Regression Models: To Accompany

Chapter 4
Regression Models
To accompany
Quantitative Analysis for Management, Tenth Edition,
by Render, Stair, and Hanna
Power Point slides created by Jeff Heyl
2008 Prentice-Hall, Inc.

Learning Objectives
After completing this chapter, students will be able to:
1. Identify variables and use them in a regression
2.
3.
4.
5.
model
Develop simple linear regression equations
from sample data and interpret the slope and
intercept
Compute the coefficient of determination and
the coefficient of correlation and interpret their
meanings
Interpret the F-test in a linear regression model
List the assumptions used in regression and
use residual plots to identify problems
42
Learning Objectives
After completing this chapter, students will be able to:
6. Develop a multiple regression model and use it
7.
8.
9.
10.
to predict
Use dummy variables to model categorical
data
Determine which variables should be included
in a multiple regression model
Transform a nonlinear function into a linear
one for use in regression
Understand and avoid common mistakes made
in the use of regression analysis
43
Chapter Outline
4.1
4.2
4.3
4.4
Introduction
Scatter Diagrams
Simple Linear Regression
Measuring the Fit of the Regression
Model
4.5 Using Computer Software for
Regression
4.6 Assumptions of the Regression
Model
44
Chapter Outline
4.7
4.8
4.9
4.10
4.11
4.12
Testing the Model for Significance

Multiple Regression Analysis
Binary or Dummy Variables
Model Building
Nonlinear Regression
Cautions and Pitfalls in Regression
Analysis
45
Introduction
Regression analysis is a very valuable
tool for a manager

Regression can be used to
Understand the relationship between
variables
Predict the value of one variable based on
another variable
Examples
Determining best location for a new store
Studying the effectiveness of advertising
dollars in increasing sales volume
46
Introduction
The variable to be predicted is called
the dependent variable
Sometimes called the response variable
The value of this variable depends on
the value of the independent variable

Sometimes called the explanatory or
predictor variable
Dependent
variable
Independent
variable
Independent
variable
47
Scatter Diagram
Graphing is a helpful way to investigate

the relationship between variables
A scatter diagram or scatter plot is often
used
The independent variable is normally
plotted on the X axis
The dependent variable is normally
plotted on the Y axis
48
Triple A Construction
Triple A Construction renovates old homes
They have found that the dollar volume of
renovation work is dependent on the area

payroll
TRIPLE AS SALES
($100,000s)
Table 4.1
LOCAL PAYROLL
($100,000,000s)
4.5
9.5
5
49
12
10
Sales ($100,000)
8
6
4
2
0
|
1
|
2
|
|
|
3
4
5
Payroll ($100 million)
|
6
|
7
|
8
Figure 4.1
4 10

Regression models are used to test if there is a
relationship between variables (predict sales

based on payroll)
There is some random error that cannot be
predicted
Y 0 1X
where
Y = dependent variable (response)
X = independent variable (predictor or explanatory)
0 = intercept (value of Y when X = 0)
1 = slope of the regression line
= random error
4 11

True values for the slope and intercept are not
known so they are estimated using sample data
Y b0 b1 X
where
^
Y
X
b0
b1
= dependent variable (response)

= independent variable (predictor or explanatory)
= intercept (value of Y when X = 0)
= slope of the regression line
4 12
Triple A Construction is trying to predict sales
based on area payroll
Y = Sales
X = Area payroll
The line chosen in Figure 4.1 is the one that
minimizes the errors
Error = (Actual value) (Predicted value)

e Y Y
4 13
Least Squares Regression

Errors can be positive or negative so the average error could
be zero even though individual errors could be large.
Least squares regression minimizes the sum of the squared
errors.
4 14
For the simple linear regression model, the
values of the intercept and slope can be

