In more complex situations the effects will come on a later stage, and we could make
several decision in a sequence with time delays between each decision. In such decision
problems we often use decision trees to help assisting the decision process.
5.2. BASIC CONCEPTS 59

5.2 Basic concepts

We use the notation d about a decision where it is only one decision to be made,
whereas we use the notation d1 , d2 , . . . in the situation where several decisions have
to be made. In this situation we also need an extra index for the decision alternatives.
In the situation where the decision is to choose a value of a numeric quantity, either
discrete or continuous we will notationally not differentiate between the decision, and
the decision variable (d).

5.2.1 Discrete end consequences vs attribute vector

Generally we use Y to describe the values of the end consequences resulting from a
decision. In some situations we want to simplify the representation by a set of few end
consequences, EC. We will let the end consequences, EC j , be disjoint. Further we
will let p j = Pr(EC j occurs) be the probability that we get end consequence EC j . It is
not always straight forward to determine what is the most convenient, either to work
with the full attribute vector Y, or the set of end consequences EC1 , EC2 , . . .. This will
depend on the level of precision in the risk analysis, the skill of the risk analyst, or the
decision maker etc.
In order to see the difference, consider the occupational safety dimension during
project execution. If we work with end consequences it could be natural to introduce
the following end consequences:

1. EC0 = No injury

2. EC1 = Minor injury

3. EC2 = Medical treatment

4. EC3 = Serious injury

5. EC4 = 1 fatality

6. EC5 = 2-10 fatalities

7. EC6 = > 10 fatalities

In order to describe the expected result we also specify the corresponding probabilities,
p0 , p1 , . . . p6 . These probabilities will be dependent on the decisions we make. If we
want to use a full attribute vector we could use Y = [Y1 , Y2 , Y3 , Y4 ], where Y1 = number
of minor injuries, Y2 = number of major injuries, Y3 = number of fatalities, and Y4 = is
the number of gross accidents, i.e. accidents with five or more fatalities. In this latter
situation we specify the expected outcome in terms of the joint probability distribution
function of Y. We then often introduce parameters that depend on the decision d we
make.
60 CHAPTER 5. DECISION UNDER UNCERTAINTIES

Utility function
The utility function expresses the preferences of the decision maker regarding various
attribute vectors or end consequences. A prerequisite for establishing a utility function
is that the decision maker is able to express preferences between different values of the
attribute vector. For example in a one dimensional situation where we set Y = NPV
(net present value) this will be rather obvious in the first place, it is reasonable that all
decision makers will prefer a higher value to a lower value. Now let y1 and y2 denote
two arbitrary values Y could take. The following relations are of interest between y1
and y2 :

Relation Explanation
y1 ∼ y2 y1 and y2 is considered equal
y1 ≻ y2 y1 is preferred over y2
y1  y2 y1 is as least as preferable as y2
y1 ≺ y2 y2 is preferred over y1
y1  y2 y2 is as least as preferable as y1

The utility function is now a function that assigns a one-dimensional utility value
to each value of the attribute vector or quantity, u = u(y). For the utility function we
require:
y1 ∼ y2 ⇔ u(y1 ) = u(y2)
y1 ≻ y2 ⇔ u(y1 ) > u(y2)
y1  y2 ⇔ u(y1 ) ≥ u(y2 )
y1 ≺ y2 ⇔ u(y1 ) < u(y2)
y1  y2 ⇔ u(y1 ) ≤ u(y2 )
There exists, however, an infinite number of utility functions that satisfy the above
criteria and we therefore want to fix the utility function for some values. In order to
be useful, the utility function should also express how much we prefer e.g. y1 over y2 .
Further we also want the utility function to reflect the fact that there will be uncertainty
regarding the future value of the attribute Y. We still consider the one dimensional
situation where Y = NPV (net present value). Y will be a stochastic variable in the
decision point. Now, assume that we could choose between a decision A that for sure
gives the net present value Y = y0 and the decision B that gives the net present value
Y = y1 with probability α and the net present value Y = y2 with probability 1 − α.
Further assume that y1 ≺ y0 ≺ y2 . For a given set of values of y0 , y1 and y2 there
will exist a value of α which makes the decision maker indifferent between the two
decisions A and B. This will be reflected in the utility function which must satisfy:

u(y0 ) = αu(y1 ) + (1 − α)u(y2 ) (5.1)

Equation (5.1) could now in principle be used to establish the utility function. In this
process we might restrict our selves to let the utility function take values between 0 and
1, or 0 and 100.

Example 5.1 Private economy

5.2. BASIC CONCEPTS 61

u(y)

100

y
1000 2000 3000 4000 5000 6000
Figure 5.1: Utility function for Example 5.1

We are asked to do a job in the firm SmartConsult. It will be 100 hours of work, and
we are offered two options for payment:

1. A fixed hour rate of 20 Euro per hour.

2. A baseline hour rate of 10 Euro, and an additional value of 50 Euro which will
be paid if the project reaches the targets that have been set up.
We have been studying the progression in the project so far, and assess the probability
that the extra 50 Euro to be paid is 40%. Simple calculations shows that the second
alternative gives the highest expected hour rate (30 Euro vs 20 Euro). However, we are
in a cash position which makes it very difficult for us if we only receive 10 Euro per
hour. After some considerations we have found out that the two alternatives are equal,
i.e. neither of them are prefered over the other.
We will now utilise Equation (5.1) to set up our utility function. Three points could
be assessed, u(1 000), u(2 000), and u(6 000). Since we arbitrary may choose the end
points, we let u(1 000) = 0 and u(6 000) = 100. We now have (α = 0.6):

u(2 000) = 0.6u(1 000) + 0.4u(6 000) = 40

The utility function is shown in Figure 5.1 where we have fitted the function u(y) =
55.702 ln(y) − 384.25 and the diamonds represent the assessed values. 

