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4

Regression
Models

To accompany
Quantitative Analysis for Management, Twelfth Edition,
by Render, Stair, Hanna and Hale
Power Point slides created by Jeff Heyl Copyright ©2015 Pearson Education, Inc.
LEARNING OBJECTIVES
After completing this chapter, students will be able to:

1. Identify variables and use them in a regression model

2. Develop simple linear regression equations from
sample data and interpret the slope and intercept
3. Compute the coefficient of determination and the
coefficient of correlation and interpret their meanings
4. Interpret the F test in a linear regression model
5. List the assumptions used in regression and use
residual plots to identify problems

LEARNING OBJECTIVES
After completing this chapter, students will be able to:

6. Develop a multiple regression model and use it for

prediction purposes
7. Use dummy variables to model categorical data
8. Determine which variables should be included in a
multiple regression model
9. Transform a nonlinear function into a linear one for use
in regression
10. Understand and avoid common mistakes made in the
use of regression analysis

CHAPTER OUTLINE
4.1 Introduction
4.2 Scatter Diagrams
4.3 Simple Linear Regression
4.4 Measuring the Fit of the Regression Model
4.5 Assumptions of the Regression Model
4.6 Testing the Model for Significance

CHAPTER OUTLINE
4.7 Using Computer Software for Regression
4.8 Multiple Regression Analysis
4.9 Binary or Dummy Variables
4.10 Model Building
4.11 Nonlinear Regression
4.12 Cautions and Pitfalls in Regression Analysis

Introduction
• Regression analysis – very valuable tool for a
manager
– Understand the relationship between variables
– Predict the value of one variable based on another
variable
• Simple linear regression models have only
two variables
• Multiple regression models have more than
one independent variable

Introduction
• Variable to be predicted is called the
dependent variable or response variable
– Value depends on the value of the independent
variable(s)
– Explanatory or predictor variable

Dependent Independent Independent

variable
= variable
+ variable

Scatter Diagram
• Scatter diagram or scatter plot often used to
investigate the relationship between variables
– Independent variable normally plotted on X axis
– Dependent variable normally plotted on Y axis

Triple A Construction
• Triple A Construction renovates old homes
• The dollar volume of renovation work is
dependent on the area payroll
TABLE 4.1

TRIPLE A’S SALES LOCAL PAYROLL

(\$100,000s) (\$100,000,000s)
6 3
8 4
9 6
5 4
4.5 2
9.5 5
Triple A Construction
Figure 4.1 – Scatter Diagram

12 –

10 –
Sales (\$100,000)

8–

6–

4–

2–

0 |– | | | | | | | |
0 1 2 3 4 5 6 7 8
Payroll (\$100 million)

Simple Linear Regression
• Regression models used to test relationships
between variables
– Random error

Y = b0 + b1 X + e

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
e = random error

Simple Linear Regression
• True values for the slope and intercept are not
known
– Estimated using sample data

Ŷ = b0 + b1 X

where
^
Y = predicted value of Y
b0 = estimate of β0, based on sample results
b1 = estimate of β1, based on sample results

Triple A Construction
• Predict sales based on area payroll
Y = Sales
X = Area payroll
– The line Figure 4.1 minimizes the errors
Error = (Actual value) – (Predicted value)

e =Y - Yˆ
– Regression analysis minimizes the sum of squared
errors
– Least-squares regression
Triple A Construction
• Formulas for simple linear regression,
intercept and slope
Ŷ = b0 + b1 X

X=
å X
= average (mean) of X values
n

Y=
åY = average (mean) of Y values
n

b1 =
å(X - X )(Y -Y )
å (X - X ) 2

b0 = Y - b1 X
Triple A Construction
TABLE 4.2 – Regression calculations

Y X (X – X)2 (X – X)(Y – Y)
6 3 (3 – 4)2 = 1 (3 – 4)(6 – 7) = 1
8 4 (4 – 4)2 = 0 (4 – 4)(8 – 7) = 0
9 6 (6 – 4)2 = 4 (6 – 4)(9 – 7) = 4
5 4 (4 – 4)2 = 0 (4 – 4)(5 – 7) = 0
4.5 2 (2 – 4)2 = 4 (2 – 4)(4.5 – 7) = 5
9.5 5 (5 – 4)2 = 1 (5 – 4)(9.5 – 7) = 2.5
ΣY = 42 ΣX = 24 Σ(X – X)2 = 10 Σ(X – X)(Y – Y) = 12.5
Y = 42/6 = 7 X = 24/6 = 4

