Simulation

A simulation is the imitation of the operation of a real-world process or system over time. Simulations
require the use of models; the model represents the key characteristics or behaviors of the selected system
or process, whereas the simulation represents the evolution of the model over time. Monte Carlo
simulation is one of the most common techniques in project management, energy, manufacturing,
engineering, research and development, insurance, oil & gas transportation.
Monte Carlo simulation
Monte Carlo simulation is a computerized mathematical technique that allows people to account for risk
in quantitative analysis and decision making.

Monte Carlo simulation furnishes the decision-maker with a range of possible outcomes and the
probabilities they will occur for any choice of action.

Monte Carlo simulation performs risk analysis by building models of possible results by substituting a range
of values—a probability distribution—for 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 people’s 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 don’t 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.

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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, it’s 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, it’s easy to see which inputs
had the biggest effect on bottom-line results.
• Scenario Analysis: In deterministic models, it’s 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, it’s possible to model interdependent
relationships between input variables. It’s important for accuracy to represent how, in reality,
when some factors go up, others go up or down accordingly.
Procedure for Monte Carlo Simulation:
Step 1: Establish a probability distribution for the variables to be analyzed.
Step 2: Find the cumulative probability distribution for each variable.
Step 3: Set Random Number intervals for variables and generate random numbers.
Step 4: Simulate the experiment by selecting random numbers from random numbers tables until the
required number of simulations are generated.
Step 5: Examine the results and validate the model.

Example 1:
An ice-cream parlor's record of previous month’s sale of a particular variety of ice cream as shown in the
Table below.
Simulation of Demand Problem

Simulate the demand for first 10 days of the month given the random numbers as: 17, 46, 85, 09, 50, 58,
04, 77, 69 and 74

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Solution:
Find the probability distribution of demand by expressing the frequencies in terms of proportion. Divide
each value by 30. The demand per day has the following distribution as shown in table.
Probability Distribution of Demand

Find the cumulative probability and assign a set of random number intervals to various demand levels. The
probability figures are in two digits, hence we use two digit random numbers taken from a random number
table. The random numbers are selected from the table from any row or column, but in a consecutive
manner and random intervals are set using the cumulative probability distribution as shown in Table.
Cumulative Probability Distribution

To simulate the demand for ten days, select ten random numbers from random number tables. The
random numbers selected are, 17, 46, 85, 09, 50, 58, 04, 77, 69 and 74 The first random number selected,
17 lies between the random number interval 17-49 corresponding to a demand of 5 ice creams per day.
Hence, the demand for day one is 5. Similarly, the demand for the remaining days is simulated as shown
in Table.
Demand Simulation

Example 2:
A dealer sells a particular model of washing machine for which the probability distribution of daily demand
is as given in Table below.
Probability Distribution of Daily Demand

Simulation Problems using Random numbers: 68, 47, 92, 76, 86, 46, 16, 28, 35, 54
The simulation problems using random numbers are given below Find the average demand of washing
machines per day.

Solution:
Assign sets of two digit random numbers to demand levels as shown in Table. Random Numbers
Assigned to Demand

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Ten random numbers that have been selected from random number tables are 68, 47, 92, 76, 86, 46, 16,
28, 35, 54. To find the demand for ten days see the Table below.
Table of Random Numbers Selected

Average demand =28/10 =2.8 washing machines per day. The expected demand /day can be computed as,
Expected demand per day

where, pi = probability and xi = demand