Problem 5.1 Consider Example 5.1. What probability would you required for being
paid the additional 50 Euro per hour in order to treat the two alternatives as equal. 

Problem 5.2 Consider Example 5.1 again, but assume that you were going to work
500 hours. Make a sketch of your utility function in this situation. 
For private economies we are usually risk averse. Risk aversion means a concave util-
ity function as shown in Figure 5.1. Also smaller enterprises will often be risk averse
reflecting that rather than optimising expected revenue, decisions are taken to minimise
the probability of big losses which could lead to bankruptcy. Larger enterprises will of-
ten have an almost linear utility function (in monetary values) because their economical
strength is good, and there is no real possibility for bankruptcy.
62 CHAPTER 5. DECISION UNDER UNCERTAINTIES

Utility function for quantities other than monetary units

In Example 5.1 we have seen how the utility function could be established for monetary
units. We will now investigate how we could include the safety dimension into the
utility function. Two important questions will be raised:
• What is the benefit, or utility of saving one (statistical) life vs saving 10 statistical
lives?
• What is the benefit, or utility of saving one (statistical) life vs the possibility to
earn an extra million Euro?
In the first situation we deal with the question to rank the consequences within the same
main dimension (safety), whereas we in the second situation need to compare benefits
or disadvantages across dimensions. The discussion below will be very short, and we
refer to e.g. [10] for further discussion on this topic.
The first issue we will discuss is the concept ‘value of prevented fatality’ (VPF).
The idea behind this concept is that in any industrial activity, transportation services
etc there will always be a risk of accidents, and hence possibilities of severe injuries
and fatalities. As a decision maker we have to face this fact. However, we will make
effort to reduce this risk, and we are willing to spend money to achieve such a reduc-
tion. The VPF value states then how much we are willing to spend in order to prevent
one statistical fatality. We use the term ‘statistical’ fatality to emphasise that this will-
ingness to pay is not related to specific persons, but arbitrary persons where it is not
meaningful or possible to identify single persons. In some presentation also the term
‘value of life’ (VOL) has been used. We feel that this term is not appropriate because
the term indicates that the life it self has a value which could be measured in monetary
units. This is not our perspective. The value of life it self could not be measured. What
we could assess figures to, is what we are willing to pay in order to reduce risk, or the
probability of fatalities. Hence, the term VPF make more sense in our understanding.
If we accept that the term VPF make sense, then the next question will be how to
assess the value of VPF. Different approaches exist. One approach is to look into eco-
nomical considerations from the society point of view. For example we could calculate
the reduction in GNP (Gross National Product) caused by a fatality. Such calculations
have been carried out, and in e.g. Norway this indicate a value of 3 million Euro for
VPF. Another approach has been to ask single persons about their willingness to pay
for risk reduction (see “The change in risk of death” [16]). For example for buyers of
cars, we could ask what they are willing to pay for a given safety system or measure,
for example an improved airbag system. Let assume that the amount one is willing to
pay is ∆W, and that the assessed risk reduction during the service life of the car is ∆P.
It would then be natural to set VPF = ∆W/∆P. In Norway no such systematic surveys
have been conducted, but more arbitrary surveys at NTNU among ordinary students
and continuation students a value of 2.5 million Euro has also been found for VPF. We
will emphasise some challenges of such a willingness to pay approach:
• Different persons have different preferences. For example young people tend to
be less willing to pay for risk reduction compared to older persons with family
obligations.
5.2. BASIC CONCEPTS 63

• Individuals are not consistent in their preference statements.

• In real surveys to establish ∆W and ∆P we face the problem that other dimen-
sions than being killed are involved, e.g. the risk of minor and major injuries.
Further one does not only consider the life of one self, but also the life of family
members etc when making decisions about safety.
• It is not obvious that “what I am willing to pay” is what I want the society to pay
for risk reduction in general, or what I expect my employer to pay for my risk
reduction.
It is a tendency to set a lower value for VPF when it comes to the area of public
responsibility compared to industrial activity. For example in the petroleum industry
we see VPF values in the order 10 to 15 million Euro. It is also a tendency to set a
higher VPF for multiple fatality accidents compared to single fatality accidents. This
could be interpreted as an aversion against gross accidents. This aversion should not
be confused with risk aversions which would be an aversion against a high number of
fatalities in general, and not the number of fatalities in single accidents. An another
perspective in this discussion is how we should treat injuries in such a framework. One
common approach here is to introduce the concept of ‘equivalent fatality’. For example
we could be willing to pay five times more to prevent a fatality than a severe injury,
which corresponds to an equivalent fatality of 0.2.
In a utility function approach we could now in case of a VPF value 2.5 million
Euro let the utility of one fatality be equivalent to -2.5. If we now extend the situation
to include multiple fatality accidents, and minor and major injuries, we could set up a
more general utility function:

u(y1 , y2 , y3 , y4 ) = −0.03y1 − 0.5y2 − 2.5y3 − 7y4 (5.2)

where y1 is the number of minor injuries, y2 is the number of major injuries, y3 is the
number of fatalities in accidents with less than five fatalities, and y4 is the number of
fatalities in gross accidents (five or more fatalities in one accident). It is important to
emphasise that the utility function offered in Equation (5.2) is a function that could be
used as a start in a discussion about value trade-offs and preferences, and should not
be considered as the “correct utility function”. Also note that Equation (5.2) includes
an aversion against gross accidents, but there is no risk aversion in terms of a concave
utility function in the attributes. If we also want to include attribute y7 as the profit in a
project measured in million Euro we could extend the utility function:

u(y1 , y2 , y3 , y4 ) = −0.03y1 − 0.5y2 − 2.5y3 − 7y4 + y7 − ae−by7 (5.3)

where a and b are constant. Reasonable values of these constants are a = 0.08 and
b = 0.7.
The utility function in Equation (5.3) is an additive utility function. Very often we
use additive utility functions for simplicity. However, arguments could indicate that a
situation with one extra fatality is “worse” if there is a situation with a gross accident
than without such a gross accident. Such discussions will not be pursued any further,
and we refer to [9].
64 CHAPTER 5. DECISION UNDER UNCERTAINTIES

