MM3425 BUSINESS ANALYTICS

SIMULATION

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SIMULATION MODEL

■ Simulation
– Evaluate the impact of uncertainty on a decision
■ Applications
– Financial applications include investment planning, project
selection, and option pricing (https://youtu.be/hhBNk0xmZ9U)
– Marketing applications include new product development and the timing
of market entry for a product
– Management applications include project management, inventory ordering,
capacity planning, and revenue management (https://youtu.be/cMgarcFkXz4
)
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RISK ANALYSIS

■ Risk analysis
– Quantifying the likelihood and magnitude of an undesirable
outcome
■ Scenarios
– Base-case scenario
– Worst-case scenario
– Best-case scenario

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RISK ANALYSIS FOR SANOTRONICS LLC

■ Analyze the first-year profit for a new medical device

■ Key parameters to determine first-year profit
– Selling price per unit (p)
– First-year administrative and advertising costs (ca)
– Direct labor cost per unit (ci)
– Parts cost per unit (cp)
– First-year demand (d)

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RISK ANALYSIS FOR SANOTRONICS LLC

■ Sanotronics estimates with a high level of certainty that

– Selling price (p) is $249 per unit
– The first-year administrative and advertising cost (Ca) is $1,000,000
■ Sanotronics is not certain about other values
■ At the planning process, the base estimates
– $45 per unit for the direct labor cost (ci)
– $90 per unit for the parts cost (cp)
– 15,000 units for the first-year demand (d)

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RISK ANALYSIS FOR SANOTRONICS LLC

■ Expected profit in first year

■ (price – direct labour cost – parts cost) * demand - administrative and advertising cost

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RISK ANALYSIS FOR SANOTRONICS LLC

■ Base-case scenario

Profit=(249-45-90)*15,000- 1,000,000=710,000

■ But Sanotronics is not certain about direct labor cost, parts cost and first-year demand
■ What-if analysis
– Consider alternative values for the random variables (direct labor cost,
parts cost, and first-year demand) and computing the resulting value for
the output (profit)
– Sanotronics could use ranges of labor costs ($43~$47), parts cost
($80~$100), and first-year demand (0~30000) to perform a what-if analysis to
evaluate a worst-case scenario and a best-case scenario 7
RISK ANALYSIS FOR SANOTRONICS LLC

■ Best-case scenario
– Lowest costs and highest
demand

Profit = 249  43  8030,000  1,000,000 

2,780,000
■ Worst-case scenario
– Highest costs and lowest demand

Profit = 249  47  1000  1,000,000  1,000,000

RISK ANALYSIS FOR SANOTRONICS LLC

■ The what-if analysis provides the conclusion that profits may range from a loss of
$1,000,000 to a profit of $2,780,000 with a base-case profit of $710,000
■ The what-if analysis indicates that either a substantial loss or a substantial profit is
possible
■ The what-if analysis does not indicate the likelihood of the various profit or loss
values
– Need to develop a spreadsheet simulation model

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SPREADSHEET SIMULATION MODEL

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RISK ANALYSIS FOR SANOTRONICS LLC

■ Identify probability distributions to represent random variables

– Sanotronics researched the random variables to identify probability
distributions
■ Direct labor cost per unit (discrete distribution)
■ Parts cost per unit (uniform distribution)
■ First-year demand (normal distribution)
■ Use the what-if approach to perform risk analysis
– Simulation randomly generates values for the random variables
– Select values for the random variables
– Compute the resulting value
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RISK ANALYSIS FOR SANOTRONICS LLC

■ Based on recent wage rates and estimated

processing requirements of the device
■ Sanotronics believes that the direct labor
cost will range from $43~$47 per unit and
follows the discrete probability distribution
■ There is 10% probability that the direct labor
cost will be $43 per unit, a 20% probability that
the direct labor cost will be
$44 per unit and so on

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RISK ANALYSIS FOR SANOTRONICS LLC

