MSBA 7014 Business Simulation

Assignment 3: @Risk Applications

1. Warranty Cost Simulation

When you buy a new product, it usually carries a warranty. A typical warranty might state
that if the product fails within a certain period such as one year, you will receive a new
product at no cost, and it will carry the same warranty. However, if the product fails after
the warranty period, you have to bear the cost of replacing the product. Due to random
lifetimes of products, we need a way to estimate the warranty costs (to the
manufacturer) of a product.
• Yakkon Company sells a popular camera for $400. This camera carries a warranty such
that if the camera fails within 1.5 years, the company gives the customer a new camera
for free. If the camera fails after 1.5 years, the warranty is no longer in effect.
• Every replacement camera carries exactly the same warranty as the original camera,
and the cost to the company of supplying a new camera is $225. Yakkon estimates the
distribution of time until failure from historical data, which indicates a gamma
distribution, with mean 2.5 years and standard deviation 1 year (from camera lifetime
data from the past).

Use @Risk to build a simulation model to estimate, for a given sale, the number of
replacements under warranty and the NPV of profit from the sale, using a discount rate
of 8%.

2. Airline revenue management

The manager of BA Airlines has been struggling with one particularly flight with a capacity
of 200 seats, and it is offering two different fare classes: a “full fare” (FF), for $850, and a
“super saver” (SS) fare, for $350. To qualify for the SS fare, customers must purchase at
least 2 months in advance. In contrast, FF is very flexible, and it offered until the date of
the flight if seats are still available. In fact, historically, the FF customers are almost
exclusively business travelers, who always make last-minute purchases and are not price
sensitive. Thus, it is reasonable to assume that FF customers make the purchase after the
discounting period.
• Using the historical data, the manager estimates that the demand for SS fares follows
a normal distribution, with mean 130 and standard deviation 45, and the demand for
FF follows a normal distribution, with mean 55 and standard deviation 20.
• It is also found that some of the passengers who inquire about SS tickets after the
booking limit is reached may actually be convinced to “buy up”, i.e., purchase an FF
ticket. Using the historical data, the manager estimates that any SS customer that is
not able to get an SS fare may “buy-up” with a probability of 30%.
• The manager would like to decide on the “booking limit” for the SS fare, i.e., how many
seats to make available to SS customers. There will be no overbooking.

Historically, that value was set at 120, but the manager is not sure if that’s right.

a) Build a simulation model that estimates the expected revenue for one flight when
the booking limit (for SS fare) is set to 120.
b) Using the model, find the booking limit that maximizes the expected revenue for one
flight.