5.2.2 Maximising expected utility

In the previous sections we have seen principles for establishing a utility function. The
utility function expresses our preferences and value trade-offs. The utility function
is independent of the given decision situation we are facing and could be viewed as
a general function we could use in many decision situations. We also observe that
the utility function is a function of the attributes. In a given situation these attributes,
Y1 , Y2 , . . . , are stochastic variables which also means that the utility function will be
stochastic, and the idea is to choose the decision that maximises the expected utility.

Result 5.1
RThe
∞
optimal decision d is the decision that maximises expected utility, E(u(Y)) =
−∞
u(y) fY (y)dy 
The basic steps in obtaining the optimal decision is then:
1. Establish an explicit expression for the utility function, u = u(y1 , y2 , . . .) which
corresponds to the preferences and value trade-offs of the decision maker.
2. Establish the probability distribution function for the attribute vector Y = [Y1 , Y2 , . . .]
for each decision alternative, or for each value of a decision variable (d).
3. Calculate the expected utility to each decision alternative by integrating the util-
ity function over the probability distribution of the attribute vector.
4. Find the decision alternative that gives the maximum expected utility.

Problem 5.3 In this problem you shall first make an attempt to construct the utility
function u(y) for a given decision maker. In the problem there is only one dimension,
and the attribute y is measured in thousand Euro by the procedures we have established
in the previous sections. Assume that u(−100) = 0, and u(400) = 1.
a) Why do we have the freedom to assess two points on the utility function, and
why is is suitable to use these two values.
Now, assume that the decision maker makes the following considerations regardingthe
outcome of a project:
• An uncertain project which gives -100 with probability 0.50 and +400 with prob-
ability 0.50 is considered as equal attractive as receiving the fixed amount +150.
• An uncertain project which gives -100 with probability 0.50 and +150 with prob-
ability 0.50 is considered as equal attractive as receiving the fixed amount +100.
• An uncertain project which gives +150 with probability 0.50 and +400 with
probability 0.50 is considered as equal attractive as receiving the fixed amount
+225.

b) Draw the points on the utility function which you could calculate based on the
above information, and make a sketch of the utility function in the interval -100
to +400.
5.2. BASIC CONCEPTS 65

c) What does the graph say about the decision makers attitudes to risk?
d) Use the graph to choose the optimum project among the following projects:
A) A project returning -100 with probability 0.2, +150 with probability 0.2
and +350 with probability 0.6.
B) A project returning 0 with probability 0.4 and +400 with probability 0.6.
e) Which of these two projects would the decision maker choose if he adopts the
principle of maximum expectation. 

Problem 5.4 In a tunnel project one could choose between bursting or drilling. Burst-
ing is considered to be the cheapest alternative, but the risk of personal injuries or
fatalities is considered higher. Assume the utility function given in Equation 5.2 on
page 63. Let fi = E(Yi ), i = 1, . . . , 4 be the expected number of minor injuries, serious
injures etc. and assume the following numbers:
• Bursting [ f1 , f2 ,. . . , f4 ] = [10, 1, 0.03,0.008]
• Drilling [ f1 , f2 ,. . . , f4 ] = [7, 0.2, 0.01,0.001]
How much cheaper need bursting be compared to drilling if these two methods should
be equally valued with respect to utility? 

5.2.3 Examples with one decision node

In this section we will investigate examples where only one decision is going to be
made.

Example 5.2 Maximising expected utility - private economy

In Example 5.1 we established the utility function in a situation with private economy.
The function could be written as: u(y) = 55.702 ln(y) − 384.25. Now, assume that we
are offered a job with two different forms of payment. For both alternatives the possible
amounts are:
• Y = YL = 2,000
• Y = Y M =5,000
• Y = YH =8,000
However, there is a difference in the probabilities for the two alternative forms of pay-
ments. These are shown under the column p for alternative a1 and a2 in Table 5.2
respectively. Expected utility is found by:
X X
E(u(Y)) = u(y) Pr(Y = y) = (55.702 ln(y) − 384.25) Pr(Y = y)(5.4)
y∈{YL ,YM ,YH } y∈{YL ,YM ,YH }

where each term in the sum is calculated in the column for U in Table 5.2. In the V
column we have similarly calculated the expected monetary value. In the last row the
66 CHAPTER 5. DECISION UNDER UNCERTAINTIES

Alternative a1 Alternative a2
↓ Amount p U V P U V
2,000 0.1 3.9 200 0.3 11.7 600
5,000 0.8 72.1 4,000 0.4 36.1 2,000
8,000 0.1 11.6 800 0.3 34.9 2,400
Sum→ 1.0 87.7 5,000 1.0 82.7 5,000

sum is shown, and we observe that the expected utility for a1 and a2 is 87.7 and 82.7 re-
spectively, and hence alternative a1 has the largest expected utility. When expectations
are considered, the two alternatives are equivalent.

