INTEGRATED RISK MANAGEMENT: PORTFOLIO ALLOCATION, TOTAL COST OF OWNERSHIP, STRATEGIC REAL OPTIONS (ANALYSIS OF ALTERNATIVES), VALUE OF FLEXIBILITY, RISK QUANTIFICATION, RETURN ON INVESTMENT, CAPABILITY ANALYSIS, FORECASTING, AND DECISION ANALYTICS Dr. Johnathan Mun and Dr. Tom Housel, Naval Postgraduate School, CAPT Mark D. Wessman, USN (Ret)
Overview Integrated Risk Management (IRM) is an 8-step quantitative softwarebased modeling approach for the objective quantification of risk (cost, schedule, technical), flexibility, strategy, and decision analysis. The method can be applied to: program management; resource portfolio allocation; return on investment to the military (maximizing expected military value and objective value quantification of nonrevenue government projects); analysis of alternatives or strategic flexibility options; capability analysis; prediction modeling; and general decision analytics. The method and toolset provide the ability to consider hundreds of alternatives with budget and schedule uncertainty, and provide ways to help the manager maximize capability and readiness at the lowest cost. This methodology is particularly amenable to resource reallocation and has been taught and applied by the authors for the past 10 years at over 100 multinational corporations, over 30 projects at the Department of Defense (DoD), and the authors’ books and methodology are used and taught at more than 100 universities globally.
Figure 1 illustrates the eight-step process and where each step is modular and can be executed in isolation or in combination with any other step.
Introduction The Secretary of Defense recently announced initiatives to save $100 billion from back office activities for reallocation to front line troop and equipment enhancements. The IRM approach was developed and has been used for these types of problems. It will provide DoD leadership with the actionable intelligence it needs to make the difficult trade-off decisions to accomplish the Secretary’s goal. IRM provides a structured approach that will yield a rapid but credible and defensible analysis of cost savings and total cost of ownership while ensuring that vital capabilities are not lost in the process. The approach does this by estimating the value of military capability in a common and objective way across various alternatives and providing the return on investment (ROI) of each in ways that are both comparable and rigorous. These ROI estimates across the portfolio of alternatives provide the inputs necessary to predict the value of various options. IRM incorporates risks, budget constraints, reallocation options, and total ownership costs in providing a defensible analysis describing management options for the path forward. This approach identifies risky projects and programs while projecting immediate and future cost savings, total lifecycle costs, flexibility alternatives, critical success factors, and portfolio optimization. Its employment presents ways for identifying the potential for cost overruns and schedule delays and enables proactive measures to mitigate those risks. IRM provides an optimized portfolio of capability options while maintaining the value of strategic flexibility. The Clinger-Cohen Act, DoD Directives 5000, 8115.01, 8115.bb, directives from the Joint Chiefs of Staff, the Intelligence Authorization Act, and many other Directives and Acts require that risk and returns be assessed, as well as that ROI analysis and portfolio optimization and allocation of resources be performed to address these questions. The IRM approach incorporates multiple Nobel-prize winning and wellestablished theories and applications in corporate finance, investments, economics, statistics, mathematics, and decision sciences, into a comprehensive and flexible process that is defensible, replicable, scalable, and extensible to all areas of the DoD. This approach is currently in use in the PEO IWS organization as well as in the CCOPS program at SPAWAR San Diego.
Figure 1: Integrated Risk Management Process
Figure 2 shows a sample tornado sensitivity analysis where a complex model can be broken down into its precedents and the main critical success factors and drivers are identified.
Figure 2: Critical Success Factors
Figure 3 shows a sample risk simulation result, where cost, schedule, technical, and other forms of risks can be simulated hundreds of thousands of times to understand the impact and characteristics of risks on a capability, project, and program. From this simulation, we can determine what the probability of success is or the probability that the cost is contained or chances of a schedule overrun, and the results can be compared across multiple projects.
The IRM Approach The IRM approach is based on an 8-step process. Each step is modular and provides useful information for decision makers by itself and, when combined, yields a complete and comprehensive analysis of portfolio allocation or reallocation options. Step 1: Step 2: Step 3: Step 4: Step 5: Step 6: Step 7: Step 8:
Problem Definition and Risk Identification Prediction and Capability Analysis Return on Investment (ROI) Modeling Risk Simulation and Risk Quantification Framing of Strategic Alternative Flexibility Options Real Options Valuation Portfolio Optimization, Allocation and Project Selection Iterative Program Management and Reallocation
Figure 3: Quantitative Risk Analysis
Figure 4 shows a sample porfolio of multiple capabilities and how portfolio optimization is used to select the best capabilities subject to budget constraints, schedule risks, cost containment, and personnel limitations in order to maximize military capability and readiness while accounting for the ROI of each capability, and their inter-relationships (correlations, platform technology with downstream options for other capabilities, path dependence, mutual exclusitivity, etc)..
Figure 6: Strategic Analysis of Alternatives
Figure 4: Porfolio Allocation and Project Selection
Figure 5 shows an efficient frontier on investment opportunities, illustrating the optimal portfolio allocations that provide the maximum capability and military value subject to different cost and budget scenarios
Figure 7: Strategic Real Options Analysis
IRM Training, Education, and Supporting Software Figure 5: Investment Efficient Frontier
Figure 6 shows the analysis of alternatives analyzed through the framing of strategic flexibility and real options. Multiple pathways or alternatives are quantified––risk simulations of hundreds of thousands of alternatives are run, flexibility options are identified and valued, and the optimal decision pathway is then determined. Decision lattices shown in Figure 7 are then built to determine the optimal timing of execution and the value of flexibility options: options to wait and defer (value of information, proof of concept, right of first refusal), execute (build or buy), expand (platform technology, acquisitions, advanced concept technology demonstration, reusability, scalability), abandon (exit, salvage), contract (joint interservice venture, foreign partnerships), switch (open architecture, strong industrial base, modularity, redundancy), and sequential options (stage gate, milestones, planned product improvement, low rate initial production).
Benefits to the Department of Defense The results of IRM analysis have identified a means to cut costs from 36% to 49% (e.g., in the Shipyard planning application depending on level of risk and investment in alternative options) over three U.S. Navy projects. Also, by using a common means for estimating the value of military capability, the results of these analyses were between $23 and $58 billion for the value of alternative options over a 10-year period (Aegis application).
The IRM approach has been tailored to the DoD context and taught to several groups of users at PEO IWS. It is currently being implemented in that organization for several projects including optimization of the Advanced Capability Build insertion portfolio of alternative options as well as potential other uses including optimization of the SBIR portfolio. The CRM certification class takes 40 hours and is followed by direct support from the IRM team as groups begin using the approach and supporting toolset for various projects.
About the Authors Dr. Johnathan Mun and Dr. Tom Housel are currently professors at the Naval Postgraduate School in Monterey, California. Between them, they have authored 15 books, and numerous articles and whitepapers, developed multiple software applications, and for the past 10 years have consulted for over 100 multinational corporations, including over 30 projects and studies for the DoD. Their books and methodology are used and taught at more than 100 universities globally, and they have personally trained over 1,000 individuals on the use of these methods and tools world wide. CAPT Mark Wessman is a retired Surface Warfare Officer and Acquisition Professional. After retiring from active duty, he has served both government and private sector customers for over 15 years. Detailed case studies, whitepapers, models, software applications, training videos, and books are available. Please contact the authors at
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