the imitative representation of the functioning of one system or process by means of the functioning of another <a computer simulation of an industrial process>

SIMULATION

Injecting Certainty Into An Uncertain Process

Webinar Presentation To The Members Of

“You can’t control risk, unless you measure it or model it!”

Using Monte Carlo Simulation to Improve Your Forecast Processes

The Landscape In Which We Plan

“There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don't know. But there are also unknown unknowns. These are things we don't know we don't know.” Donald Rumsfeld“If there's one thing that's certain in business, it's uncertainty.” Stephen Covey“Information is the resolution of uncertainty.” Claude Shannon

“You can’t control risk, unless you measure it or model it!”

Why Do We Plan?• You can’t get to where you want to go without a road map!• You may have objectives for Net Sales, Net Earnings and Returns on Equity and/or Capital

Employed. How are they going to be achieved within the national or global economic climate? In the next 6-12 months it is likely that we will see higher market interest rates; investors seeking greater liquidity; and “lumpy” demand by customers.

• You may also have objectives for conserving Cash for future investments. How will this be done?

• You have an obligation to your stakeholders to protect and enhance their interests.

“You can’t control risk, unless you measure it or model it!”

The Osborne Company• Manufacturer of widgets• Purchases partially assembled product• Adds manufactured components• Sells nationally

• 5 year old profitable company with Retained Earnings of $110,760• C Corporation for Income Tax purposes

“You can’t control risk, unless you measure it or model it!”

Monday, August 15th• Management staff meeting• Attendees• CEO• CMO• GM• CFO

“You can’t control risk, unless you measure it or model it!”

Planning for next year begins• CEO says • Market dictates that we can’t change price• Give me your forecasts of Unit Volume?

• CMO says • Production line functioning well and positive reaction to new design• 989,300 Units

• GM says • Too high for shop to handle• 950,000 Units

“You can’t control risk, unless you measure it or model it!”

CEO makes final call

• Let’s shoot for the moon. I say 995,000

“You can’t control risk, unless you measure it or model it!”

http://cliparts.co/clipart/183111

CFO is deep in thought• How will he create a single financial projection with three disparate

projections of unit volume?• No mention has been made of purchased assemblies required to

achieve those projections while maintaining inventory• Minimum 685,000; maximum 700,000; most likely 690,000• Sourced from several suppliers whose prices range from $.375 to $.48 cents

each depending on supplier availability

“You can’t control risk, unless you measure it or model it!”

General Manager interrupts CFO’s thoughts• Possibility of an increase in the minimum wage• 9 people in the shop• 6 of them earn at the minimum wage of $8.25 per hour• 1,896 production hours for each, without overtime, that I need to put an

hourly rate on• What are the odds of an increase and to what amount?

• Group consensus is that there is a 30% likelihood of the minimum wage going to $10.50 an hour

“You can’t control risk, unless you measure it or model it!”

CFO is rolling his eyes when CEO turns to him• Take these figures that we have discussed and put together our most

likely case scenario• We’ll meet again next Monday and go over what you come up with• By the way, don’t forget about that mandatory $20,000 bank loan

repayment• There should be no problem meeting that requirement based on the

numbers discussed, RIGHT?• CFO says it appears that way but let me see what the numbers look like

“You can’t control risk, unless you measure it or model it!”

CFO hurries back to his office• He can’t wait to put pencil to paper• He also has a glimmer of an idea that he would like to try, but

first he has to create the “most likely case scenario”• He comes up with the following

“You can’t control risk, unless you measure it or model it!”

Assumptions for Most Likely Case

“You can’t control risk, unless you measure it or model it!”

Most Likely Case Estimates

Not Considered In Most Likely Case

Income Statement

“You can’t control risk, unless you measure it or model it!”

Cost of Goods Sold and Direct Labor

“You can’t control risk, unless you measure it or model it!”

Balance Sheet

“You can’t control risk, unless you measure it or model it!”

Cash Flow Statement

“You can’t control risk, unless you measure it or model it!”

CFO Reaction to Current Forecasting Process• Satisfied

• Mandatory Debt Repayment is barely covered

• Dissatisfied• Did not address wide discrepancy in unit volume forecasts• Did not address wide discrepancy in raw material unit purchases• Did not address wide range of prices for the raw materials• Did not even consider the 30% likelihood of an increase in the minimum wage

• Conclusion: We need a forecasting process that will give us sensitivity of key drivers and probability of outcomes!

“You can’t control risk, unless you measure it or model it!”

