What is Monte Carlo Simulation?

Monte Carlo simulation, or probability simulation, is a technique used to understand the impact of risk and uncertainty in financial, project management, cost, and other forecasting models.

Monte Carlo Simulation

Monte Carlo simulation is a further attempt to model real-world uncertainty. This approach takes its name from the famous European casino, because it analyzes projects the way one might evaluate gambling strategies.

Monte Carlo simulation of capital budgeting projects is often viewed as a step beyond either sensitivity analysis or scenario analysis. Interactions between the variables are explicitly specified in Monte Carlo simulation; so, at least theoretically, this methodology provides a more complete analysis. While the pharmaceutical industry has pioneered applications of this methodology, its use in other industries is far from widespread.

How It Works

In a Monte Carlo simulation, a random value is selected for each of the tasks, based on the range of estimates. The model is calculated based on this random value. The result of the model is recorded, and the process is repeated. A typical Monte Carlo simulation calculates the model hundreds or thousands of times, each time using different randomly-selected values. When the simulation is complete, we have a large number of results from the model, each based on random input values. These results are used to describe the likelihood, or probability, of reaching various results in the model.

Process
Step 1: Specify the Basic Model Step 2: Specify a Distribution for Each Variable in the Model Step 3: The Computer Draws One Outcome Step 4: Repeat the Procedure Step 5: Calculate NPV

Example
Task Job 1 Job 2 Job 3 Total Time Estimate 5 Months 4 Months 5 Months 14 Months

Table 1: Basic Forecasting Model

Task Job 1 Job 2 Job 3 Total

Minimum 4 Months 3 Months 4 Months 11 Months

Most Likely 5 Months 4 Months 5 Months 14 Months

Maximum 7 Months 6 Months 6 Months 19 Months

Table 2: Forecasting Model Using Range Estimates

Time 12 Months 13 Months 14 Months 15 Months 16 Months 17 Months

Number of Times (Out of 500) 1 313 171 394 482 499

Percent of Total (Rounded) 00% 06% 034% 079% 096% 0100% 0100%

18 Months 500 Table 3: Results of a Monte Carlo Simulation

How Reliable Is It?

Like any forecasting model, the simulation will only be as good as the estimates you make. It's important to remember that the simulation only represents probabilities and not certainty. Nevertheless, Monte Carlo simulation can be a valuable tool when forecasting an unknown future.