Problem 5.5 Consider Example 5.2, but now assume that the probability distribution
for the payments are PERT(4000,5000,6000) and PERT(2000,6000,8000) respective.
Hint: you might use the program [Link]. 

Example 5.3 Tender offer - linear utility function

We are going to prepare a tender for a large road project. We have made a cost estimate,
and found the total cost of executing the project, PC, to be PERT distributed, PC ∼
PERT(L, M, H) = PERT(10 , 30 ,80 ) where all costs are given in million Euro. We
also have some knowledge about our competitors. We have judged the lowest tender
from the other contractors, LP, to be PERT distributed, e.g. LP ∼ PERT(30, 35, 50).
The challenge is to set our tender price (TP) such that it is lower than the lowest of the
(serious) competitors , but also not too low as we then will loose money. The following
notation is introduced:

TP = Our tender price, TP, i.e. the decision variable.

LP = Lowest tender prince among our competitors. We assume a lump sum contract.

PC = Project cost, i.e. a stochastic variable.

Y1 = 1 if we get the contract, 0 otherwise, i.e. Y1 = ILP>TP .

p = The probability that we get the contract, p = p(TP) = E(Y1 ) = Pr(LP > TP) .

Y2 = TP = Our tender price. TP is also an “attribute” because this is our income.

Y3 = PC = project cost.

u = utility function, u(y1 , y2 , y3 ) = y1 · (y2 − y3 ).

Expected utility is given by

E(u(Y1 , Y2 , Y3 |TP)) = E(Y1 ) · E(Y2 − Y3 ) = p(T P) · (T P − E(PC)) (5.5)

In order to find p = p(TP) we could utilise the [Link] program, and the function
CDFPert. The syntax to enter in an EXCEL cell where we store the result is:
5.2. BASIC CONCEPTS 67

p(TP)

1
.8
.6
.4
.2
TP
30 35 40 45 50
Figure 5.2: Probability p of getting the project as a function of tender price, TP

E(u)

1
0
-1
-2
-3
-4
-5 TP
30 35 40 45 50
Figure 5.3: Expected utility as a function of the tender price, TP

= 1 - CDFPert(TP,30,35,50)

where TP is a cell reference or a numeric value for the tender price. Figure 5.2 shows
the probability of getting the contract as a function of the tender price. Given that we
get the contract, the expected utility equals TP-E(PC). The expectation in the PERT
distribution is given as (L + 4M + H)/6, i.e. (10 + 4 · 30 + 80)/6 = 35 million Euro,
and the expected utility equals:

E(u(Y1 , Y2 , Y3 |TP)) = p(TP) · (TP − 35) (5.6)

By using the result for p = p(TP) from Figure 5.2 we could easily find the expected
utility as shown in Figure 5.3. The optimum tender price is found to be 39 million
Euro. 

Example 5.4 Tender offer - concave utility function

We will investigate the situation in Example 5.3 but we will now assume that the deci-
sion maker is risk averse. A possible utility function is:

u(y) = y − a · e−by (5.7)

where a and b er parameters. We set a = 0.2, and b = 0.2, and we let money be
measured in million Euro. With these parameters the utility of 10 million Euro is then
9.97 whereas the utility of a loss of 20 million Euro is - 30.9 and the utility of -30 is
68 CHAPTER 5. DECISION UNDER UNCERTAINTIES

E(u)

1
0
-1
-2
TP
35 36 37 38 39 40 41
Figure 5.4: Expected utility as a function of the tender price, TP

-110. In this example we will also add one if we get the contract. This extra utility unit
could represent the value of competence improvement. The utility function is then:

u(y1 , y2 , y3 ) = y1 · (y2 − y3 ) − 0.2 · exp(0.2 · y1 · (y2 − y3 )) + y1 (5.8)

It will not be easy to maximise expected utility as a function of the tender price, TP. We
therefore use [Link] to carry out a Monte Carlo simulation, and the result is shown
in Figure 5.4. We see that the optimum value is slightly increased from 39 million to
almost 40 million. The reason for this is the concave utility function where we want to
reduce the probability of the large losses. 

Problem 5.6 Make a sketch of the utility function in Example 5.4. Discuss the utility
when y approaches minus infinity and plus infinity. 

Problem 5.7 Use [Link] to perform the calculations for the example in Exam-
ple 5.4. Discuss the influence of the parameter b and discuss the effect of letting b
approach zero. 

Extra effort in order to reduce penalties for default

We are a part of the project management for a large road development project and
realise that it will be difficult to reach the completion date agreed upon. The following
quantities describe the situation:
CD = 30 = Agreed completion date, in days from now
Y1 =T = Completion date, in days from now. Y1 ∼ PERT(L, M, H).
PD = 10,000 Euro = Penalty for default, i.e the amount to pay each day the project
is delayed (Y1 >CD).
BO = 5,000 Euro= Bonus, i.e the amount BO is paid extra for each day the project
is completed before CD.
Y2 = EE = Extra effort we invest in order to speed up the project.
L0 = 25 = Lowest value of Y1 , if nothing extra is done.
5.2. BASIC CONCEPTS 69

M0 = 35 = Most likely value ofY1 , if nothing extra is done.

