Page 169 - Microsoft Word - 00 Prelims.docx

Risk and Uncertainty

Simulation

Simulation is a modelling technique that shows the effect of more than
one variable changing at the same time.

 The Monte Carlo simulation method uses random numbers and probability
statistics. It can include all random events that might affect the success or
failure of a proposed project – for example, changes in material prices, labour
rates, market size, selling price, investment costs or inflation.

 The model identifies key variables in a decision: costs and revenues, say.
Random numbers are then assigned to each variable in a proportion in
accordance with the underlying probability distribution. For example, if the most
likely outcomes are thought to have a 50% probability, optimistic outcomes a
30% probability and pessimistic outcomes a 20% probability, random numbers,
representing those attributes, can be assigned to costs and revenues in those
proportions.

 A powerful computer is then used to repeat the decision many times and give
management a view of the likely range and level of outcomes. Depending on
the management's attitude to risk, a more informed decision can be taken.

 This helps to model what is essentially a one-off decision using many possible
repetitions. It is only of any real value, however, if the underlying probability
distribution can be estimated with some degree of confidence.

Illustrations and further practice

Now try Illustration 2 ‘The MP Organisation’ and Illustration 3 ‘Simulation’ on
Chapter 7.

163