Risk Modeling: The Old Way• Single Point Estimates

Do you make multi-million dollar decisions based on 1 number?

• 3-Point Estimates or Scenario Analyses Do you make multi-million dollar decisions based on 3 numbers?

• Manual What-if Analyses Will you mandate that your analysts run hundreds or thousands of scenarios for your million dollar

decision? How much will that cost and will you get those analyses in time?

******************************************

What if something changes? What if many things change, and change at different times? Managing risk then becomes cumbersome, time consuming, and error laden.

“You can’t control risk, unless you measure it or model it!”

Risk Modeling: The New Way

• Use Probability DistributionsThe direct result of Monte Carlo simulations, which are necessary for making

competitive business decisions and for balancing risk and return.

• Probability distributions furnish you with the full range of possible outcomes, how likely those outcomes are to occur, and identify those items that impact your bottom line most significantly and by how much.

“You can’t control risk, unless you measure it or model it!”

A Bright Idea ● Use Monte Carlo Simulation

“You can’t control risk, unless you measure it or model it!”

What is Monte Carlo simulation?!?!

It’s really not rocket science.

At its core, Monte Carlo simulation is a virtual experiment – repeated hundreds, thousands, even millions of times – all the while generating random samples, bound by a set of parameters that you define, from each repetition of that experiment.

Those random samples are collected and then organized and analyzed to help you understand the behavior of a simple or complex system or process.

CFO starts with the model he just created• He uses Monte Carlo simulation software which is commercially available.• He gives effect to the discrepancies missing from that scenario by assigning probability

distributions to the key model drivers.• You may already be familiar with the normal or “bell shaped” curve distribution. There

are many others.• Which distribution to use is a question that always comes up.

• Historical data, expert opinion or management “gut feel” are all acceptable answers to that question

• With available historical data, it is possible to use software to analyze the data and determine the most appropriate distribution to use

• In this case, the CFO is using his own judgement

“You can’t control risk, unless you measure it or model it!”

Let’s move over to the Excel Model and run a simulation

“You can’t control risk, unless you measure it or model it!”

Net Income Observations• 90% of the results fall between a Net Loss of $16,303 and a Net

Income of $53,351• 10% of the results are outside of these values• The single most damaging impact to Net Income was the Unit Price of

Raw Material Purchases

“You can’t control risk, unless you measure it or model it!”

Net Change In Cash Observations• Model suggested that the company could really lose its shirt cash-

wise, with 90% of the results falling between a cash shortfall of $62,840 and a cash gain of only $6,814. With all of the results considered, the cash flow ranges from a negative $94,146 to a positive $18,391. The mean cash flow is a negative $26,522.• The $20,000 mandatory debt repayment could be in serious jeopardy• In fact, the bank and mortgage holder might be uncomfortable

enough to foreclose against the company

“You can’t control risk, unless you measure it or model it!”

Conclusions• Single point presentations do not provide an in depth picture of risk. Using Monte Carlo simulation gives

you much greater insight into an uncertain future and points the way to areas where your risk can be mitigated.

• If you have not begun to collect history, it is a good thing to do. The past can be a useful resource for selecting the right probability distribution.

• The use of statistical techniques like Monte Carlo simulation can actually support gut feel and lead to more confidence and better, more insightful forecasts in the future. In the example shown here today, it led to the structuring of fixed price contracts with the company’s raw material providers.

• Thank you for your time and attention

“You can’t control risk, unless you measure it or model it!”

Who Are We?

With more than 30 years of experience in utilizing technology to assist in management decision making, Jerry Scherer, a member of FENG, focuses on changing corporate culture to embrace stochastic rather than deterministic modeling. As a financial officer at a Fortune 200 company, Jerry utilized Monte Carlo simulation and optimization in the management of a $1.1 Billion dollar Revolving Credit portfolio. He now builds risk models for clients.

JB Scherer Consulting Group LLC(847) 835-1175januerry@Comcast.netwww.jbschererconsultinggroup.com

Founded in 1984, Palisade is proud to celebrate its 30th year helping professionals make better decisions. Established as an internationally recognized industry leader with its core products @RISK™ and the Decision Tools Suite™, Palisade continues to focus on its core values: providing user-friendly analytical tools that enable decision-makers in any industry to choose the best approach. Palisade’s core products may be found in more than 94% of the Fortune 500 companies.

Palisade Corporation (800) 432-7475www.palisade.com

“You can’t control risk, unless you measure it or model it!”