Triple A Construction
• Regression calculations

X=
å X 24
= =4 Y=
åY 42
= =7
6 6 6 6

b =
å (X – X )(Y –Y ) 12.5
= = 1.25
1
å(X – X ) 10 2

b0 = Y - b1 X = 7 – (1.25)(4) = 2

Therefore Ŷ = 2 + 1.25X

Triple A Construction
• Regression calculations

X=
å = =4 Y=
å
X 24 sales = 2 + 1.25(payroll)
Y 42
= =7
6 6 6 6
If the payroll next

b1 =
å (X – X )(Yyear
–Y )is \$600
=
12.5 million
= 1.25
å(X – XŶ )= 2 + 1.25(6)
2
10
= 9.5 or \$ 950,000
b0 = Y - b1 X = 7 – (1.25)(4) = 2

Therefore Ŷ = 2 + 1.25X

Measuring the Fit
of the Regression Model
• Regression models can be developed for any
variables X and Y
• How helpful is the model in predicting Y?
• With average error positive and negative
errors cancel each other out
• Three measures of variability
– SST – Total variability about the mean
– SSE – Variability about the regression line
– SSR – Total variability that is explained by the
model

Measuring the Fit
of the Regression Model
• Sum of squares total
SST = å(Y -Y )2
• Sum of squares error
SSE = å e2 = å(Y - Ŷ )2
• Sum of squares regression
SSR = å(Yˆ -Y )2
• An important relationship
SST = SSR + SSE
Measuring the Fit
of the Regression Model
TABLE 4.3 – Sum of Squares for Triple A Construction

^ ^ ^
Y X (Y – Y)2 Y (Y – Y)2 (Y – Y)2
6 3 (6 – 7)2 = 1 2 + 1.25(3) = 5.75 0.0625 1.563

9.5 5 (9.5 – 7)2 = 6.25 2 + 1.25(5) = 8.25 1.5625 1.563

^2 ^
∑(Y – Y)2 = 22.5 ∑(Y – Y) = 6.875 ∑(Y – Y)2 = 15.625
Y=7 SST = 22.5 SSE = 6.875 SSR = 15.625

Measuring the Fit
of the Regression Model
• Sum of squares total
å
SST = For
(Y -Y )
Triple
2
A Construction
• Sum of squares error SST = 22.5
SSE =2 6.875
SSE = å e = å(Y - Ŷ )
2
SSR = 15.625
• Sum of squares regression
SSR = å(Yˆ -Y )2
• An important relationship
SST = SSR + SSE
Measuring the Fit
of the Regression Model
FIGURE 4.2 – Deviations from the Regression Line and from the Mean

12 –
Ŷ = 2 + 1.25X
10 –
Y – Ŷ
Sales (\$100,000)

8– Y –Y
Yˆ – Y Y
6–

4–

2–

0 |– | | | | | | | |
0 1 2 3 4 5 6 7 8
Payroll (\$100 million)

Coefficient of Determination
• The proportion of the variability in Y explained
by the regression equation
– The coefficient of determination is r2.

SSR SSE
r2 = =1 –
SST SST

– For Triple A Construction

15.625
r2 = = 0.6944
22.5

Coefficient of Determination
• The proportion of the variability in Y explained
by the regression equation
– The coefficient of determination is r2.

SSE69% of the
r = = 1 variability
– 2

SST SST in Y is
explained by the equation
– For Triple A Construction based on payroll (X)
15.625
r2 = = 0.6944
22.5

Correlation Coefficient
• An expression of the strength of the linear
relationship
– Always between +1 and –1
– The correlation coefficient is r

r = ± r2

– For Triple A Construction

r = 0.6944 = 0.8333

Four Values of the
FIGURE 4.3
Correlation Coefficient
Y Y

(a) Perfect Positive X (b) Positive X

Correlation: Correlation:
r = +1 0<r<1
Y Y

(c) No Correlation: X (d) Perfect Negative X

r=0 Correlation:
r = –1
Assumptions of the
Regression Model
• With certain assumptions about the errors,
statistical tests can be performed to determine
the model’s usefulness
1. Errors are independent
2. Errors are normally distributed
3. Errors have a mean of zero
4. Errors have a constant variance
• A plot of the residuals (errors) often highlights
glaring violations of assumptions

Residual Plots
FIGURE 4.4A – Pattern of Errors Indicating Randomness
Error

Residual Plots
FIGURE 4.4B – Nonconstant error variance
Error

Residual Plots
FIGURE 4.4C – Errors Indicate Relationship is not Linear
Error

Estimating the Variance
• Errors are assumed to have a constant
variance ( 2), usually unknown
– Estimated using the mean squared error (MSE),
s2
SSE
s 2 = MSE =
n - k -1

where
n = number of observations in the sample
k = number of independent variables