calculated using the formulas below
Y b0 b1 X
X
average (mean) of X values
n
Y
average (mean) of Y values
n
b1
( X X )(Y Y )
(X X )
2
b0 Y b1 X
4 15
Regression calculations
Y
(X X)2
(X X)(Y Y)
(3 4)2 = 1
(3 4)(6 7) = 1
(4 4)2 = 0
(4 4)(8 7) = 0
(6 4)2 = 4
(6 4)(9 7) = 4
(4 4)2 = 0
(4 4)(5 7) = 0
4.5
(2 4)2 = 4
(2 4)(4.5 7) = 5
9.5
(5 4)2 = 1
(5 4)(9.5 7) = 2.5
(X X)2 = 10
(X X)(Y Y) = 12.5
Y = 42
Y = 42/6 = 7
X = 24
X = 24/6 = 4
Table 4.2
4 16
X 24
4
6
Y 42
7
6
b1
( X X )(Y Y ) 12.5
1.25
10
(X X )
2
b0 Y b1 X 7 (1.25 )( 4 ) 2
Therefore Y 2 1.25 X
4 17
X 24
sales = 2 + 1.25(payroll)
Y 42
If the payroll next

year is $600 million
b1
) 2 12
1.5
.25(6) 9.5 or $ 950,000
( X X )(Y YY
1.25
10
(X X )
2
b0 Y b1 X 7 (1.25 )( 4 ) 2
Therefore Y 2 1.25 X
4 18
Measuring the Fit

of the Regression Model
Regression models can be developed
for any variables X and Y

How do we know the model is actually
helpful in predicting Y based on X?
We could just take the average error, but
the positive and negative errors would

cancel each other out
Three measures of variability are

SST Total variability about the mean
SSE Variability about the regression line
SSR Total variability that is explained by
the model
4 19
Measuring the Fit

Sum of the squares total
SST (Y Y )2
Sum of the squared error
SSE e 2 (Y Y )2
Sum of squares due to regression
SSR (Y Y )2
An important relationship
SST SSR SSE

4 20
Measuring the Fit

X
(Y Y)2
Y^
^ 2
(Y Y)
(Y^ Y)2
(6 7)2 = 1
2 + 1.25(3) = 5.75
0.0625
1.563
(8 7)2 = 1
2 + 1.25(4) = 7.00
(9 7)2 = 4
2 + 1.25(6) = 9.50
0.25
6.25
(5 7)2 = 4
2 + 1.25(4) = 7.00
4.5
(4.5 7)2 = 6.25
2 + 1.25(2) = 4.50
6.25
9.5
(9.5 7)2 = 6.25
2 + 1.25(5) = 8.25
1.5625
1.563
(Y Y)2 = 22.5
Y=7
SST = 22.5
^2
(Y Y)
= 6.875
SSE
= 6.875
(Y Y)2 =
15.625
SSR = 15.625
Table 4.3
4 21
Measuring the Fit

Sum of the squares total
For Triple
A Construction
2
SST (Y Y )
SST = 22.5
Sum of the squared error SSE = 6.875
SSR=2 15.625
2
SSE e (Y Y )
Sum of squares due to regression
SSR (Y Y )2
An important relationship
SST SSR SSE

SSR explained variability
SSE unexplained variability
4 22
Measuring the Fit

12
Y = 2 + 1.25X
10
^
YY
Sales ($100,000)
8
^
YY
YY
4
2
0
|
1
|
2
|
|
|
3
4
5
Payroll ($100 million)
|
6
|
7
|
8
Figure 4.2
4 23
Coefficient of Determination
The proportion of the variability in Y explained by
regression equation is called the coefficient of

determination
The coefficient of determination is r2
SSR
SSE
2
r
1
SST
SST
For Triple A Construction
15.625
r
0.6944
22.5
2
About 69% of the variability in Y is explained by
the equation based on payroll (X)
4 24
Correlation Coefficient
The correlation coefficient is an expression of the
strength of the linear relationship

It will always be between +1 and 1
The correlation coefficient is r
r r2
r 0.6944 0.8333
4 25
Correlation Coefficient
Y
*
** *
*
** *
* *
* *
*
*
Y
(a) Perfect Positive X