H0 = 60 = Highest value of Y1 ,if nothing extra is done.
LY2 =L0 (0.5 + 0.5e(−Y2 /50000) ) = Lowest value of Y1 , with extra effort Y2 .
MY2 =M0 (0.5 + 0.5e(−Y2 /50000) ) = Most likely value of Y1 , with extra effort Y2 .
HY2 =H0 (0.5 + 0.5e(−Y2 /50000) ) = Highest value of Y1 , with extra effort Y2 .
We will use a linear utility function, and we let the utility of one Euro be equal to one.
The following utility function the applies:

u(y1 , y2 ) = PD · (CD − y1 ) · ICD<y1 + BO · (y1 − CD) · ICD>y1 − y2 (5.9)

Also here we utilise the [Link] program to calculate expected utility. The following
statements are entered into the Excel sheet:
CD=30
L_0=25
M_0=30
H_0=60
PD=10000
BO=5000
Y_2= 10000
LY_2=L_0*(0.5+0.5*exp(-Y_2/50000))
MY_2=M_0*(0.5+0.5*exp(-Y_2/50000))
HY_2=H_0*(0.5+0.5*exp(-Y_2/50000))
Y_1=RndPERT(RAND(),LY_2, MY_2, HY_2)

We obtain the following values for expected utility:

EE=Y2 0 10 000 20 000 30 000 40 000 50 000

E(u(Y1 ,Y2 )) -44 000 -28 000 -19 000 - 15 000 -15 000 -18 000

The maximum expected utility is obtained by spending between 30 and 40 thousand

Euros in order to reduce the risk of delays in the project.

Problem 5.8 Use the [Link] program to perform the simulation as indicated above.
Check the sensitivity in the results as a function of the number of simulation runs. Then
find a more exact result for the optimum value of the extra effort. 

5.2.4 Decision trees

The use of decision trees is a fruitful approach when we are going to systemise a
decision process where the decisions are made at different point of times. The main
reason for postponing a decision is to follow the development of e.g. a project, and
hence make the most appropriate decision when more information is available. The
70 CHAPTER 5. DECISION UNDER UNCERTAINTIES

drawback is that postponing a decision could yield more costly solutions. Another
drawback could be that it is no time to implement necessary measures in due time if
we wait to take action.

Starting point

Decision node

Chance node

Consecutive costs

C End consequences, terminal node

Coupling between nodes and end consequences

Figure 5.5: Symbols used in decision trees

Analysis of decision trees

The following notation is introduced:
CNi = Chance node i
pi, j = probability that chance node i results in outcome j.
DNi = Decision node i.
CIN j = Cost of intermediate node j
CTN j = Cost related to terminal node j.
EMV = Expected Monetary Value .
EMVi, j = EMV for branch j into chance node i.
EMVi = EMV for chance node i, or decision node i.
The algorithm for numeric calculating is shown in Figure 5.6.

Example 5.5
Construction Ltd. is the main contractor for a road tunnel project. During the work
more water penetration than expected is discovered. Physically there are three alterna-
tives to choose among:i) bursting an outlet drain which is very costly but a satisfactorily
solution, ii) build a pumping station to pump away the water which is a cheaper solu-
tion but may not be adequate if there is very much water, and iii) carry out seal work
which is even cheaper, but adequate only in case of very little water. The amount of
water is uncertain at the time being. Below we discuss the decision process:
The first decision is now (DN1 ), and at this decision node we have the following
options:
5.2. BASIC CONCEPTS 71

Repeat for all end terminals

(*) Move to the node to the left, and bring with the EMV-value in the current node
IF this is a chance node THEN
Calculate EMVi, j = pi, j · EMV
IF EMV has been calculated for all branches into this node THEN
Calculate EMVi = Σ j EMVi, j
GoTo (*)
ELSE
GoTo next terminal node
ENDIF
ELSEIF this is a decision node THEN
IF EMV has been calculated for all branches into this node THEN
Let EMVi = Min j ( EMVi, j )
Optimum decision in DNi is the branch with minimum EMVi, j
GoTo (*)
ELSE
GoTo next terminal node
ENDIF
ELSEIF this is a consecutive node THEN
Add EMV of the consecutive node to EMV
GoTo (*)
ELSEIF this is the start node THEN
We are done
ENDIF

Figure 5.6: Algorithm for processing a decision tree

A: Immediate start bursting work

B: Wait half a year until more information about the amount water is available

If we postpone the decision (B) we would have more information about the amount of
water in half a year and a better decision could be made. Two outcomes are foreseen
in half a year (CN1 ):

C: It is obviously so much water that bursting the outlet drain is necessary

D: There is still uncertainty regarding the amount of water, and we have a new
option in decision node DN2 :

E: Build a pumping station and hope that this is sufficient, or

F: Wait another half year to obtain even more information

If the pumping station is build at this time (E) this could result in the following out-
comes (CN2 ):

G: The pumping station was sufficient

72 CHAPTER 5. DECISION UNDER UNCERTAINTIES

Drain outlet
A 50 million

DN1 Drain outlet

C 60 million
Pump station
B CN1 E CN2 G
20 million

DN2 Fiasco
D H 90 million
Drain outlet
I 70 million

CN3 Seal work

F J 10 million
Pump station
K
25 million
Figure 5.7: Decision tree for tunnel project

H: The pumping station was not sufficient, and an outlet drain have to be bursted
If we wanted to postpone the decision (F) there are tree possible outcomes (CN3 ):
I: Bursting the outlet drain is required
J: Sealing work is sufficient
K: A pumping station is sufficient
Table 5.1 shows the associate costs (the letter in parentheses corresponds to the alter-
native above).

