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Simulation
Operations -- Prof. Juran
Overview
Monte Carlo Simulation
– Basic concepts and history
@Risk
– Probability Distributions
• Uniform, Normal, Gamma
– Distribution and Output cells
– Simulation Settings
– Output Analysis
Examples
– Coin Toss, TSB Account
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Monte Carlo Simulation
Using theoretical probability distributions to model
real-world situations in which randomness is an
important factor.
Differences from other spreadsheet models
•No optimal solution
•Explicit modeling of random variables in special cells
•Many trials, all with different results
•Objective function studied using statistical inference
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Origins of Monte Carlo
Stanislaw M. Ulam (1909 - 1984)
Nicholas Metropolis (1915-1999)
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Example: Coin Toss
Imagine a game where you flip a coin once.
If you get “heads”, you win $3.00
If you get “tails”, you lose $1.00
The coin is not fair; it lands on “heads” 35% of the time
What is the expected value of this game?
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Simulation “By Hand”
Set up a spreadsheet model
Add an element of randomness
• Excel built-in random number generator
• Use F9 key to create repetitive iterations of the
random system (“realizations”)
Keep track of the results
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A
B
1
2 Random # 0.2002
3 Outcome
Head
4 Profit
$3.00
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C
D
E
=RAND()
=IF(B2<0.35,"Head","Tail")
=IF(B2<0.35,3,-1)
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What Does =RAND() Do?
Uniform random number between 0 and 1
Never below 0; never above 1
All values between 0 and 1 are equally likely
0.35
0.65
P(X<0.35) = 0.35
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What Does =IF Do?
Evaluates a logical expression (true or false)
Gives one result for true and a different result for false
In our “coin” model, RAND and IF work together to
generate heads and tails (and profits and losses) from a
specific probability distribution
A
B
1
2 Random # 0.7438
3 Outcome
Tail
4 Profit
-$1.00
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C
D
E
=RAND()
=IF(B2<0.35,"Head","Tail")
=IF(B2<0.35,3,-1)
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Some Random Results
Sample means from 15 trials:
A
B
C
1 Random # Outcome Profit
2
0.4619
Tail -$1.00
3
0.4118
Tail -$1.00
4
0.5815
Tail -$1.00
5
0.9792
Tail -$1.00
6
0.2852
Head $3.00
7
0.9064
Tail -$1.00
8
0.9855
Tail -$1.00
9
0.9988
Tail -$1.00
10
0.2206
Head $3.00
11
0.0986
Head $3.00
12
0.9696
Tail -$1.00
13
0.8026
Tail -$1.00
14
0.8189
Tail -$1.00
15
0.7137
Tail -$1.00
16
0.9258
Tail -$1.00
17
-$0.20
D
E
=AVERAGE(C2:C16)
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F
A
B
C
1 Random # Outcome Profit
2
0.1979
Head $3.00
3
0.9185
Tail -$1.00
4
0.4688
Tail -$1.00
5
0.6670
Tail -$1.00
6
0.0902
Head $3.00
7
0.3757
Tail -$1.00
8
0.1492
Head $3.00
9
0.4518
Tail -$1.00
10
0.8503
Tail -$1.00
11
0.1392
Head $3.00
12
0.1924
Head $3.00
13
0.0179
Head $3.00
14
0.4799
Tail -$1.00
15
0.5064
Tail -$1.00
16
0.3051
Head $3.00
17
$0.87
D
E
F
=AVERAGE(C2:C16)
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Problems with this Model
Hitting F9 thousands of times is tedious
Keeping track of the results (and summary statistics) is
even more tedious
What if we want to simulate something other than a
uniform distribution between 0 and 1?
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Simulation with @Risk
Special cells for random variables (Distributions)
Special cells for objective functions (Outputs)
Simulation Settings
•Number of trials
•Random number seed
•Sampling method
Output Analysis
•Studying outputs
•Extracting data
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A
B
1 COIN.XLS
2
3
Random #
Outcome
4
0.702
Tail
5
6
=RAND()
7
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C
D
Profit
-1
E
=IF(A4<0.35,3,-1)
=IF(A4<0.35,"Head","Tail")
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Running an @Risk simulation:
1. Define input distribution(s)
2. Define output(s)
3. Simulation settings
4. Start simulation
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1. Define Input Distribution
First make sure there is a number in cell A4 (it cannot be blank or
contain a formula). Then move the cursor to cell A4 and click on the
@Risk “Define Distributions” button. Choose the uniform
distribution from the list of distributions.
