Adeel Rasheed
CMS - 15866
Supply Chain Management
Sir Nadeem Khan
___________________________________________________
Monte Carlo Simulation
Risk analysis is part of every decision we make. We are constantly faced with uncertainty,
ambiguity, and variability. And even though we have unprecedented access to information, we
cant accurately predict the future. Monte Carlo simulation (also known as the Monte Carlo
Method) lets you see all the possible outcomes of your decisions and assess the impact of risk,
allowing for better decision making under uncertainty.
What is Monte Carlo simulation?
Monte Carlo simulation is a computerized mathematical technique that allows people to account
for risk in quantitative analysis and decision making. The technique is used by professionals in
such widely disparate fields as finance, project management, energy, manufacturing, engineering,
research and development, insurance, oil & gas, transportation, and the environment.
Monte Carlo simulation furnishes the decision-maker with a range of possible outcomes and the
probabilities they will occur for any choice of action.. It shows the extreme possibilitiesthe
outcomes of going for broke and for the most conservative decisionalong with all possible
consequences for middle-of-the-road decisions.
The technique was first used by scientists working on the atom bomb; it was named for Monte
Carlo, the Monaco resort town renowned for its casinos. Since its introduction in World War II,
Monte Carlo simulation has been used to model a variety of physical and conceptual systems.
How Monte Carlo simulation works
Monte Carlo simulation performs risk analysis by building models of possible results by
substituting a range of valuesaprobability distributionfor any factor that has inherent
uncertainty. It then calculates results over and over, each time using a different set of random
values from the probability functions. Depending upon the number of uncertainties and the
ranges specified for them, a Monte Carlo simulation could involve thousands or tens of
thousands of recalculations before it is complete. Monte Carlo simulation produces distributions
of possible outcome values.
By using probability distributions, variables can have different probabilities of different
outcomes occurring. Probability distributions are a much more realistic way of describing
uncertainty in variables of a risk analysis. Common probability distributions include:
Normal Or bell curve. The user simply defines the mean or expected value and a standard
deviation to describe the variation about the mean. Values in the middle near the mean are most
likely to occur. It is symmetric and describes many natural phenomena such as peoples heights.
Examples of variables described by normal distributions include inflation rates and energy
prices.
Lognormal Values are positively skewed, not symmetric like a normal distribution. It is
used to represent values that dont go below zero but have unlimited positive potential.
Examples of variables described by lognormal distributions include real estate property values,
stock prices, and oil reserves.
Uniform All values have an equal chance of occurring, and the user simply defines the
minimum and maximum. Examples of variables that could be uniformly distributed include
manufacturing costs or future sales revenues for a new product.
Triangular The user defines the minimum, most likely, and maximum values. Values around
the most likely are more likely to occur. Variables that could be described by a triangular
distribution include past sales history per unit of time and inventory levels.
PERT- The user defines the minimum, most likely, and maximum values, just like the triangular
distribution. Values around the most likely are more likely to occur. However values between
the most likely and extremes are more likely to occur than the triangular; that is, the extremes are
not as emphasized. An example of the use of a PERT distribution is to describe the duration of a
task in a project management model.
Discrete The user defines specific values that may occur and the likelihood of each. An
example might be the results of a lawsuit: 20% chance of positive verdict, 30% change of
negative verdict, 40% chance of settlement, and 10% chance of mistrial.
During a Monte Carlo simulation, values are sampled at random from the input probability
distributions. Each set of samples is called an iteration, and the resulting outcome from that
sample is recorded. Monte Carlo simulation does this hundreds or thousands of times, and the
result is a probability distribution of possible outcomes. In this way, Monte Carlo simulation
provides a much more comprehensive view of what may happen. It tells you not only what
could happen, but how likely it is to happen.
Monte Carlo simulation provides a number of advantages over deterministic, or single-point
estimate analysis:
Probabilistic Results. Results show not only what could
happen, but how likely each outcome is.
Graphical Results. Because of the data a Monte Carlo
simulation generates, its easy to create graphs of different outcomes
and their chances of occurrence. This is important for
communicating findings to other stakeholders.
Sensitivity Analysis. With just a few cases, deterministic
analysis makes it difficult to see which variables impact the
outcome the most. In Monte Carlo simulation, its easy to see which
inputs had the biggest effect on bottom-line results.
Scenario Analysis: In deterministic models, its very difficult to
model different combinations of values for different inputs to see
the effects of truly different scenarios. Using Monte Carlo
simulation, analysts can see exactly which inputs had which values
together when certain outcomes occurred. This is invaluable for
pursuing further analysis.
Correlation of Inputs. In Monte Carlo simulation, its possible
to model interdependent relationships between input variables. Its
important for accuracy to represent how, in reality, when some
factors goes up, others go up or down accordingly.
An enhancement to Monte Carlo simulation is the use of Latin Hypercube sampling, which
samples more accurately from the entire range of distribution functions
Example of Monte Carlo Simulation
Forecast of Units Sold
For example, let's say that you want to use a forecast of units sold to know how much capital you
will need to invest or people you will need to hire to support sales. Since it is a forecast it has a
range of outcomes and these outcomes have a % chance of occurring given the range and the
assumption that it is a normal distribution.
Let's say one assumes that sales will be 1,000 units with +/- 200 units. We can define this +/- 200
as the standard deviation of the possible outcomes. This isn't the complete range of outcomes,
sales could be 0 or 2000 possibly, but let's assume it represents the most likely range of
outcomes.
You could do the same for sale price => $100 assumed sale price +/-$10.
With these two distributions we can now model as many potential revenue outcomes as we want
to develop an estimated revenue distribution over the sales period.
To randomize and input combine the two equations as follows:
=NORMINV( RAND(), 1000, 200) for units and,
=NORMINV (RAND(), 100, 10) for sales price
Then copy and paste this formula down as many cells as simulations you would like to run. This
is a little clunky compared to add-in software, but still effective.
This example shows 10 simulations which generally will not be enough to get a good sample but
it's for illustrative purposes only. Imagine extending the above to one thousand cells or more and
that would be a more realistic data set.