Options Cost now Cost in half a year Cost in one year

Outlet drainage bursting 50 mil. (A) 60 mil. (C) 70 mil. (I,H)
Pumping station 20 mil. (G) 25 mil. (K)
Seal work 10 mil. (J)

Table 5.1: Cost of the various options

At the moment we make the following probability assessments:

P(C|CN1 ) = 30%
P(D|CN1 ) = 70%
P(G|CN2 ) = 90%
P(H|CN2 ) = 10%
P(I|CN3 ) = 10%
P(J|CN3 ) = 40%
5.2. BASIC CONCEPTS 73

Drain outlet
50 50 million

DN1 Drain outlet

18 60 million
Pump station
34.45 CN1 27 CN2 18
20 million

DN2 Fiasco
16.45 9 90 million
Drain outlet
7 70 million

CN3 Seal work

23.4 4 10 million
Pump station
12.5
25 million
Figure 5.8: Decision tree for tunnel project with calculations

P(K|CN3 ) = 50%
Note that in the example we have not used the symbol for consecutive costs. For
the calculation we use the algorithm indicated in Figure 5.6. We start with the upper
right terminal node, and “collect” the EMV = 50 mill. into the decision node to the left,
e.g. DN1 . In this decision node we observe that not all branches (from the right) into
node DN1 have been processed, and we therefore need to go back to a new terminal
node. We go back to the next upper terminal node and collect EMV = 60 mill. which
is multiplied with the branch probability (30%) such that we get EMV = 0.3 · 60 mill.
= 18 mill. into chance node CN1 . Here, the second branch into the chance node has
not been processed and we again have to go back to the next non-processed terminal
node. Here we collected EMV = 20 mil which is multiplied with 90% gives EMV = 18
mill. into chacne node CN2 . Similarily we get EMV = 90 mill. · 10% = 9 mill. for the
second branch into chance noe CN2 . We may now complete the processing of chance
node CN2 by adding the EMV values entering the node from the right, yilding an EMV
of 27 mill. This number now goes into decision node DN2 . Now the remaining end
nodes are processed, and we get the EMV to collect from CN3 equal to 23.5 which
again will be the second EMV into decision node DN2 . In decision node DN2 we shall
choose the branch having the lowest EMV value, i.e. branch F with an EMV of 23.5.
In decision node DN2 it is most beneficial to postpone the decision for another half
year. We complete the tree similarly, and find that in decision node DN1 the optimal
decision is to postpone any physical activity. We remain then with an EMV equal to
34.45. The number from these calculations are shown in Figure 5.8. Also note that we
have not taken the discounting aspects into account, something that also would have
been an argument for postponing the decision. 
74 CHAPTER 5. DECISION UNDER UNCERTAINTIES

Problem 5.9 An oil company has the rights for a given oil field, and have the options
between:
• Drill a well (D)
• Sell our rights (S)
The decision will depend on the amount of oil that might reside in the field. There are
two options:
• Profitable oil pool (P)
• Non profitable oil pool (NP)
Before the final decision is made, our oil company could conduct an expensive seis-
mic investigation which might give information regarding the probability that the field
contains a profitable oil pool. The result from such an investigation will be one of the
following statements:
• No structure (NS)
• Open structure (OS)
• Closed structure (CS)
In this problem you should establish a decision tree for the situation. The decision node
following the start node should be:
• Perform a seismic investigation (SEI)
• Do not perform a seismic investigation (NINV)
The cost involved in the decision tree is as follows:

Cost of seismic inveestigation: 10

Cost of drilling a well: 100

Net profit (after drilling) if oil: 700

Selling price without seismic investigation: 30

Selling price with seismic investigation:
- No structure 0
- Open structure 50
- No structure 200

The probability that shall go into the decision tree is as follows:

Probabilities in relation to a seismic investigation (e.g. based on experience figures
from geologists):
The probabilities for finding a profitable oil pool, given the result of the seismic
investigation:
5.2. BASIC CONCEPTS 75

No structure: 0.60
Open structure: 0.30
Closed structure: 0.10

No structure: 0.10
Open structure: 0.25
Closed structure: 0.70

The probability for finding oil when no seismic investigation has been performed: 0.20.
Find the optimal decision in each decision node, and formulate the conclusions from
your analysis. 
76 CHAPTER 5. DECISION UNDER UNCERTAINTIES
Chapter 6

Life cycle cost and life cycle

profit

6.1 Introduction
In this chapter we will give a short introduction to life cycle cost (LCC) modelling
and anaylysis in connection with project management. The term LCC is defined in
IEC 60300: “LCC is the cumulative cost of a product over its life cylce”. The LCC
concept was first introduced in the US Army and the idea was to establish the cost of
development, production and use (operation and maintenance) of military equipment.
In the original use the revenues was not included in the modelling. However, in order to
get a complete picture we will usually also include the possible profit of a new system
or product. Hence the term ‘Life Cycle Profit’ has been introduced. Kawacuchi and
Rausand [?] suggest a process for LCC analysis comprising the following steps:

1. Problem definition

2. Cost element definition

3. System modelling

4. Data collection

5. Cost profile development

6. Evaluation

7. Reporting

In this presentation we will focus on the cost modelling aspects, i.e. mainly step 3 in
the above procedure.

77
78 CHAPTER 6. LIFE CYCLE COST AND LIFE CYCLE PROFIT

(now)

X1 X2 X3 X4 X5 XT −1 XT
time
0 1 2 3 4 5 T − 1T
Figure 6.1: Visualisation of the cach flow, Xt

6.2 Net present value calculation

The formulas for LCC calculation is based on standard formulas used in net present
value (NPV) calculations. In the following we will sumarise the most frequent used
formulas. The basic idea in NPV calculation is that money received in the future will
be less valued than the same amount of money today. To treat this formally all future
amounts are discounted to the present time, i.e. present values. We will only consider
discrete time, i.e. all amounts will occur at the end of each year, or now (beginning of
year one). The cash flow is illustrated in Figure 6.1.
The net present value of an amount Xt that occurs at the end of year t is:
NPV = Xt (1 + r)−t (6.1)
where r is the discount rate. Similarly, we find the net present value of a cash flow
X0 , X1 . . . . , XT :
T
X
NPV = Xt (1 + r)−t (6.2)
t=0

where X0 represents in or outgoing cash now, and T is the number of years to consider.
Sometimes we want to establish the net present value of a constant yearly (nominal)
amount XA , i.e. the same amount each year. By utilising the formula for the sum of a
geometric serials, ni=1 qi = q(1 − qn )/(1 − q) we obtain:
P

