Example of Calculating NPV Probability Using Crystal Ball Simulation - Project Management
A manufacturing firm has set up a project for developing a new machine for one of its production lines. The most likely estimated cost of the project itself is $1 million, but the most optimistic estimate is $900,000 while the pessimists predict a project cost of $1,200,000. The real problem is that even if the project costs are within those limits, if the project itself plus its implementation cost exceed 1,425,000, the project will not meet the firm’s NPV hurdle. There are four cost categories involved in adding the prospective new machine to the production line: (1) engineering labor cost, (2) non-engineering labor cost, (3) assorted materials cost, and (4) production line down-time cost.
The engineering labor requirement has been estimated to be 600 hours, plus or minus 15% at a cost of $80 per hour. The non-engineering labor requirement is estimated to be 1500 hrs., but could be as low as 1200 hrs. or as high as 2200 hrs. at a cost of $35 per hour. Assorted material may run as high as $155,000 or as low as $100,000 but is most likely to be about $135,000. The best guess of time lost on the production line is 110 hours, possibly as low as 105 hours and as high as 120 hours. The line contributes about $500 per hour to the firms profit and overhead. What is the probability that the new machine project will meet the firm’s NPV hurdle? Use Crystal Ball simulation to answer the question. Although this problem can be solved using different methods, we will be solving this using Crystal Ball. No pints will be awarded if you do not use the Crystal Ball.
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The first step is to determine the optimistic, most likely, and pessimistic values of the overall project and each of the sections of the project. For the project, the information is provided that;
The most likely estimated cost of the project itself is $1 million, but the most optimistic estimate is $900,000 while the pessimists predict a project cost of $1,200,000.
Hence:
Optimistic value = $900,000
Most likely value = $1, 000,000
Pessimistic value = $1, 200,000
For the other sections, use the information provided in part 2. For instance;
The engineering labor requirement has been estimated to be 600 hours, plus or minus 15% at a cost of $80 per hour.
Hence:
Optimistic value = [600 - (15% of 600)] × 80 = $40,800
Most likely value = 600 × 80 = $48,000
Pessimistic value = [600 + (15% of 600)] × 80 = $55,200
Use the same to calculate the other sections as show in the table below.
Feed the values into the Crystal Ball simulation using the Normal Distribution.
The project has a 91.94% chance of meeting the NPV hurdle
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