Correlation:
r = +1
* **
* * * *
*
* *** *
(c) No Correlation: X
Figure 4.3
r=0
(b) Positive
Correlation:
0<r<1
(d) Perfect Negative X

Correlation:
r = 1
4 26
Using Computer Software

for Regression
Program 4.1A
4 27

for Regression
Program 4.1B
4 28

for Regression
Program 4.1C
4 29

for Regression
Program 4.1D
4 30

for Regression
Correlation coefficient is
called Multiple R in Excel
Program 4.1D
4 31
Assumptions of the Regression Model

If we make certain assumptions about the errors
in a regression model, we can perform statistical

tests to determine if the model is useful
1.
2.
3.
4.
Errors are independent

Errors are normally distributed
Errors have a mean of zero
Errors have a constant variance
A plot of the residuals (errors) will often highlight
any glaring violations of the assumption
4 32
Residual Plots
Error
A random plot of residuals
X
Figure 4.4A
4 33
Residual Plots
Nonconstant error variance
Errors increase as X increases, violating the
Error
constant variance assumption
X
Figure 4.4B
4 34
Residual Plots
Nonlinear relationship
Errors consistently increasing and then consistently
Error
decreasing indicate that the model is not linear
X
Figure 4.4C
4 35
Estimating the Variance

Errors are assumed to have a constant
variance ( 2), but we usually dont know

this
It can be estimated using the mean
squared error (MSE),
MSE s2
SSE
s MSE
n k 1
2
where
n = number of observations in the sample
k = number of independent variables
4 36
Estimating the Variance

SSE
6.8750 6.8750
s MSE
1.7188
n k 1 6 1 1
4
2
We can estimate the standard deviation, s

This is also called the standard error of the
estimate or the standard deviation of the

regression
s MSE 1.7188 1.31
4 37

When the sample size is too small, you
can get good values for MSE and r2 even if

there is no relationship between the
variables
Testing the model for significance helps
determine if the values are meaningful
We do this by performing a statistical
hypothesis test
4 38

We start with the general linear model
Y 0 1X
1 = 0, the null hypothesis is that there is

no relationship between X and Y
The alternate hypothesis is that there is a
linear relationship ( 1 0)
If
If the null hypothesis can be rejected, we
have proven there is a relationship

We use the F statistic for this test
4 39

The F statistic is based on the MSE and MSR
SSR
MSR
k
where
k = number of independent variables in the

model
The F statistic is
MSR
F
MSE
This describes an F distribution with

degrees of freedom for the numerator = df1 = k
degrees of freedom for the denominator = df2 = n k 1
4 40

If there is very little error, the MSE would be
small and the F-statistic would be large

indicating the model is useful
If the F-statistic is large, the significance
level (p-value) will be low, indicating it is
unlikely this would have occurred by
chance
So when the F-value is large, we can reject
the null hypothesis and accept that there is
a linear relationship between X and Y and
the values of the MSE and r2 are meaningful
4 41
Steps in a Hypothesis Test

1. Specify null and alternative hypotheses
H 0 : 1 0
H1 : 1 0
2. Select the level of significance ( ). Common

values are 0.01 and 0.05
3. Calculate the value of the test statistic using the
formula
MSR
F
MSE
4 42
Steps in a Hypothesis Test

4. Make a decision using one of the following
methods
a) Reject the null hypothesis if the test statistic is

greater than the F-value from the table in Appendix D.
Otherwise, do not reject the null hypothesis:
Reject if Fcalculated F ,df1 ,df2
df1 k
df 2 n k 1
b) Reject the null hypothesis if the observed significance