1 − (1 + r)−T
" #
NPV = XA (6.3)
r
Note that NPV approaches XA /r as T approaches infinity.
Now, consider a situation with a fixed increasing yearly value, were the first in or
outgoing amount is XA,v (at the end of the first year), and where the amount is increasing
by a factor (1 + v) each year. The net present value for T years is then found to be:
 1 − 1+v T 
   
1+r
NPV =   X (6.4)

 r − v  A,v

IF r = v in Equation (6.4) we use NPV = XA,v T/(1 + r) obtained by l’Hopitals rule.

The expression in Equation (6.3) assumes that the amount XA,v occurs every year. In
some situations we want to consider an amount XA,v which occurs every k year, where
k > 1. The net present value is now given by (assuming first amount now (t = 0)):
∞
X XA
NPV = XA (1 + r)ki = (6.5)
i=0
1 − (1 + r)−k
6.2. NET PRESENT VALUE CALCULATION 79

If the first amount occurs at the end of year l we obtain:

XA (1 + r)−l
NPV = (6.6)
1 − (1 + r)−k

6.2.1 Trend modelling

When modelling trend it is important to find a simple mathematical expression for the
time development. Further note that the change in the yearly amount is due to at least
the following factors:

• The monetary value increases due to general conditions, such as inflation.

• The monetary value increases due to increased operating costs, e.g. physical
deterioration and hence more maintenance is required.

Increased operating costs due to deterioration could usually be reset by a renewal of

the system we are considering, whereas external conditions like inflation is not affected
by e.g. a system renewal. In the modellling we will assume a fixed inflation rate, even
if we in a more advanced model also could let the inflation rate vary. This inflation rate
will be denoted v, and we could use Equation 6.4 to calculate the net present value of a
amount that changes due to inflation. When we want to model increased operating cost
due to deterioration, we need to introduce a local age parameter. We will let a denote
the age of the system, or the age of the system since the last system renewal. When we
consider degradation, we introduce the degradation rate d where we assume that the
yearly increase due to deterioration equals (1 + d). This corresponds to an exponential
growth which very often is found realistic if we have degradation mechanisms that
drive the costs. Now, let c0 be the yearly cost of operation, maintenance etc now (i.e.
at time t = 0). We then have the yearly cost in year t (occurring at the end of year t):

ct = c0 (1 + d)t (6.7)

In order to obtain the degradation rate d we usually need data about the costs as a
function of time. A very simple approach if we know that c(t) has increased by a
growth factor (GF) during a period of T years. We then have:

d = eln(GF)/T − 1 (6.8)

6.2.2 Example areas of LCC calculations

In the following we give examples of areas where LCC analysis and calculation could
be used. We differentiate between situations were decisions are related to project exe-
cution, and the progression of one project, or a portfolio of projects, and the situation
where we consider which project are profitable, or how the profitability could be max-
imised. Examples related to project execution:

• Invest in equipment to increase efficiency in project execution, e.g. a new exca-

vator.
80 CHAPTER 6. LIFE CYCLE COST AND LIFE CYCLE PROFIT

• Choice between construction method A and B.

• Outsourcing of truck-maintenance.

• Lease equipment rather than by our selves.

Examples related to project profitability:

• Development of one or more oil fields.

• Construction of a new passing loop.

• Renewal of ballast in a railway track.

• Point wise refill of ballast in order to postpone the need for a full renewal (ballast
cleaning).

• Grinding of rails.

• Invest in a new production line.

There are several aspects to consider when conducting an LCC analysis, for example:

• Visualise the cost picture, enabling the possibility to work actively with elimi-
nating the main cost drivers, or the effect of these.

• Use the LCC model as a decision support when making decision about the prof-
itability of projects or measures, and when to conduct or implement these.

• Use the LCC model as a basis for contractual follow-up, e.g. LCC contracts.

Example 6.1 We will consider a railway system where the quality of the ballast has
deteriorated during the last years, and in order to compensate for this it is proposed
to do a point wise replacement of the ballast on the line. The age of the ballast is
35 years, and without this point wise refill of ballast it is expected that a full renewal
(ballast cleaning) is necessary within five years. If we conduct the project we could
postpone the ballast cleaning with another five year. The length of the line we are
considering is 10 km. The quantities to include in the LCC model is as follows:

RC = 2.5 million Euro = Renewal cost = 250 Euro per meter for ballast cleaning.

IC = 400,000 Euro= Improvement cost, e.g. cost of point wise ballast refill.