Estimating the Variance
• For Triple A Construction
SSE 6.8750 6.8750
s = MSE =
2
= = = 1.7188
n - k -1 6-1-1 4

– Estimate the standard deviation, s

– The standard error of the estimate or the
standard deviation of the regression

s= MSE = 1.7188 = 1.31

Testing the Model for Significance

• 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
– Performing a statistical hypothesis test

Testing the Model for Significance

Y = b0 + b1 X + e

– If 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 the null hypothesis can be rejected, we have
proven there is a relationship
– We use the F statistic

Testing the Model for Significance

• 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
Describes an F distribution with:
degrees of freedom for the numerator = df1 = k
degrees of freedom for the denominator = df2 = n – k – 1
Testing the Model for Significance

• If there is very little error, MSE would be small

and the F statistic would be large – model is
useful
• If the F statistic is large, the significance level
(p-value) will be low, – unlikely would have
occurred by chance
• 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

Steps in a Hypothesis Test
1. Specify null and alternative hypotheses
H 0 : b1 = 0
H1 : b1 ¹ 0

2. Select the level of significance ()

Common values are 0.01 and 0.05.
3. Calculate the value of the test statistic

MSR
F=
MSE

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 > Fa,df1,df2
df1 = k
df2 = 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 < a
Triple A Construction
Step 1
H0: 1 = 0 (no linear relationship between X and Y)
H1: 1 ≠ 0 (linear relationship exists between X and Y)

Step 2
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
Triple A Construction
• 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
Triple A Construction
FIGURE 4.5
– 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 9.09

Analysis of Variance (ANOVA) Table
• With software models, 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
TABLE 4.4

DF SS MS F SIGNIFICANCE
Regression k SSR MSR = SSR/k MSR/MSE P(F > MSR/MSE)

Residual n - k - 1 SSE MSE =

SSE/(n - k - 1)
Total n-1 SST

ANOVA for Triple A Construction
PROGRAM 4.1C – Excel Output for Triple A Construction

P(F > 9.0909) = 0.0394

Using Software
PROGRAM 4.1A – Accessing the Regression Option in Excel

Using Software
PROGRAM 4.1B – Data Input

Using Software
PROGRAM 4.1C – Excel Output

Using Software
PROGRAM 4.2A – Using Excel QM

Using Software
PROGRAM 4.2B – Initializing the Spreadsheet

Using Software
PROGRAM 4.2C – Input and Results

Using Software
PROGRAM 4.3A – QM for Windows Regression Option in Forecasting Module

Using Software
PROGRAM 4.3B – QM for Windows Screen to Initialize the Problem

Using Software
PROGRAM 4.3C – Data Input

Using Software
PROGRAM 4.3D – QM for Windows Output

Multiple Regression Analysis
• Extensions to the simple linear model
• Models with more than one independent
variable
Y = 0 + 1X1 + 2X2 + … + kXk + e
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
e= random error

Multiple Regression Analysis
• To estimate these values, a sample is taken
the following equation developed

Ŷ = b0 + b1 X1 + b2 X 2 +... + bk X k
Where
Yˆ = predicted value of Y
b0 = sample intercept (an estimate of 0)
bi = sample coefficient of the ith variable (an estimate of i)

Jenny Wilson Realty
• Develop a model to determine the suggested
listing price for houses based on the size and
age of the house
Ŷ = b0 + b1 X1 + b2 X 2
where
Yˆ = 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 respectively
– Selects a sample of houses that have sold
recently and records the data
Jenny Wilson Real Estate Data
TABLE 4.5
SELLING SQUARE
AGE CONDITION
PRICE (\$) FOOTAGE
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
Jenny Wilson Realty
PROGRAM 4.2A – Input Screen for the Jenny Wilson Realty Multiple Regression Example

Jenny Wilson Realty
Program 4.2B – Excel Output

Yˆ = b0 + b1 X 1 + b2 X 2
= 146,630.89 + 43.82X 1 - 2898.69X 2
Evaluating Multiple
Regression Models
• Similar to simple linear regression models
• The p-value for the F test and r2 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 at the same time

Evaluating Multiple
Regression Models
• To determine which independent variables are
significant, tests are performed for each
variable
H 0 : b1 = 0
H1 : b1 ¹ 0

