Chapter 12

Monte Carlo Simulation

and Risk Analysis

Model Uncertainty and Risk Analysis

Many situations dictate that randomness be explicitly

incorporated into our models. This is usually done by
specifying probability distributions for the appropriate
uncontrollable inputs.
Such models are called stochastic, or probabilistic.

Risk is the likelihood of an undesirable outcome. It can

be assessed by evaluating the probability that the
outcome will occur along with the severity of the
outcome.
Risk analysis seeks to examine the impact of uncertain
inputs on various outputs.

Example 12.1: Incorporating Uncertainty in the

Outsourcing Decision Model

Production volume is uncertain; assume normal with a mean of

1000 and standard deviation of 100.
Replace cell B12 with =ROUND(NORM.INV(RAND(), 1000, 100, true), 0)

Whenever F9 key or Formula > Calculation > Calculate Now is

clicked, the value of demand will change randomly

Monte Carlo Simulation

Monte Carlo simulation is the process of generating

random values for uncertain inputs in a model,
computing the output variables of interest, and repeating
this process for many trials to understand the distribution
of the output results.
Monte Carlo simulation can easily be accomplished on a
spreadsheet using a data table.

Example 12.2: Using Data Tables for Monte

Carlo Spreadsheet Simulation

Excel file Outsourcing Decision Monte Carlo Simulation Model.

Enter the trial number (1 to 20) in column D.
Reference the cells associated with model outputs in row 3: (E3, F3,
G3) (=B12, =B19, =B20)
Select the range for the data table (D3:G23)
In the Data Table dialog, enter any blank cell for the Column Input
Cell.

Monte Carlo Simulation Using Analytic Solver Platform

1. Develop a spreadsheet model.

2. Determine probability distributions for uncertain
input variables.
3. Identify output variables you want to predict.
4. Choose the number of trials for the simulation.
5. Run the simulation.
6. Interpret the results.

Defining Uncertain Model Inputs

For many decision models, empirical data may be available,

either in historical records or collected through special efforts.
In other situations, historical data are not available, and we
can draw upon the properties of common probability
distributions to help choose a representative distribution that
has the shape that would most reasonably represent the
analysts understanding about the uncertain variable.
Uniform or triangular distributions are often used in the
absence of data.
In Analytic Solver Platform, use custom Excel functions or the
Distributions button in the ribbon.

Example 12.3: Using Analytic Solver Platform Probability

Distribution Functions

Outsourcing Decision Model

Demand (production volume) is
normally distributed with a mean of
1000 and standard deviation of 100
units.
=PsiNormal(1000, 100) in cell B12
Use ROUND function to ensure that the
result is a whole number:
=ROUND(PsiNormal(1000,100),0).

Unit cost has a triangular distribution

with a minimum of $160, most likely
value of $175, and a maximum of
$200.
=PsiTriangular(160, 175, 200) in cell
B10.

Example 12.4: Using the Distributions Button in

Analytic Solver Platform

For demand, select

cell B12.
Click the
Distributions button
in the Analytic Solver
Platform ribbon and
select the normal
distribution from the
Common category.

Example 12.4 Continued

Normal distribution dialog

Change the parameters to mean = 1000, stdev = 100

Example 12.4 Continued

For unit cost, select cell B10 and select the triangular distribution
Change the parameters in the dialog

Defining Output Cells

To define a cell you wish to predict and create a

distribution of output values from your model, first select
it, and then click on the Results button in the Simulation
Model group in the Analytic Solver Platform ribbon.
Choose the Output option and then In Cell.
Analytic Solver Platform calls output cells uncertain function
cells.
Uncertain function cells must be numeric.

Analytic Solver Platform adds the function PsiOutput( )

to uncertain function cell formulas.
You may also add +PsiOutput( ) to any output cells manually

Example 12.5: Using the Results

Button in Analytic Solver Platform

Select cell B19

After defining the cell as
an uncertain function,
the formula should read:

=B16 B17 + PsiOutput( )

Running a Simulation

First click on the Options button in

the Options group in the Analytic
Solver Platform ribbon. This
displays a dialog in which you can
specify the number of trials and
other options to run the simulation
(make sure the Simulation tab is
selected).
Trials per Simulation allows you to
choose the number of times that
the simulation will generate
random values for the uncertain
cells in the model and recalculate
the entire spreadsheet.