LT = 40 years = Life length of ballast = period between ballast cleaning.

a = ballast age, i.e. effective age relative to the implemented measures. Without
point wise refill of ballast a = 35 years, and with point wise refill of ballast
a = 30 year. For a track that has just being renewed a = 0.

c0 = 25,000 Euro = yearly cost of maintenance and operation of the track, for a new
track, i.e. just being renewed.
6.2. NET PRESENT VALUE CALCULATION 81

c40 = 250,000 Euro = yearly cost of maintenance and operation of the track, for a
track that has reached it’s service life, e.g. 40 years.
d = eln(250000/2500)/40 − 1 = 0.05925
ct = c0 (1 + d)t+a = 25000(1 + 0.05925)t+a = total maintenance and operation cost
in year t (from now), and a is the effective age of the track.
r = 6% = interest rent.
We start by calculating the various LCC-terms (in million Euros) if the improvement
project (point wise refill of ballast) is not executed. The total renewal cost if found by
Equation (6.6):
RC(1 + r)−5
LCCRC = = 2.069
1 − (1 − r)−40
The variable cost the next five years (up to the next renewal) is found from Equa-
tion (6.4)
 1 − 1+d 5 
   
1+r
LCCVC,1 =  c (1 + d)35 = 0.883
 
 r − d  0

After the renewal in five year the variable costs will be reset to v0 , and then start in-
creasing again. The net present value in one cycle is:
 1 − 1+d 40 
   
1+r
LCCVC,0 =  c (1 + d) = 0.986
 
 r − d  0

The amount LCCVC,0 will then be repeated every 40 year, and the first time will be in
five years:
LCCVC,0 (1 + r)−5
LCCVC,∞ = = 0.816
1 − (1 + r)−40
Finally we have the total contribution from variable costs:
LCCVC = LCCVC,1 + LCCVC,∞ = 1.699
If we execute the improvement project, the calculations are similar. We start with the
total renewal cost (first renewal after 10 years):
RC(1 + r)−10
LCCRC = = 1.546
1 − (1 + r)−40
The variable cost the next ten years (up to the next renewal) noting that the effective
age after the improvement project is a = 30:
 1 − 1+d 10 
   
1+r  c (1 + d)3 0 = 1.322
LCCVC,1 = 

 r − d  0
82 CHAPTER 6. LIFE CYCLE COST AND LIFE CYCLE PROFIT

After the renewal in ten year the variable costs will be reset to v0 , and then start in-
creasing again. The net present value in one cycle, LCCVC,0 , is the same as without the
improvement project, but the first cycle will start in ten years:

LCCVC,0 (1 + r)−10
LCCVC,∞ = = 0.610
1 − (1 + r)−40
Finally we have the total contribution from variable costs:

LCCVC = LCCVC,1 + LCCVC,∞ = 1.932

In this last situation we also need to include the investment cost:

LCCIC = 0.4

Summing up all LCC contributions we find that implementing the improvement project
gives a total LCC of 3.878 million versus not implementing the project gives a total cost
of 3.768. Thus the improvement project is not profitable. 
Bibliography

[1] Fischhoff, B., S. Lichtenstein, P. Slovic, S.L. Derby, and R.L. Keeney. Acceptable
Risk. Cambridge University Press, New York, 1981.

[2] Austeng, K. og Hugsted, R.: Trinnvis kalkulasjon, BATEK, 1995.

[3] Klakegg, O.J.: Tidsplanlegging under usikkerheit, BATEK, 1994.

[4] Klakegg, O.J.: Trinnvis-prosessen, Institutt for bygg- og anleggsteknikk NTH,

1993.

[5] Chapman, C. & Ward, S., 1997. Project Risk Management; Processes, Techniques
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[6] Hokstad, P. Life Cycle Cost Analysis in Railway Systems. SINTEF Report STF38
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[7] IEC 60300. International Standard, IEC 60300-3-3, Dependability management -

Part 3: Application Guide - Section 3: Life Cycle Costing

[8] Kawauchi, Y. and Rausand, M. Life Cycle Cost (LCC) analysis in oil and chemi-
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Index

α-percentiles, 32 Hazard, 11
Hazard and Operability Study, 11
Bayes rule, 29
Binomial distribution, 36 Independent events, 27
Intersection, 26
Central limit theorem, 41 Inverse-Gauss distribution, 37
Checklists, 12 Inverted gamma distribution, 35
Commitment, 10
Complementary event, 26 Life cycle cost, 77
Conditional probability, 27 Life cycle profit, 77
Confidence level, 13 Lognormal distribution, 36
Cost modelling, 13
Critical path method, 47 Maximum likelihood principle, 40
Median, 32
Cumulative distribution function, 30
Mode, 32
Decision trees, 69 Monte Carlo simulation, 50
Degradation rate, 79
Net present value, 78
Dependency, 5
Normal distribution, 33
Stochastic, 6
Discount rate, 78 Observable quantity, 6
Disjoint events, 26
Distribution Parameter, 6
Maximum values, 42 Estimate, 6
Product, 42 Penalty for default, 53
Sums, 40 PERT
Double expectation, 32 Method, 47
PERT Distribution, 38
EMax function, 48 Poisson distribution, 37
Erlang distribution, 35 Precision, 32
Event, 25 Preliminary hazard analysis, 11
Event uncertainty, 53 pRisk, 5
Expectation, 32 Probability, 6, 25
Project expectation, 10 Density function, 31
Expert judgment, 40 Program Evaluation and Review Technique
Exponential distribution, 34 (PERT), 47

Gamma distribution, 35 Risk, 6

85
86 INDEX

Acceptance criterion, 6
Identification, 11
Management, 9
Risk and opportunity reg, 14

Scenario, 11
Schedule, 6, 45
Model, 12
Standard deviation, 32
Stochastic variable, 6, 29
Successive schedule planning, 47

Target, 10
Task analysis, 11
Threat, 11
Total probability, 28
Triangular distribution, 38
Triple estimate, 40

Uncertainty
Aleatory, 5, 7
Cost and schedule model, 13
Decision under, 57
Epistemic, 5
Event, 53
Undesired event, 11
Union, 26
Utility
Maximising expected, 64
Utility function, 60

Variance, 32
VarMax function, 48
Venn diagram, 26

Weibull distribution, 35