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After you select “Uniform”, a graph of the uniform distribution
will appear. Set the “Min” of the uniform to 0 and the “Max” to 1.
Then press “OK”.
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A
B
C
1 COIN.XLS
2
3 Random # Outcome
Profit
4
0.500
Tail
-1
5
=RiskUniform(0,1)
6
7
D
Note the special @Risk function now in cell A4. You
could have entered this function by hand, or by using
the @Risk – Model – Define Distribution menu.
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2. Define Output Cell
Select cell C4. Then click on the @Risk “Add Output”
button. Give the output variable a name, such as
“Profit.” The window should now look as shown
below. Press “OK” to return to the spreadsheet.
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A
B
C
1 COIN.XLS
2
3 Random # Outcome
Profit
4
0.500
Tail
-1
5
=RiskUniform(0,1)
6
D
E
F
G
=RiskOutput()+IF(A4<0.35,3,-1)
Note the special @Risk function now in cell C4. You
could have entered this function by hand, or by using
the @Risk – Model – Add Output menu.
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3. Simulation Settings
Click on the “Settings” button. Specify the number of iterations.
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4. Run the Simulation
Click on the @Risk “Start Simulation” icon. The “Forecast: profit”
window will appear, and the number of trials simulated will show
in the bottom left corner of the Excel window.
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4. Run the Simulation
@Risk displays a graph for each output cell.
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Analyzing the Results
Excel Reports: download and save results in Excel
Browse Results: interactive graphs
Summary: detailed output for each “special” cell
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Analyzing the Results
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Simulation Results
The 10,000-trial @Risk simulation gives sample mean
profit of $0.400. The number $0.400 is only an estimate
of the true mean profit from the coin-flipping game.
The standard error of the mean is 0.01908.
𝑠𝑋
=
=
𝑠𝑥
𝑛
1.908
10,000
= 0.01908
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Simulation Results
A 95% confidence interval for the true mean profit is
approximately:
0.400  1.96(0.01908)
We are 95% confident that the true mean lies
somewhere between $0.3626 and $0.4374.
To get a better estimate using simulation, we could
increase the number of simulation trials, and continue
the simulation run.
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Example 2: Tax-Saver Benefit
A TSB (Tax Saver Benefit) plan allows you to put
money into an account at the beginning of the calendar
year that can be used for medical expenses. This
amount is not subject to federal tax — hence the phrase
TSB.
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As you pay medical expenses during the year, you are
reimbursed by the administrator of the TSB until the TSB
account is exhausted. From that point on, you must pay
your medical expenses out of your own pocket. On the
other hand, if you put more money into your TSB than
the medical expenses you incur, this extra money is lost to
you.
Your annual salary is $50,000 and your federal income tax
rate is 30%.
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Assume that your medical expenses in a year are
normally distributed with mean $2000 and standard
deviation $500.
Build an @Risk model in which the output is the
amount of money left to you after paying taxes,
putting money in a TSB, and paying any extra
medical expenses. Experiment with the amount of
money put in the TSB, and identify an amount that is
approximately optimal.
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First, we set up a spreadsheet to organize all of the
information. In particular, we want to make sure we’ve
identified the decision variable (how much to have taken
out of our salary and put into the TSB account — here in
cell B1), the output (net income — after tax, and after extra
medical expenses not covered by the TSB — which we have
here in cell B14), and the random variable (in this case the
amount of medical expenses — here in cell B9).
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1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
A
TSB Amount (Decision Variable)
B
$ 3,000.00
C
D
=B3-B1
Annual Salary
Tax Rate
After TSB Income
Taxes Owed
Net Income Before Medical Expenses
$ 50,000.00
30%
$ 47,000.00
$ 14,100.00
$ 32,900.00
Total Medical Expenses
Amount in TSB
Expenses Not Covered (Must Be Paid Out-Of-Pocket)
Money Left Over in TSB (Lost)
$ 2,000.00
$ 3,000.00
$
$ 1,000.00
Net Income After Medical Expenses (Objective)
$ 32,900.00
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=B5*B4
=B5-B6
This will be a random variable.
