“ (16.1 Mee 16.1 Risk Analysis n5 Simulation is ot an optimization technique. Itis a method shat can be used 1 describe or predict how a systom will operate given certain choices for the controllable inputs and rardomly generaied values for the probebilistic inputs. Analysts offea use simulation t0 etermine values for the controllable inputs that are likely to lead to desirable system ‘outputs. In this sense, simulation ean be an effective tool in designing a system to provide 200d performance. In tischapter we begin by showing bow simulation caa be used to sty the financial risks ascocizted with the development ofa new product. We continue withillustraons showing how ‘Simulation can be used to estzblish an effective inventory policy and bow itcan be used t9 de- sign waiting line systems. We conclude with a discussion of other isues, such as very ‘simulation program, validating the mode}, and selecting a simulation software package Risk Analysis ‘Risk analysis is the process of predicting the outcome of a decision in the face of uncer- tainty In this section we describe a problem that invelves considerable uncertainty: the de- velopment of a new product. We first show how risk analysis can be conducted without using simulation; we then show how a more comprehensive risk analysis can be conducied ‘with the aid of simulation. PortaCom Project PortaCom mianufacurres notebook computers and related equipment. PortaCom’s product design aroup developed pretorype for new high-quality portable printer. The new printer Features an innovative design and has the potential to capture a significant share of the portable printer market, Preliminary marketing and financial anelyses provided the follow- ing selling price, first-year administrative cost, and first-year advertising cost Selling price = $249 per unit Administrative cost = $400,000 ‘Advertising cost = $600,000 In the simulation model for the PortzCom problem. the preceding values are constants and are referred to as parameters of the model. ‘The cost of dizect labor, the cost of parts, and the first-yeer demand for the printer are hot known with certainty and are considered probabiliscie inputs. At this stage of the plan ning process, PortaCom's best estimates of these inputs are $45 per unit forthe direct labor ‘cost, $90 per unit for the parts cost, and 15,000 units for the first-year demand. PortaCom ‘would lke an analysis of the first-year profit potential for the printer. Because of PortaCom’s tight cash flow situntion, management is particularly concerned about the potential for loss, What-lf Analysis One approach to risk analysis is called what-if analgsis. A what-if analysis involves ge erating values for the probabilistic inpu's (direct labor cos, paris cost, and fi demand) and competing the resulting value forthe ouput (prot), Wit a selling price Of $249 per oni: and administrative pls advertising costs equal co $100,000 + $606,000 $1,000,000, the PortaCon: profit model is Profit = (S249 — Direct labor cost per unit ~ Paris cost per unit)(Demand) — $1,000,00076 Cheploe 15 Simulation FIGURE 16.2 PORTACOM PROFIT MODEL Probabilistic puts Direct nt Tato: Fars _ Year Gest Cost Demand {ii Iprgtiee lp eye ~ 1,000,000} — rote Leting 6, = direct labor cost per unit 6 = pats cow per unit x= first-year demand ihe profit model for ce frst year can be written as follows Profit = (249 ~ c — eqhx ~ 1,000,000 (16.1) ‘The PoxsCom profit model ean be depicted as shown in Figure 16.2 Recall that PortaCom's best estimates of the direct labor cost per uni, the parts cost p: ‘ani, end first-year demand are S45, $90, and 15.000 units, respectively. These values eo stitute the hase-eace scenario for PortaCom. Substituting these values into equation (16. ylelds the following profit projection: Profit = (249 ~ 45 ~ 90)(15,000) ~ 1.000.000 = 710,000 Thus, the buse-case scenario leads 0 au anticipated profit of $710,006 Inrisk analysis we are concemed with both the probability of loss and the magnituc of a loss. Although the base-case scenario looks sppealing. PortuCom might be interest: in what hapgeus if the estimates of the direst labor cost per unit, pats cost per unit, ar rstyear demand do not tum ont t9 be as expecied uncer the buse-case scenario. F instance, suppose that PortaCom believes that direct labor costs could range fiom $43, S47 per unit, parts cost could range from $80 to $100 per unit, and first-year demand cou range from 1500 ro 28,500 units. Using these ranges. what-it analysis can be used evaluate a Worst-case scenario and a best-case scenario, The worst-case value for the divecr labor cost is S47 ((he highest value), the worst-ea: value forthe paris cost is $100 (the highest value), and the worst-case value for demand 1500 wits the lowest value). Thus, in the worst-case scenaio, ¢; = 47,€3 ~ 100, and. 1500. Substituting chose values into equation (6.1) leads to the following profit projestio Profit = (249 — 47 — 190)(1500) ~ 1,000,000 = —847,000 So the worst-case scenario less to.a projected lose of $847,000, The best-case value for the direct labor cost is $43 (the lowest value), the besteca value for the puts cost is $80 (the lowest value). and the best-cose valve for demandProbl 2 wil give x08 practesashig whee ‘nal One abvanese of simalsion isthe abil diszituvons thet are nique the system being 161 Anolyie nr 28,500 units (the highest value). Subetitting Following protic projection: Profit = (219 — 43 — 804: hase values into equation (16.1) leads to the 10) ~ 1,000,000 = 2.591,000 So the best-case scenario leads to 2 projected profit of $2,591,000, At this point the sshati analysis provides the conclusion that profits can rar Joss of $847,000 to a profi of S2.591.000 with a base-case profit of $710,000. Although the base-case profit of $710.000 is possible, the what-if analysis indicates that either a substantial loss or a substantial profit is possible. Other scenarios that PortaCom might ‘Want to consider can also be evaluated. However. the difficulty with whee if analysis is that it does act indicate the likelihood of the various profit or oss values. In particular we de not Enow anything about the probability ofa loss. mulation to perform risk analysis for the PortsCom problem is like playing ovt many enaos by randomly generating values lor the probsbilistic inputs, The advantage of Simulation is tet it alos us to assess the probability of a profit and the pmobubilty ofa less Using the what-if approach io risk analysis, we selected values forthe probabilistic in~ puis (direct tabor cost per unit |. parts cos! per unit (c,), and first-year demand (s)} and then computed the resulting profit, Applying simulation to the PortaCom problem requires generating values forthe probabilistic inputs that are representative of what we might ob- serve in practice, To generate such values. we must know the probability distribution for ‘each probabilistic input, Further analysis by PortaCom ledto the following probability dis butions forthe direct labor cust per unit. tke parts cost per unit, and First-year demand: Direct Labor Cost PostaCom believes thu the direct labor cost will range from $43 to $47 Der nit and js described by the discrots probability distribution shown in Table 16.1. Thusy we see a O11 probability thatthe direct labor cost will be $43 per unit, a 0.2 probability that the direct labor cost will be $44 per unit, and so on, The higltest probability of 4 is asso- ciated with a direct labor cost of S45 per unit. Parts Cost This cost depends upon the general economy. the overall demund for pars, and the pricing policy of PortaCom's parts suppliers. PoetaCom believes tha the parts eost will range from $8) to $100 per unit aud iy described by the uniform probability distribution shown in Figure 16,3. Costs per unit between $80 and $100 are equally likely. First-Year Demand PoraCom believes tha first-year demand is desciibed by the norma Probability distribution shown in Figure [6.4. The mean or expecied value of first-year TABLE 16.1 PROBABILITY DISTRIBUTION FOR DIRECT LABOR COST PER UNIT Direct Labor Cost per Unit, su Sti SS S16 Su