BUAD 812 – Analysis for Business Decision

Course Outline
MODULE 1: A Conspectus to Investment Opportunities and Investment
Decisions Under Risk and Uncertainty Situations
Study Session 1: Business Decision Analysis
Study Session 2: Descriptive Analysis of Survey Data
Study Session 3: Meaning of Linear Programming
Study Session 4: Simplex Approach to solving Linear Programming
MODULE 2: Investment Decision’s Programming Approach and
Investment Cost of Capital Evaluation
Study Session 1: Simplex Approach to solving Linear Programming II
Study Session 2: Transportation Model
Study Session 3: Vogel Approximation Method
Study Session 4: Queuing Theory
MODULE 3: Evaluation of Non-monetary Aspects of Projects and Further
Issues on Investment and Project Appraisal
Study Session 1: Ratio Analysis
Study Session 2: Decision Making Under Risk and Uncertainty
Study Session 3: Regression Analysis
Study Session 4: Time Series Analysis
Study Session 5: Simulation
Business Decision Analysis
Decision Analysis has been defined as a logical procedure of balancing the factors that
influence a decision. According to Howard (2004), the procedure incorporates uncertainties,
values, and preferences in a basic structure that involves the decision. Typically, it includes
technical, marketing, competitive, and environmental factors.
The major components that constitute risk and uncertainty in decision making are:
• Decision alternatives - These are alternative courses of action available to the decision
maker. The alternatives should be feasible and evaluating them will depend on the
availability of a well-defined objective. E.g. choice of product to manufacture.
• States of Nature – A future occurrence for which the decision maker has no control over.
• The decision itself - A choice which is arrived at after considering all alternatives
available given an assumed future state of nature. In the view of Dixon-Ogbechi (2001),
“A good decision is based on logic, considers all available data, and possible alternative
and employs quantitative technique.
• Decision screening criteria - These criteria form the basis upon which alternatives are
compared.
Phases of Decision Analysis
Grouped into four phases. Also known as the decision analysis cycle.
1. Deterministic Analysis Phase: This phase accounts for certainties rather than
uncertainties. Here, graphical and diagrammatic models like influence diagrams and flow
charts can be translated into mathematical models.
2. Probabilistic Analysis: Probabilistic analyses cater for uncertainties in the decision-
making process. We can use the decision tree as a tool for probabilistic analysis.
3. Evaluation Phase: At the phase, the alternative strategies are evaluated to enable one to
identify the decision outcomes that correspond to sequence of decisions and events.
4. Choice Activity Phase: This is the final phase of the decision analysis cycle. It is the
judgmental stage where the decision maker decides on the best strategy to adopt having
carefully analyses all other options.
Errors that Can Occur in Decision Making
• Inability to identify and specify key objectives: Identifying specific objectives gives the
decision maker a clear sense of direction.
• Focusing on the wrong problem: This could create distraction and will lead the decision
maker to an inappropriate solution.
• Not giving adequate thoughts to trade-offs which may be highly essential to the
decision-making process.
• Not taking uncertainty and risk into consideration.
• Lack of foresight about plan especially when decision has some risk over time.
Descriptive Statistics
Descriptive statistics is the analysis of data that helps describe, show or summarise data in a
meaningful way such that, for example, patterns might emerge from the data. They are
simply a way to describe our data.
Typically, there are two general types of statistic that are used to describe data
• Measures of central tendency: These are ways of describing the central position of a
frequency distribution for a group of data. Includes the mode, median, and mean.
• Measures of spread: These are ways of summarising a group of data by describing how
spread out the scores are. Includes the range, quartiles, absolute deviation, variance and
standard deviation.
Meaning of Linear Programming
Every linear programming problem, called the “primal problem,” has a corresponding or
symmetrical problem called the “dual problem.”
The technique of linear programming was formulated by a Russian mathematician L.V.
Kantorovich. But the present version of simplex method was developed by Geoge B. Dentzig
in 1947.
Linear programming (LP) is an important technique of operations research developed for
optimum utilisation of resources. The problem before any manager is to select only those
alternatives which can maximise the profit or minimise the cost of production.
In the words of William M. Fox, “Linear programming is a planning technique that permits
some objective function to be minimised or maximised within the framework of given
situational restrictions.
Characteristics of Linear Programming Model
1. Objective function: In business problems the objective is generally profit maximization
or cost minimization.
2. Constraints: These are limitations regarding resources
3. Non-negativity: The value of variables must be zero or positive and not negative.
4. Linearity: The relationships between variables must be linear.
5. Finiteness: The number of inputs and outputs need to be finite otherwise to compute
feasible solution is not possible.