level, or p-value, is less than the level of significance
( ). Otherwise, do not reject the null hypothesis:
p - value P ( F calculated test statistic )
Reject if p - value
4 43
Step 1.
Step 2.
H0 : 1 = 0
(no linear
relationship between X and Y)
H1 : 1 0
(linear
relationship exists between X
and Y)
Select = 0.05
Step 3.
Calculate the value of the test
statistic
SSR 15.6250
MSR
15.6250
k
1
MSR 15.6250
F
9.09
MSE 1.7188
4 44
Step 4.
Reject the null hypothesis if the test statistic
is greater than the F-value in Appendix D
df1 = k = 1
df2 = n k 1 = 6 1 1 = 4
The value of F associated with a 5% level of
significance and with degrees of freedom 1
and 4 is found in Appendix D
F0.05,1,4 = 7.71
Fcalculated = 9.09
Reject H0 because 9.09 > 7.71
4 45
We can conclude there is a
statistically significant
relationship between X and Y
The r2 value of 0.69 means
about 69% of the variability
in sales (Y) is explained by
local payroll (X)
0.05
F = 7.71
Figure 4.5
9.09
4 46
r2 coefficient of determination
The F-test determines whether or not there is
a relationship between the variables.

r2 (coefficient of determination) is the best
measure of the strength of the prediction
relationship between the X and Y variables.
Values closer to 1 indicate a strong prediction
relationship.
Good regression models have a low significance
level for the F-test and high r2 value.
4 47
Coefficient Hypotheses
Statistical tests of significance can be performed on
the coefficients.
The null hypothesis is that the coefficient of X (i.e.,
the slope of the line) is 0 i.e., X is not useful in
predicting Y
P values are the observed significance level and can
be used to test the null hypothesis.
Values less than 5% negate the null hypothesis and
indicate that X is useful in predicting Y
For a simple linear regression, the test of the
regression coefficients gives the same information

as the F-test.
4 48
Analysis of Variance (ANOVA) Table

When software is used to develop a regression
model, an ANOVA table is typically created that

shows the observed significance level (p-value)
for the calculated F value
This can be compared to the level of significance
( ) to make a decision
DF
SS
MS
Regression
SSR
MSR = SSR/k
Residual
n-k-1
SSE
MSE =
SSE/(n - k - 1)
Total
n-1
SST
SIGNIFICANCE
MSR/MSE
P(F > MSR/MSE)
Table 4.4
4 49
ANOVA for Triple A Construction
Program 4.1D
(partial)
P(F > 9.0909) = 0.0394

Because this probability is less than 0.05, we
reject the null hypothesis of no linear relationship

and conclude there is a linear relationship
between X and Y
4 50

Multiple regression models are
extensions to the simple linear model

and allow the creation of models with
several independent variables
Y = 0 + 1 X1 + 2 X2 + + k Xk +
where
Y=
dependent variable (response variable)
Xi =
ith independent variable (predictor or
explanatory variable)
0 =
intercept (value of Y when all Xi = 0)
I =
coefficient of the ith independent variable
k=
number of independent variables
=
random error
4 51

To estimate these values, a sample is taken
the following equation developed
Y b0 b1 X 1 b2 X 2 ... bk X k
where
Y =
predicted value of Y
b0 = sample intercept (and is an estimate
of 0)
bi =
sample coefficient of the ith variable
(and is an estimate of i)
4 52
Jenny Wilson Realty

Jenny Wilson wants to develop a model to
determine the suggested listing price for houses

based on the size and age of the house
Y b0 b1 X 1 b2 X 2 ... bk X k
where
She
=
predicted value of dependent
variable (selling price)
b0 =
Y intercept
X1 and X2 =
value of the two independent
variables (square footage and age)
respectively
b1 and b2 =
slopes for X1 and X2
selects
a sample of houses that have sold
respectively
recently and records the data shown in Table 4.5
4 53
Jenny Wilson Realty

SELLING
PRICE ($)
Table 4.5
SQUARE
FOOTAGE
AGE
95,000
1,926
30
Good
119,000
2,069
40
Excellent
124,800
1,720
30
Excellent
135,000
1,396
15
Good
142,000
1,706
32
Mint
145,000
1,847
38
Mint
159,000
1,950
27
Mint
165,000
2,323
30
Excellent
182,000
2,285
26
Mint
183,000
3,752
35
Good
200,000
2,300
18
Good
211,000
2,525
17
Good
215,000
3,800
40
Excellent
219,000
1,740
12
Mint
CONDITION
4 54
Jenny Wilson Realty
Program 4.2
Y 146631 44 X 1 2899 X 2
4 55
Evaluating Multiple Regression Models

