Question

How and when do you use the Monte Carlo analysis? Does it have anything to do with understanding the probability of a risk occurring as well?

Answer 1

• Monte Carlo analysis is performed to know the risk impact and its uncertainty. It is also called as probablity simulation and generally used in forecasting in finance and project management domains. It is applicable when there are outcomes in the form of range of values and used for understanding the risk and uncertainty. The main feature of the Monte Carlo analysis or simulation is to let us know on how 'likely' the expected outcomes going to be and on the basis of estimates range (values).
• The way it works is by selecting a random value pertaining to each task (which are based on the range of values or estimates) and the model is formed, outcome is recorded and the entire procedure is revised to have another set of random values. This may be repeated many times (could be thousands) to have several random values. Once the simulation is done , then there will be a larger set of outcome based on the random values. These outcomes entails the likelihood of several expected outcomes in the forecasting model.
• For example, considering a project where tasks need to be executed one by one and the total time (in months) for project is the summation of the tasks. By applying Monte Carlo Analysis, single estimate for each of the project task is created. And this will result into overall time taken in months.However, this may be a good outcome but still it does not says about the risk that on 'likelihood' of the project completion. Hence, by using the Monte Carlo analysis the separate estimate for each task is created by considering the previous data (e.g. historical) and have the minimum and maximum time. These expected time values will be used along with 'most likely' estimate. But still the model needs more information that means the possible range of values which may vary from let's say 15 month to 25 months for project completion. Therefore, it is required to create random values to calculate the project completion time and execute the monte carlo simulation several times (may be 300 times) to detail the risks associated with project completion. In order to know the likelihood of the outcome , it is needed to count on how many times the monte carlo analysis resturned the outcome and how many times the outcome was '<' or '=' to the time (in months).
• Monte Carlo Analysis is a valuable technique to know forecasted outcome when not sure on the future.