• The test statistic is calculated and if the p-

value is lower than the level of significance
(), the null hypothesis is rejected
Jenny Wilson Realty
• Full model is statistically significant
– Useful in predicting selling price
p-value for F test = 0.002 r2 = 0.6719

• Are both variables significant? H 0 : b1 = 0

– For X1 (square footage) H1 : b1 ¹ 0
For  = 0.05, p-value = 0.0013 null hypothesis is rejected

– For X1 (age)
For  = 0.05, p-value = 0.0039 null hypothesis is rejected
Jenny Wilson Both
Realty
square footage
in predicting the
• Full model is statistically significant
selling price
– Useful in predicting selling price
p-value for F test = 0.002 r2 = 0.6719

• Are both variables significant? H 0 : b1 = 0

– For X1 – square footage H1 : b1 ¹ 0
For  = 0.05, p-value = 0.0013 null hypothesis is rejected

– For X1 – age
For  = 0.05, p-value = 0.0039 null hypothesis is rejected
Binary or Dummy Variables
• Binary (or dummy or 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

Jenny Wilson Realty
• A better model can be developed if
information about the condition of the property
is included
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
Jenny Wilson Realty
PROGRAM 4.5A – Excel Input Screen with Dummy Variables

Jenny Wilson Realty
PROGRAM 4.5B – Excel Output with Dummy Variables

Ŷ = 121,658 + 56.43X1 – 3,962X 2 + 33,162X 3 + 47,369X 4

Jenny Wilson Realty
PROGRAM 4.5B – Excel Output with Dummy Variables

Coefficient of
determination,
r2 = 0.898

Ŷ = 121,658 + 56.43X1 – 3,962X 2 + 33,162X 3 + 47,369X 4

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 increases
• For this reason, the adjusted r2 value is often
used to determine the usefulness of an
• The adjusted r2 takes into account the
number of independent variables in the model

Model Building
• The formula for r2
SSR SSE
r2 = = 1-
SST SST
• The formula for adjusted r2
SSE / (n - k -1)

SST / (n -1)
• 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
Model Building
• The formula for r2In general, if a new variable
increases the adjusted r2, it should
SSR SSE
r 2 = probably
= 1- be included in the model
SST SST
• The formula for adjusted r2
SSE / (n - k -1)

SST / (n -1)
• 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
Model Building
• Stepwise regression systematically adds or
deletes independent variables
• A forward stepwise procedure puts the most
significant variable in first, adds the next
variable that will improve the model the most
• Backward stepwise regression begins with all
the independent variables and deletes the

Model Building
• In some cases variables contain duplicate
information
• When two independent variables are
correlated, they are said to be collinear
• 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

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

Colonel Motors
• Use regression analysis to improve fuel
efficiency
– Study the impact of weight on miles per gallon (MPG)

TABLE 4.6

WEIGHT WEIGHT
MPG (1,000 LBS.) MPG (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
Colonel Motors
FIGURE 4.6A – Linear Model for MPG Data

45 –

40 –

35 –

30 –

25 –
MPG

20 –

15 –

10 –

5–

0 |– | | | | |
1.00 2.00 3.00 4.00 5.00
Weight (1,000 lb.)

Colonel Motors
Useful model
PROGRAM 4.6 – Excel Output for Linear Regression Model with MPG Data
Small F test for significance
Good r2 value

Ŷ = 47.6 - 8.2X1 or MPG = 47.6 – 8.2 (weight in 1,000 lb.)

Colonel Motors
FIGURE 4.6B – Nonlinear Model for MPG Data

45 –

40 –

35 –

30 –

25 –
MPG

20 –

15 –

10 –

5–

0 |– | | | | |
1.00 2.00 3.00 4.00 5.00
Weight (1,000 lb.)

Colonel Motors
• The nonlinear model is a quadratic model
• The easiest approach – develop a new variable
X 2 = (weight)2

• New model
Ŷ = b0 + b1 X1 + b2 X 2

Colonel Motors
Improved model
PROGRAM 4.7 – Excel Output for Nonlinear Regression Model with MPG Data
Small F test for significance
Adjusted r2 and r2 both increased

Ŷ = 79.8 - 30.2X1 + 3.4X 2

Cautions and Pitfalls
• If the assumptions are not met, the statistical
test may not be valid
• Correlation does not necessarily mean
causation
• Multicollinearity makes interpreting
coefficients problematic, but the model may
still be good
• Using a regression model beyond the range
of X is questionable, as the relationship may
not hold outside the sample data

Cautions and Pitfalls
• A t-test 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
• Even though a relationship is statistically
significant it may not have any practical value