Random Number Seed

Analytic Solver Platform

generates a stream of random
numbers from which the values of
the uncertain inputs are selected
from their probability distributions.
Every time you run the model, you will
get slightly different results because of
sampling error.

Setting a value for Sim. Random

Seed will guarantee that the same
sequence of random numbers will
be used for generating the
random values for the uncertain
inputs every time the simulation is
run.

Sampling Methods

Monte Carlo sampling selects

random variates independently
over the entire range of possible
values of the distribution.
With Latin Hypercube sampling,
the uncertain variables probability
distribution is divided into
intervals of equal probability and
generates a value randomly
within each interval.
Monte Carlo sampling is more
representative of reality and should be
used if you are interested in evaluating
the model performance under various
what-if scenarios.

Running a Simulation

Click the Simulate button in the Solve Action group.

When the simulation finishes, you will see a message
Simulation finished successfully in the lower-left corner
of the Excel window.

Viewing and Analyzing Results

You may specify whether you want output charts to

automatically appear after a simulation is run by clicking
the Options button in the Analytic Solver Platform ribbon,
and either checking or unchecking the box Show charts
after simulation in the Charts tab.

An easy way to view results for any uncertain function is

to double-click an uncertain function cell.

Example 12.6: Analyzing Simulation Results

for the Outsourcing Decision Model

Frequency distribution of cost difference

Select other
options:
Percentiles,
Chart Type,
Chart Options,
Axis Options,
and Markers.

Example 12.6 Continued

Set Upper Cutoff = 0 to find the probability of a negative

cost difference.

New Product Development Model

Moore Pharmaceuticals
spreadsheet. With
uncertain data:
1. What is the risk that the
net present value over the 5
years will not be positive?
2. What are the chances
that the product will show a
cumulative net profit in the
third year?
3. What cumulative profit in
the fifth year are we likely to
realize with a probability of
at least 0.90?

Model Assumptions

Market size: normal with mean of 2,000,000 units and

standard deviation of 400,000 units
R&D costs: uniform between $600,000,000 and
$800,000,000
Clinical trial costs: lognormal with mean of $150,000,000
and standard deviation $30,000,000
Annual market growth factor: triangular with minimum =
2%, maximum = 6%, and most likely = 3%
Annual market share growth rate: triangular with
minimum = 15%, maximum = 25%, and most likely =
20%

Example 12.7: Setting Up the Simulation

Model for Moore Pharmaceuticals

Market size:
=PsiNormal(2000000, 400000)

R&D costs:
=PsiUniform(600000000,800000000)

Clinical trial costs:

=PsiLognormal(150000000, 30000000)

Annual market growth factor:

=PsiTriangular(2%, 3%, 6%)

Annual market share growth rate:

=PsiTriangular(15%, 20%, 25%)

Uncertain functions:
Cumulative net profit each year and net present value

Simulation Results: Variables Chart

Summary of output functions and uncertain variables

Customize this by checking or unchecking the boxes in the Filters
pane.

Example 12.8: Risk Analysis for Moore

Pharmaceuticals
1. What is the risk that the NPV over the 5 years will not
be positive?

Example 12.8 Continued

2. What are the chances the product will show a
cumulative net profit in the third year?

Example 12.8 Continued

3. What cumulative profit in the 5th year are we likely to
realize with a probability of at least 0.90 (that is, the 10 th
percentile)?

Confidence Interval for the Mean

Each time you run a simulation, you will obtain
slightly different results.
Confidence interval:

Because a Monte Carlo simulation will generally have a

very large number of trials, we may use the standard
normal z-value instead of the t-distribution in the
confidence interval formula.

Example 12.9: A Confidence Interval for the

Mean Net Present Value

Moore Pharmaceuticals
95% Confidence interval

Sensitivity Chart

A sensitivity chart allows you to determine the influence that

each uncertain model input has individually on an output
variable based on its correlation with the output variable.
Displays rankings of uncertain variables according to their impact on an
output cell.