Assumptions in Linear Programming Models
1. Proportionality: This assumption implies that if a product yields a profit of #10, the
profit earned from the sale of 12 such products will be # (10 x 12) = #120. This may not
always be true because of quantity discounts and variation in the manufacturing resources
cost.
2. Additivity: It means that if we use t1 hours on machine A to make product 1 and t2 hours
to make product 2, the total time required to make products 1 and 2 on machine A is t1 +
t2 hours. This, however, is true only if the change-over time from product 1 to product 2
is negligible. Some processes may not behave in this way. E.g. Chemical mixing.
3. Continuity: The decision variables are continuous i.e. they are permitted to take any non-
negative values that satisfy the constraints.
4. Certainty: The various parameters, namely, the objective function coefficients, R.H.S.
coefficients of the constraints and resource values in the constraints are certainly and
precisely known and that their values do not change with time.
5. Finite Choices: A linear programming model also assumes that a finite (limited) number
of choices (alternatives) are available to the decision-maker and that the decision
variables are interrelated and non-negative.
Advantages of Linear Programming
1. LP makes logical thinking and provides better insight into business problems.
2. Manager can select the best solution with the help of LP by evaluating the cost and profit
of various alternatives.
3. LP provides an information base for optimum allocation of scarce resources.
4. LP assists in planning according to changing conditions.
5. LP helps in solving multi-dimensional problems.
Disadvantages of Linear Programming
1. This technique could not solve the problems in which variables cannot be stated
quantitatively.
2. In some cases, the results of LP give a confusing and misleading picture. For example, the
result of this technique is for the purchase of 1.6 machines. It is very difficult to decide
whether to purchase one or two- machine because machine can be purchased in whole.
3. LP technique cannot solve the business problems of non-linear nature.
4. The factor of uncertainty is not considered in this technique.
5. This technique is highly mathematical and complicated.
6. If the numbers of variables or constrains involved in LP problems are quite large, then
using costly electronic computers become essential, which can be operated, only by
trained personnel.
7. Under this technique to explain clearly the objective function is difficult.
Areas of Application of Linear Programming
1. Industrial Applications
 Product mix problems: Typically, different products will have different selling prices,
will require different amounts of production capacity will, therefore, have different unit
profits; The problem is to determine the product mix that will maximise the total profit.
 Blending problems: These problems are likely to arise when a product can be made from
a variety of available raw materials of various compositions and prices. For instance,
different grades of gasoline are required for aviation purposes. The problem is to decide
the proportions of these raw materials so that:
o maximum output is obtained and
o storage capacity restrictions are satisfied.
 Production scheduling problems: Determination of optimum production schedule to
meet fluctuating demand. The objective is to meet demand, keep inventory and
employment at reasonable minimum levels, while minimising the total cost Production
and inventory.
 Trim loss problems: They are applicable to paper, sheet metal and glass manufacturing
industries where items of standard sizes must be cut to smaller sizes as per customer
requirements with the objective of minimising the waste produced.
 Assembly-line balancing: It relates to a category of problems wherein the final product
has several different components assembled. These components are to be assembled in a
specific sequence or set of sequences.
 Make-or-buy (sub-contracting) problems: Manufacturers, not being sure of the demand
pattern, is usually reluctant to add additional capacity and has to make a decision
regarding the products to be manufactured with his own resources and the products to be
sub-contracted so that the total cost is minimised.
2. Management Applications
 Media selection problems: They involve the selection of advertising mix among
different advertising media such as T.V., radio, magazines and newspapers that will
maximise public exposure to company’s product.
 Portfolio selection problems: They are frequently encountered by banks, financial
companies, insurance companies, investment services, etc. A given amount is to be
allocated among several investment alternatives such as bonds, saving certificates,
common stock, mutual fund, real estate, etc. to maximise the expected return or minimise
the expected risk.
 Profit planning problems: They involve planning profits on fiscal year basis to
maximise profit margin from investment in plant facilities, machinery, inventory and cash
on hand.
 Transportation problems: They involve transportation of products from, say, n sources
situated at different locations to, say, different destinations. Supply position at the
sources, demand at destinations, freight charges and storage costs, etc. are known and the
problem is to design the optimum transportation plan that minimises the total
transportation cost (or distance or time).
 Assignment problems: They are concerned with allocation of facilities (men or
machines) to jobs. Time required by each facility to perform each job is given and the
problem is to find the optimum allocation (one job to one facility) so that the total time to
perform the jobs is minimised.
 Man-power scheduling problems: They are faced by big hospitals, restaurants and
companies operating in few shifts. The problem is to allocate optimum manpower in each
shift so that the overtime cost is minimised.
