Price estimates must take into account all necessary costs. Accurate estimates must further consider costs that only might apply. Financial analysts therefore include in valuations a risk margin, which is a buffer against potential losses. For example, bond issuers add risk margins to return rates to compensate investors against the risk of default. Managers set aside contingency reserves to fund projects' risk margins. These margins needn't cover the entire cost of undesired outcomes. They only need to cover the outcomes' expected value, which factors in the probability of occurring.
1. Identify all possible outcomes other than certain occurrences, which can increase your costs. In some cases, such as loan default, only one such outcome exists. For this example, assume that you identify three different outcomes that threaten to raise a project's cost.
2. Identify the cost of each outcome. For example, assume the outcomes could add $3,000, $4,000 and $2,500 respectively to the cost of the project.
3. Estimate the probability of each outcome occurring. For example, assume the three outcomes have a 0.005, 0.02 and 0.015 respective chance of occurring. Multiply each outcome's cost by it's probability of occurring. $3,000 times 0.005 is $15; $4,000 times 0.02 is $80; $2,500 times 0.015 is $37.50.
4. Add these costs together. With this example, the costs add up to $132.50, so this is an appropriate risk margin for the project.
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