Evaluation is similar to simple linear
regression models
The p-value for the F-test and r2 are
interpreted the same
The hypothesis is different because there
is more than one independent variable
The F-test is investigating whether all
the coefficients are equal to 0
4 56
Evaluating Multiple Regression Models

To determine which independent
variables are significant, tests are

performed for each variable
H 0 : 1 0
H1 : 1 0
The test statistic is calculated and if the
p-value is lower than the level of

significance ( ), the null hypothesis is
rejected
4 57
Jenny Wilson Realty

The model is statistically significant
The p-value for the F-test is 0.002
r2 = 0.6719 so the model explains about 67% of
the variation in selling price (Y)

But the F-test is for the entire model and we cant
tell if one or both of the independent variables are
significant
By calculating the p-value of each variable, we can
assess the significance of the individual variables
Since the p-value for X1 (square footage) and X2
(age) are both less than the significance level of
0.05, both null hypotheses can be rejected
4 58
Binary or Dummy Variables

Binary (or dummy or indicator)
indicator variables
are special variables created for

qualitative data
A dummy variable is assigned a value of
1 if a particular condition is met and a
value of 0 otherwise
The number of dummy variables must
equal one less than the number of
categories of the qualitative variable
4 59
Jenny Wilson Realty

Jenny believes a better model can be developed if
she includes information about the condition of

the property
X3 = 1 if house is in excellent condition

= 0 otherwise
X4 = 1 if house is in mint condition
= 0 otherwise
Two dummy variables are used to describe the
three categories of condition
No variable is needed for good condition since
if both X3 and X4 = 0, the house must be in good
condition
4 60
Jenny Wilson Realty
Program 4.3
4 61
Jenny Wilson Realty
Y 121,658 56.43 X 1 3,962 X 2 33,162 X 3 47,369 X 4

Model explains about
90% of the variation
in selling price
F-value
indicates
significance
Program 4.3
Low p-values
indicate each
variable is
significant
4 62
Model Building
The best model is a statistically significant
model with a high r2 and few variables
As more variables are added to the model, the
r2-value usually increases

For this reason, the adjusted r2 value is often
used to determine the usefulness of an
additional variable
The adjusted r2 takes into account the number
of independent variables in the model
When variables are added to the model, the
value of r2 can never decrease; however, the
adjusted r2 may decrease.
4 63
Model Building
The formula for r2
r2
SSR
SSE
1
SST
SST
The formula for adjusted r2
SSE /( n k 1)
Adjusted r 1
SST /( n 1)
2
As the number of variables increases, the
adjusted r2 gets smaller unless the increase due to

the new variable is large enough to offset the
change in k
4 64
Model Building
It is tempting to keep adding variables to a model
to try to increase r2
The adjusted r2 will decrease if additional
independent variables are not beneficial.
As the number of variables (k) increases, n-k-1
decreases.
This causes SSE/(n-k-1) to increase which in turn
decreases the adjusted r2 unless the extra variable
causes a significant decrease in SSE
The reduction in error (and SSE) must be sufficient
to offset the change in k
4 65
Model Building
In general, if a new variable increases the
adjusted r2, it should probably be included in the

model
In some cases, variables contain duplicate
information
When two independent variables are correlated,
they are said to be collinear (e.g., monthly salary
expenses and annual salary expenses)
When more than two independent variables are
correlated, multicollinearity exists
When multicollinearity is present, hypothesis
tests for the individual coefficients are not valid
but the model may still be useful
4 66
Nonlinear Regression
In some situations, variables are not linear
Transformations may be used to turn a
nonlinear model into a linear model
*
** *
***
*
Linear relationship
*
* **
* **
*
*
*
Nonlinear relationship
4 67
Colonel Motors
The engineers want to use regression analysis to
improve fuel efficiency

