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MB0048 : State two major reasons for using simulation. Explain the basic steps of Monte-Carlo simulation. Briefly describe the application in finance & Accounting.

Posted on: October 5, 2011

MB0048 : State two major reasons for using simulation. Explain the basic steps of Monte-Carlo simulation. Briefly describe the application in finance & Accounting.

Answer: – major reasons for using simulation

Simulation is also called experimentation in the management laboratory. While dealing with business problems, simulation is often referred to as ‘Monte Carlo Analysis’. Two American mathematicians, Von Neumann and Ulan, in the late 1940s found a problem in the field of nuclear physics too complex for analytical solution and too dangerous for actual experimentation. They arrived at an approximate solution by sampling. The method they used had resemblance to the gambler’s betting systems on the roulette table; hence the name ‘Monte Carlo’ has stuck.

Imagine a betting game where the stakes are based on correct prediction of the number of heads, which occur when five coins are tossed. If it were only a question of one coin; most people know that there is an equal likelihood of a head or a tail occurring, that is the probability of a head is ½. However, without the application of probability theory, it would be difficult to predict the chances of getting various numbers of heads, when five coins are tossed. In this kind of situation simulation plays an important role.


Monte Carlo simulation is useful when same elements of a system, such as arrival of parts to a machine, etc., exhibit a chance factor in their behavior. Experimentation on probability distribution for these elements is done through random sampling. Following five steps are followed in the Monte Carlo simulation:

Procedure of Monte Carlo Simulation:

  1. Decide the probability distribution of important variables for the stochastic process.
  2. Calculate the cumulative probability distributing for each variable in Step 1
  3. Decide an interval of random numbers for each variable.
  4. Generate random numbers.
  5. Simulate a series of trials and determine simulated value of the actual random variables.

Application of Simulation in finance & Accounting.

The range of application of simulation in business is extremely wide. Unlike other mathematical models, simulation can be easily understood by the users and thereby facilitates their active involvement. This makes the results more reliable and also ensures easy acceptance for implementation. The degree to which a simulation model can be made close to reality is dependent upon the ingenuity of the OR team who identifies the relevant variables as well as their behavior.

You have already seen by means of an example how simulation could be used in a queuing system. It can also be employed for a wide variety of problems encountered in production systems – the policy for optimal maintenance in terms of frequency of replacement of spares or preventive maintenance, number of maintenance crews, number of equipment for handling materials, job shop scheduling, routing problems, stock control and so forth. The other areas of application include dock facilities, facilities at airports to minimize congestion, hospital appointment systems and even management games.

In case of other OR models, simulation helps the manager to strike a balance between opposing costs of providing facilities (usually meaning long term commitment of funds) and the opportunity and costs of not providing them.

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