=B1
=MAX(B9-B10,0)
=MAX(B10-B9,0)
=B7-B11
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Note (this is important): We will never get a simulation
model to tell us directly what is the optimal value of the
decision variable (how much to have deducted from our
pre-tax pay).
We will try different values (here we have arbitrarily
started with $3000 in cell B1) and see how the objective
changes.
Through educated trial-and-error, we will eventually
come to some conclusion about what is the best amount
of money to put into the TSB account.
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Now we add the element of randomness by making B9 into
a distribution cell. First, enter the mean and standard
deviation for the medical expenses random variable (we
put them in cells B16 and B17, respectively).
A
16 Mean
17 Standard Deviation
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B
$ 2,000.00
$
500.00
40
Select cell B9 and click on the Define Distribution button.
Note that we have used cell references for the mean and
standard deviation.
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1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
A
TSB Amount (Decision Variable)
$
Annual Salary
Tax Rate
After TSB Income
Taxes Owed
Net Income Before Medical Expenses
$ 50,000.00
30%
$ 47,000.00
$ 14,100.00
$ 32,900.00
Total Medical Expenses
Amount in TSB
Expenses Not Covered (Must Be Paid Out-Of-Pocket)
Money Left Over in TSB (Lost)
$
$
$
$
Net Income After Medical Expenses (Objective)
$ 32,900.00
Mean
Standard Deviation
$
$
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B
3,000.00
2,000.00
3,000.00
1,000.00
C
D
=RiskNormal(B16,B17,RiskStatic(2000))
2,000.00
500.00
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Now we need to tell @Risk to keep track of our output cell
during all of our simulation runs, so we can see its mean and
standard deviation over many trials. Select the net income cell
B14 and click on the Add Output button.
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1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
A
TSB Amount (Decision Variable)
$
Annual Salary
Tax Rate
After TSB Income
Taxes Owed
Net Income Before Medical Expenses
$ 50,000.00
30%
$ 47,000.00
$ 14,100.00
$ 32,900.00
Total Medical Expenses
Amount in TSB
Expenses Not Covered (Must Be Paid Out-Of-Pocket)
Money Left Over in TSB (Lost)
$
$
$
$
Net Income After Medical Expenses (Objective)
$ 32,900.00
Mean
Standard Deviation
$
$
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B
3,000.00
2,000.00
3,000.00
1,000.00
C
D
=RiskNormal(B16,B17,RiskStatic(2000))
=RiskOutput()+B7-B11
2,000.00
500.00
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Now click on the Simulation Settings button, and set
the number of iterations.
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Unfortunately, we can’t tell whether $3000 is the optimal
amount without trying many other possible amounts. This
could entail a long and tedious series of simulation runs, but
fortunately it is possible to test many values at once.
We set up numerous columns in the worksheet, so that we can
perform simulation experiments on many possible TSB
amounts simultaneously:
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
A
TSB Amount (Decision Variable)
$
B
1,000
$
D
1,500
$
50,000
30%
47,750
14,325
33,425
$
$
I
2,750
$
J
3,000
$ 3,250.00
$
$ 1,250.00
Net Income After Medical Expenses (Objective)
$ 33,300.00
$ 33,375.00
$ 33,450.00
$ 33,525.00
$ 33,600.00
$ 33,425.00
$ 33,250.00
$ 33,075.00
$ 32,900.00
$ 32,725.00
=RiskOutput("1750",A14,4)+E7-E11
=RiskOutput("1500",A14,3)+D7-D11
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$
K
3,250
$ 3,000.00
$
$ 1,000.00
$
$
$
50,000
30%
47,000
14,100
32,900
$
$ 2,750.00
$
$
750.00
$
$
$
50,000
30%
47,250
14,175
33,075
$
$ 2,500.00
$
$
500.00
$
$
$
50,000
30%
47,500
14,250
33,250
$
$ 2,250.00
$