They have been asked to study the impact of
weight on miles per gallon (MPG)
MPG
WEIGHT
(1,000 LBS.)
MPG
WEIGHT
(1,000 LBS.)
12
4.58
20
3.18
13
4.66
23
2.68
15
4.02
24
2.65
18
2.53
33
1.70
19
3.09
36
1.95
19
3.11
42
1.92
Table 4.6
4 68
Colonel Motors
45
40
35
30
MPG
Linear model
Y b0 b1 X 1
25
20
15
10
5
0
Figure 4.6A
1.00
2.00
3.00
4.00
5.00
Weight (1,000 lb.)

4 69
Colonel Motors
Program 4.4
A useful model with a small F-test for
significance and a good r2 value
4 70
Colonel Motors
45
40
35
30
MPG
Nonlinear model
MPG b0 b1( weight ) b2 ( weight )2
25
20
15
10
5
0
Figure 4.6B
1.00
2.00
3.00
4.00
5.00
Weight (1,000 lb.)

4 71
Colonel Motors
The nonlinear model is a quadratic model
The easiest way to work with this model is to
develop a new variable
X 2 ( weight)2
This gives us a model that can be solved with
linear regression software
Y b0 b1 X 1 b2 X 2
4 72
Colonel Motors
Y 79.8 30.2 X 1 3.4 X 2
Program 4.5
A better model with a smaller F-test for
significance and a larger adjusted r2 value

4 73
Cautions and Pitfalls

If the assumptions are not met, the statistical
test may not be valid

Correlation does not necessarily mean causation
Your annual salary and the price of cars may be
correlated but one does not cause the other
Multicollinearity makes interpreting coefficients
problematic, but the model may still be good

Using a regression model beyond the range of X
is questionable, the relationship may not hold
outside the sample data
4 74
Cautions and Pitfalls

t-tests for the intercept (b0) may be ignored
as this point is often outside the range of

the model
A linear relationship may not be the best
relationship, even if the F-test returns an
acceptable value
A nonlinear relationship can exist even if a
linear relationship does not
Just because a relationship is statistically
significant doesn't mean it has any
practical value
4 75

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Chapter 4

2008 Prentice-Hall, Inc.

2009 Prentice-Hall, Inc.

Testing the Model for Significance

2009 Prentice-Hall, Inc.

tool for a manager

Understand the relationship between

the dependent variable

Sometimes called the response variable

The value of this variable depends on

the value of the independent variable

2009 Prentice-Hall, Inc.

Graphing is a helpful way to investigate

2009 Prentice-Hall, Inc.

renovation work is dependent on the area

Simple Linear Regression

relationship between variables (predict sales

Simple Linear Regression

known so they are estimated using sample data

= dependent variable (response)

2009 Prentice-Hall, Inc.

based on area payroll

minimizes the errors

Error = (Actual value) (Predicted value)

2009 Prentice-Hall, Inc.

Least Squares Regression

2009 Prentice-Hall, Inc.

values of the intercept and slope can be

2009 Prentice-Hall, Inc.

If the payroll next

Measuring the Fit

for any variables X and Y

the positive and negative errors would

Three measures of variability are

Measuring the Fit

Sum of the squared error

Sum of squares due to regression

SST SSR SSE

Measuring the Fit

(4.5 7)2 = 6.25

(9.5 7)2 = 6.25

2009 Prentice-Hall, Inc.

Measuring the Fit

SST SSR SSE

2009 Prentice-Hall, Inc.

Measuring the Fit

regression equation is called the coefficient of

About 69% of the variability in Y is explained by

the equation based on payroll (X)

2009 Prentice-Hall, Inc.

strength of the linear relationship

2009 Prentice-Hall, Inc.

(a) Perfect Positive X

(d) Perfect Negative X

Using Computer Software

2009 Prentice-Hall, Inc.

Using Computer Software

Using Computer Software

Using Computer Software

Using Computer Software

Assumptions of the Regression Model

in a regression model, we can perform statistical

Errors are independent