Benefits:
It tells which uncertain variables influence output variables the most and
which would benefit from better estimates.
It tells which uncertain variables influence output variables the least and
can be ignored or discarded altogether.
By providing understanding of how the uncertain variables affect your
model, it allows you to develop more realistic spreadsheet models and
improve the accuracy of your results.

Click on the Sensitivity tab in the Simulation Results window.

Example 12.10: Interpreting the Sensitivity Chart for

NPV

Moore Pharmaceuticals

Market size:
R&D cost:
Clinical trial cost:

Overlay Charts

If a simulation has multiple related forecasts, an

overlay chart superimposes the frequency
distributions from selected forecasts on one chart
in order to compare differences and similarities
that might not be apparent.

Example 12.11: Creating an Overlay

Chart

Moore Pharmaceuticals
Click the Charts button in the
Analysis group
Click Multiple Simulation
Results (do not choose
Multiple Simulations!) and
then choose Overlay.
In the Reports dialog that
appears, select the output
variable cells you wish to
include in the chart and move
them to the right side of the
dialog

Example 12.11 Continued

Result for year

1 and year 5
cumulative
profit

Trend Charts

If a simulation has multiple output variables that

are related to one another (such as over time),
you can view the distributions of all output
variables on a single chart, called a trend chart.
A trend chart shows the mean values as well as 75% and
90% bands (probability intervals) around the mean.

Example 12.12: Creating a Trend Chart

Moore Pharmaceuticals
Click the Charts button in
the Analysis group
Click Multiple Simulation
Results and then choose
Trend.
In the Reports dialog that
appears, select the output
variable cells you wish to
include in the chart and
move them to the right
side of the dialog.

Box-Whisker Charts

A box-whisker chart
shows the minimum,
first quartile, median,
third quartile, and
maximum values in a
data set graphically.
The first and third
quartiles form a box
around the median,
showing the middle 50
percent of the data,
and the whiskers
extend to the minimum
and maximum values.

Simulation Reports

Analytic Solver Platform creates reports in the form of

Excel worksheets that summarize a simulation.
Click the Reports button in the Analysis group in the
ribbon, and choose Simulation from the options that
appear.
The report summarizes basic statistical information
about the model, simulation options, uncertain variables,
and output variables,

Newsvendor Model

Apply Monte Carlo simulation to forecast the profitability of different

purchase quantities when the future demand is uncertain.
Suppose that the store owner kept records for the past 20 years on
the number of boxes sold

Example 12.13: Using Average Values

in the Newsvendor Model

Historical candy sales

average 44.05.
Using 44 for demand and
purchase quantity, the
model predicts a profit of
$264.00.
However, if we construct a
data table to evaluate the
profit for each of the
historical values, the
average profit is only
$255.00.

The Flaw of Averages

The evaluation of a model output using the

average value of the input is not necessarily equal
to the average value of the outputs when
evaluated with each of the input values.
In the newsvendor example, the quantity sold is limited to
the smaller of the demand and purchase quantity, so
even when demand exceeds the purchase quantity, the
profit is limited.

Using average values in models can conceal risk.

Monte Carlo Simulation Using

Historical Data

We can perform a Monte Carlo simulation by

resampling from the historical sales distribution
that is, by selecting a value randomly from the
historical data.

Example 12.14: Simulating the

Newsvendor Model Using Resampling

Generate candy sales by resampling from the 20 historical values.

Enter the formula =PsiDisUniform(D2:D21) into cell B11.
Set profit in B17 as an uncertain function.

Example 12.14 Continued

Simulation results for purchase quantity = 44

Monte Carlo Simulation Using a Fitted

Distribution

Sampling from empirical data has some

drawbacks.
The empirical data may not adequately represent the
true underlying population because of sampling error.
Using an empirical distribution precludes sampling
values outside the range of the actual data.

It is usually advisable to fit a distribution using the

techniques described in Chapter 5 and use it for
the uncertain variable.

Example 12.15: Using a Fitted

Distribution for Monte Carlo Simulation

Newsvendor Model with Historical Data

The best-fitting distribution is a negative binomial distribution.

Example 12.15 Continued

After fitting the

distribution, when you
attempt to close the
dialog, Analytic Solver
Platform will ask if you
wish to accept the fitted
distribution.
Click Yes, and place the
Psi function in the first
cell of the data (cell D2).
Then reference cell D2 in
cell B11.