$
250.00
$
$
$
$
H
2,500
$ 2,000.00
$
$
-
$
$
$
50,000
30%
48,000
14,400
33,600
G
2,250
$
$ 1,750.00
$
250.00
$
-
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$
F
2,000
$ 1,500.00
$
500.00
$
-
$
$
$
50,000
30%
48,250
14,475
33,775
$
$ 1,250.00
$
750.00
$
-
$ 2,000.00
=RiskOutput("1250",A14,2)+C7-C11
$
500.00
$
E
1,750
$ 2,000.00
$ 1,000.00
$ 1,000.00
$
-
$
$
$
50,000
30%
48,500
14,550
33,950
$
Total Medical Expenses
Amount in TSB
Expenses Not Covered (Must Be Paid Out-Of-Pocket)
Money Left Over in TSB (Lost)
$
$
$
50,000
30%
48,750
14,625
34,125
$
$
Mean
Standard Deviation
$
C
1,250
Annual Salary
Tax Rate
After TSB Income
Taxes Owed
Net Income Before Medical Expenses
$
$
$
50,000
30%
49,000
14,700
34,300
$
$
$
$
50,000
30%
46,750
14,025
32,725
The @Risk Output Results report (a new worksheet created automatically):
@RISK Output Results
Performed By: admin
Date: Saturday, January 25, 2014 2:54:48 PM
Name
Cell
Graph
Min
Mean
Max
5%
95% Errors
Range: Net Income After Medical Expenses (Objective)
1000
B14
$
31,332.38
$
33,295.75
$
34,300.00
$
32,477.41
$
34,122.42 0
1250
C14
$
31,407.38
$
33,360.35
$
34,125.00
$
32,552.41
$
34,125.00 0
1500
D14
$
31,482.38
$
33,408.34
$
33,950.00
$
32,627.41
$
33,950.00 0
1750
E14
$
31,557.38
$
33,426.10
$
33,775.00
$
32,702.41
$
33,775.00 0
2000
F14
$
31,632.38
$
33,400.53
$
33,600.00
$
32,777.41
$
33,600.00 0
2250
G14
$
31,707.38
$
33,326.10
$
33,425.00
$
32,852.41
$
33,425.00 0
2500
H14
$
31,782.38
$
33,208.34
$
33,250.00
$
32,927.41
$
33,250.00 0
2750
I14
$
31,857.38
$
33,060.35
$
33,075.00
$
33,002.41
$
33,075.00 0
3000
J14
$
31,932.38
$
32,895.75
$
32,900.00
$
32,900.00
$
32,900.00 0
3250
K14
$
32,007.38
$
32,724.00
$
32,725.00
$
32,725.00
$
32,725.00 0
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TSB Simulation Analysis Results
$33,500
$33,400
Mean Net Income
$33,300
$33,200
$33,100
$33,000
$32,900
$32,800
$32,700
$32,600
$32,500
$1000
$1250
$1500
$1750
$2000
$2250
$2500
$2750
$3000
$3250
Amount Put Into TSB Account
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Rework part a, but this time assume a gamma
distribution for your annual medical expenses.
Use $0 for the location parameter, $125 for the scale
parameter (sometimes symbolized with β), and 16
for the shape parameter (sometimes symbolized
with ).
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Gamma vs. Normal
Normal Distribution
Probability
Gamma Distribution
$0
$1,000
$2,000
$3,000
$4,000
$5,000
Medical Expense
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TSB Simulation Analysis Results
$33,500
$33,400
Mean Net Income
$33,300
$33,200
$33,100
$33,000
$32,900
$32,800
$32,700
$32,600
$32,500
$1000
$1250
$1500
$1750
$2000
$2250
$2500
$2750
$3000
$3250
Amount Put Into TSB Account
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Conclusions
• The best amount to put into the TSB is
apparently about $1,750 per year.
• This result is robust over different
distributions of medical costs.
• This result is based on sample statistics, not
known population parameters.
• We have confidence in these sample statistics
because of the large sample size (1,000).
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Random Number Generator
Built into Excel
• RAND() function
• Tools – Data Analysis – Random Number Generation
Built into all simulation software
Not really random; correctly called pseudo-random
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Random Number Generator
Needs a “seed” to get started
Each random number becomes the seed for its successor
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Summary
Monte Carlo Simulation
– Basic concepts and history
@Risk
– Probability Distributions
• Uniform, Normal, Gamma
– Distribution and Output cells
– Simulation Settings
– Output Analysis
Examples
– Coin Toss, TSB Account
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