3. Miscellaneous Applications
 Diet problems: Nutrient contents such as vitamins, proteins, fats, carbohydrates, starch,
etc. in each of several food stuffs is known. Also, the minimum daily requirement of each
nutrient in the diet as well as the cost of each type of food stuff is given and the problem
is to determine the minimum cost diet that satisfies the minimum daily requirement of
nutrients.
 Agriculture problems: These problems are concerned with the allocation of resources
such as acreage of land, water, labour, fertilisers & capital to various crops to maximise
net revenue.
 Flight scheduling problems: They are devoted to the determination of the most
economical patterns and timings of flights that result in the most efficient use of aircrafts
and crew.
 Environment protection: They involve analysis of different alternatives for efficient
waste disposal, paper recycling and energy policies.
 Facilities location: These problems are concerned with the determination of best location
of public parks, libraries and recreation areas, hospital ambulance depots, telephone
exchanges, nuclear power plants, etc.
Steeps Involved in Solving Linear Programming
• Standard form
• Introducing slack variables
• Creating the tableau
• Pivot variables
• Creating a new tableau
• Checking for optimality
• Identify optimal values
Ratio Analysis
The term 'ratio' refers to the mathematical relationship between any two inter-related
variables. In other words, it establishes relationship between two items expressed in
quantitative form.
Analysis or Interpretations of Ratios - The following approaches are usually found to exist:
a) Interpretation or Analysis of an Individual (or) Single ratio.
b) Interpretation or Analysis by referring to a group of ratios.
c) Interpretation or Analysis of ratios by trend.
d) Interpretations or Analysis by inter-firm comparison.
Principles of Ratio Selection
(1) Ratio should be logically inter-related.
(2) Pseudo ratios should be avoided.
(3) Ratio must measure a material factor of business.
(4) Cost of obtaining information should be borne in mind.
(5) Ratio should be in minimum numbers.
(6) Ratio should be facilities comparable.
Advantages of Ratio Analysis
1. It facilitates the accounting information to be summarised and simplified in a required
form.
2. It highlights the inter-relationship between the facts and figures of various segments of
business.
3. Ratio analysis helps to remove all type of wastages and inefficiencies.
4. It provides necessary information to the management to take prompt business decisions.
5. It helps to the management to effectively discharge its functions such as planning,
organising, controlling, directing and forecasting.
6. Ratio analysis reveals profitable and unprofitable activities.
7. Ratio analysis is used as a measuring rod for effective control of performance of business
activities.
8. Ratios are an effective means of communication about financial position of the business
concern to the proprietors, investors, creditors and other parties.
9. An effective tool for measuring the operating results of the enterprises.
10. It facilitates control over the operation as well as resources of the business.
11. Ratio analysis helps to determine the performance of liquidity, profitability and solvency
position of the business concern.
Limitations of Ratio Analysis
12. Ratio analysis is used based on financial statements. Number of limitations of financial
statements may affect the accuracy or quality of ratio analysis.
13. Ratio analysis heavily depends on quantitative facts and figures and it ignores qualitative
data. Therefore, this may limit accuracy.
14. Ratio analysis is a poor measure of a firm's performance due to lack of adequate standards
laid for ideal ratios.
15. It is not a substitute for analysis of financial statements. It is merely used as a tool for
measuring the performance of business activities.
16. Ratio analysis clearly has some latitude for window dressing.
17. It makes comparison of ratios between companies which is questionable due to
differences in methods of accounting operation and financing.
18. Ratio analysis does not consider the change in price level, as such, this ratio will not help
in drawing meaningful inferences.
Classification of Ratios
Accounting Ratios are classified based on the different parties interested in making use of the
ratios. A very large number of accounting ratios are used for the purpose of determining the
financial position of a concern for different purposes. Ratios may be broadly classified in to:
1. Classification of Ratios based on Balance Sheet.
2. Classification of Ratios based on Profit and Loss Account.
3. Classification of Ratios based on Mixed Statement (or) Balance Sheet and
Profit and Loss Account - This classification further grouped in to:
A. Liquidity Ratios
B. Profitability Ratios
C. Turnover Ratios
D. Solvency Ratios
E. Overall Profitability Ratios

Time Series/Trend Analysis

Time series data refers to observation of a variable over time. The data allows the analyst to
view the evolution of a variable
over a period. For instance: Sales, unemployment rate, inflation rate, cost of production, price
of oil, etc.