Example 12.15 Continued

Results

Interactive Simulation

Whenever the Simulate button is clicked, you will notice that the
lightbulb in the icon turns bright. If you change any number in the
model, Analytic Solver Platform will automatically run the simulation
for that quantity; this makes it easy to conduct what-if analyses.
Example: change the purchase quantity to 50; mean profit is less than if
purchase quantity is 44

Overbooking Model with Custom Demand

Historical demand data

shown in columns D and E
Assume that each
reservation has a constant
probability p = 0.04 of being
canceled; therefore, the
number of cancellations
(cell B14) can be modeled
using a binomial distribution
with n = number of
reservations made and p =
probability of cancellation.

Example 12.16: Defining a Custom

Distribution in Analytic Solver Platform

Select cell B12 and then click on

the Distributions button in the
ribbon and choose Discrete from
the Custom category.
Edit the range for values and
weights in the Parameters
section
Values correspond to the range of
demand in cells D2:D13, and
weights are the relative
frequencies or probabilities in
cells E2:E13.

Or, use the function in cell B12:

=PsiDiscrete($D$2:$D$13,$E$2:$E$13)

Example 12.16 Continued

To model the number of cancellations in cell B14, choose the

binomial distribution from the Discrete category in the Distributions
list. The number of trials is the value in cell B13 and is referenced in
the Parameters section.

Or, use the function =PsiBinomial(B13, 0.04) in cell B14.

Overbooking Model Results

Frequency charts
for number of
overbooked
customers and net
revenue if 310
reservations are
accepted.
You can use
Interactive
Simulation to
quickly change the
number of
reservations to find
the best solution.

Cash Budget Model

Cash Budgeting is the process of projecting
and summarizing a companys cash inflows and
outflows expected during a planning horizon.
Most cash budgets are based on sales
forecasts.

Because of the inherent uncertainty in sales forecasts,

Monte Carlo simulation is an appropriate tool for
modeling cash budgets.

Example Cash Budget Model

Highlighted cells are uncertain variables (blue) and

uncertain functions (green)

Cash Budget Model Assumptions

Sales are normally distributed with a standard deviation

of 10% of the mean.
Sales in adjacent months are correlated with one
another, with a correlation coefficient of 0.6.
On average, 20% of sales are collected in the month of
sale, 50%, in the month following the sale, and 30%, in
the second month following the sale.
These figures are uncertain, so a uniform distribution is used to
model the first two values (15% to 20% and 40% to 50%,
respectively), with the assumption that all remaining revenues are
collected in the second month following the sale.

Example 12.17: Simulating the Cash

Budget Model Without Correlations

Define distributions for all uncertain variables.

Example for April sales (cell E5): =PsiNormal(600000,60000)
Cell B7: =PsiUniform(15%, 20%)
Cell B8: =PsiUniform(40%, 50%).

Define the available balances in row 25 as output variables

Example 12.17 Continued

Trend chart

Example 12.17 Continued

Likelihood of not meeting minimum balance in April

Correlating Uncertain Variables

Unless you specify otherwise, Monte Carlo
simulation assumes that each of the uncertain
variables is independent of all the others.
Analytic Solver Platform allows you to specify
correlations between uncertain variables.

Example 12.18: Incorporating

Correlations in Analytic Solver Platform

Cash Budget Monte

Carlo Simulation Model
Click the Correlations
button in the Simulation
Model group in the
ribbon.
In this example we are
only correlating the
variables in the range
E5:K5. Move these to the
right pane.

Example 12.18 Continued

Initial correlation matrix

The numerical values show
the correlations (initially set
to zero)
The green distributions are
those used in the uncertain
cells.
The blue scatterplots show
visual representations of the
correlations between the
variables.

Replace the zeros by the

correlations you want in the
model.

Example 12.18 Continued

Analytic Solver Platform will check that the correlations

are mathematically consistent; if not, it will ask you to
adjust the correlations. Always choose Yes. Click the
Update Matrix button and then Accept Update.
Adjusted correlation matrix:

Analytic Solver Platform then adds these to the

simulation model.