■ Sanotronics is relatively unsure of the parts cost

because it depends on the general economy, the
overall demand for parts, and the pricing policy of
Sanotronics’ parts suppliers
■ Sanotronics decides to describe the uncertainty in
parts cost with a uniform probability distribution,
ranging from $80 to $100
■ A uniform probability distribution is an example of a
continuous probability distribution, which means that
the parts cost can take on any value between
$80 and $100
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RISK ANALYSIS FOR SANOTRONICS LLC

■ Based on sales of comparable medical

devices, Sanotronics believes that first-
year demand is described by the normal
probability distribution
■ The mean or expected value of first-
year demand is 15,000 units
■ The standard deviation of 4,500 units
describes the variability in the first-year
demand

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RISK ANALYSIS FOR SANOTRONICS LLC

■ Generate values for random variables with Excel

– Computer-generated random numbers are randomly
selected numbers from 0 up to, but not including, 1 [0, 1)
– [ means include, ( means exclude
– Placing the formula =RAND() in a cell of an Excel worksheet will result in
a random number between 0 and 1 being placed into that cell

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DIRECT LABOUR COST

■ E.g., If the random number is 0.8364, then the direct labour cost is $46.

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PARTS C OST

■ If the random number is 0.4576

■ Parts cost = 80+20*0.4576
= 80+9.15
= 89.15 per unit

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FIRST-YEAR D EMAN D

■ If the random number is 0.6026

■ Demand = 16,170

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 X

■ Z=0.26=(X-15000)/4500
■ X=16170

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VLOOKUP

◾ This function allows the user to pull a subset of data from a larger table of data based on some
criterion
◾ =VLOOKUP(value, table, index, range)
◾ value = the value to search for in the first column of the table
◾ table = the cell range containing the table
◾ index = the column in the table containing the value to be returned
◾ range = TRUE if looking for the first approximate match of value and FALSE if looking for an exact match
of value

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EXECUTING SIMULATION TRIALS W ITH EXCEL
■ Cell B6 uses a random number generated by
the RAND function and looks up the
corresponding cost per unit by applying the
VLOOKUP function to the table of intervals
contained in cells A15:C19
■ Cell B7 executes the equation using
references to the lower bound and upper
bound of the uniform distribution of the
parts cost in cells F14 and F15, respectively
■ Cell B8 executes the equation using
references to the mean and standard
deviation of the normal distribution of the
first-year demand in cells F18 and F19,
respectively 22
 EXECUTING SIMULATION TRIALS W ITH EXCEL

■ Step 1. Select cell range A22:E1021

■ Step 2. Click the Data tab
■ Step 3. Click What-If Analysis and
select Data Table
■ Step 4. When the Data Table dialog
box appears, enter any empty cell in
the spreadsheet (e.g., D1) into the
Column input cell:
■ Step 5. Click OK
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EXECUTING SIMULATION TRIALS W ITH EXCEL

■ For the collection of simulation trials, it is helpful to compute descriptive

statistics such as sample count, minimum and maximum sample value,
sample mean and sample standard deviation

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Decision? 25
VALIDATION

◾ The process of ensuring that the simulation model provides an

accurate representation of a real system
◾ Validation requires an agreement among analysts and managers that
the logic and the assumptions used in the design of the simulation
model accurately reflect how the real system operates
◾ The first phase of the validation process is done prior to or in
conjunction with the development of the computer procedure for the
simulation process

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VERIFICATION

■ The process of determining that the computer procedure that performs the
simulation calculations is logically correct
■ An analyst may compare computer results for a limited number of events with
independent hand calculations
■ Tests may be performed to verify that the random variables are being generated
correctly and that the output from the simulation model seems reasonable
■ The verification step is not complete until the user develops a high degree of
confidence that the computer procedure is error free

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APPLICATION I

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APPLICATION II

22.78

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APPLICATION III

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https://youtu.be/ZvI6V9LLf-U