Components of a time series
1. Trend (T); 2. Cyclical (C); 3. Seasonal (S); 4. Irregular (I)
These components may be combined in different ways. It is usually assumed that they are
multiplied or added, i.e.,
Yt = T * C * S * I
Yt = T + C + S + I
1. Trend component - The trend is the long-term pattern of a time series. A trend can be
positive or negative depending on
whether the time series exhibits an increasing long-term pattern or a decreasing long-term
pattern.
2. Cyclical component - Any pattern showing an up and down movement around a given
trend is identified as a cyclical
pattern. The duration of a cycle depends on the type of business or industry being analyzed.
3. Seasonal component - Seasonality occurs when the time series exhibits regular fluctuations
during the same month (or
months) every year, or during the same quarter every year. For instance, retail sales peak
during the month of December.
4. Irregular component - This component is unpredictable. Every time series has some
unpredictable component that makes
it a random variable.
Time series methods
Time series methods or models makes reference to models use in forecasting where no
"explanatory" variables are involved.
These models include smoothing methods (moving averages, single and double exponential
smoothing, and Holt-Winters
exponential smoothing). There are two main goals of time series analysis:
(a) Identifying the nature of the phenomenon represented by the sequence of observations
(b) Forecasting (predicting future values of the time series variable).
Both goals require that the pattern of observed time series data is identified and formally
described. Once the pattern is
established, we can interpret and integrate it with other data (i.e., use it in our theory of the
investigated phenomenon, e.g.,
seasonal commodity prices).
STUDY SESSION 3 - Regression Analysis
Regression analysis is a statistical technique that is widely used for research. It is used to
predict the behaviour of the dependent
variables, based on the set of independent variables. In regression analysis, dependent
variables can be metric or non-metric
and the independent variable can be metric, categorical, or both a combination of metric and
categorical.
The simplest form with one dependent and one independent variable is defined by the
formula y = a + b*x.
Sometimes the dependent variable is also called endogenous variable, prognostic variable or
regress and. The independent variables are also called exogenous variables, predictor
variables or repressors.
However Linear Regression Analysis consists of more than just fitting a linear line through a
cloud of data points. It consists of 3 stages;
1. Analyzing the correlation and directionality of the data,
2. Estimating the model, i.e., fitting the line, and
3. Evaluating the validity and usefulness of the model.
Uses of Linear Regression Analysis
1. Might be used to identify the strength of the effect that the independent variable(s) have on
a dependent variable.
2. It can be used to forecast effects or impacts of changes. That is regression analysis helps us
to understand how much the dependent variable will change when we change one or more
independent variables. Typical questions are how much additional Y do i get for one
additional unit X?
3. Regression analysis predicts trends and future values. The regression analysis can be used
to get point estimates. Typical questions are what will the price for gold be in 6 months from
now? What is the total effort for a task X?
Assumptions of linear regression
1. There is normal distribution.
2. There is a linear relationship between the dependent and independent variable.
3. There is no multicollinearity between the independent variables or no exact correlation
between the independent variable.
4. There is no autocorrelation.
5. The means lagged value of the regression variable does not affect the current value.
6. The homoscedasticity or variance between all the independent variables is equal.
Simple linear regression is explained best through regression equation (Y = α + βX)
Y = the continuous dependent variable
X = the independent variable (can be a categorical dummy variable)
α = the Y intercept (regression line intercepts Y axis)
β = the slope of the coefficient (rise over run)
α (Y intercept) is a fixed point that is considered a constant (how much Y can exist without
X)
Below are the assumptions that must be met for the linear regression to be valid:
• The random variables must both be normally distributed (bivariate normal) and linearly
related.
• The x values (independent variable) must be free of error.
• The variance of y (the dependent variable) as a function of x must be constant. This is
referred to as homoscedasticity.
Statistical Regression Selection Methods of Entry
• Forward selection begins with an empty equation. Predictors are added one at a time
beginning with the predictor with the highest correlation with the dependent variable.
Variables of greater theoretical importance are entered first. Once in the equation, the
variable remains there.
• Backward elimination (or backward deletion) is the reverse process. All the variables are
entered into the equation first and each one is deleted one at a time if they do not contribute
to the regression equation.
• Stepwise selection is considered a variation of the previous two methods. Stepwise selection
involves analysis at each step to determine the contribution of the predictor variable entered
previously in the equation. In this way it is possible to understand the contribution of the
previous variables now that another variable has been added. Variables can be retained or
deleted based on their statistical importance.
Sequential Regression Selection Method of Entry
Block-wise selection is a version of forward selection that is achieved in blocks or sets. The
predictors are grouped into blocks based on psychometric consideration or theoretical reasons
and a stepwise selection is applied. Each block is applied separately while the other predictor
variables are ignored.