Business Analytics Module 8

Chapter 9:
Regression Analysis
Business Analytics: Methods, Models,

and Decisions, 1st edition
James R. Evans
Copyright © 2013 Pearson Education, Inc.

publishing as Prentice Hall 9-1
Chapter 9 Topics
 Regression Analysis
 Simple Linear Regression
 Residual Analysis and Regression Assumptions
 Multiple Linear Regression
 Building Good Regression Models
 Regression with Categorical Independent
Variables
 Regression Models with Nonlinear Terms

Regression Analysis
 Regression analysis is a tool for building statistical
models that characterize relationships among a
dependent variable and one or more independent
variables, all of which are numerical.
 Simple linear regression involves a single
independent variable.
 Multiple regression involves two or more
independent variables.

Simple Linear Regression
 Finds a linear relationship between:
- one independent variable X and
- one dependent variable Y
 First prepare a scatter plot to verify the data has a
linear trend.
 Use alternative approaches if the data is not linear.
Figure 9.1

Example 9.1
Home Market Value Data
Size of a house is
typically related to its
market value. Figure 9.2
X = square footage
Y = market value ($)
The scatter plot of the full
data set (42 homes)
indicates a linear trend.
Figure 9.3

Finding the Best-Fitting Regression Line
 Two possible lines are shown below.
 Line A is clearly a better fit to the data.
 We want to determine the best regression line.
^
Y = b0 + b1X
where
b0 is the intercept
b1 is the slope
Figure 9.4

Example 9.2
Using Excel to Find the Best Regression Line
 Market value = 32673 + 35.036(square feet)
The regression model

explains variation in
market value due to
size of the home.
It provides better
estimates of market
value than simply
using the average.
Figure 9.5

Least-Squares Regression
Regression analysis finds
the equation of the best-
fitting line that minimizes
the sum of the squares of the

Figure 9.6
observed errors (residuals).

Using calculus we can solve for the slope and intercept
of the least-squares regression line.

Least-Squares Regression Equations
Slope
b1 =SLOPE(known ys, known xs)

Intercept
b0 =INTERCEPT(known ys, known xs)
^
Predict
^
Y for specified X values: Y = b0 + b1X
Y =TREND(known ys, known xs, new xs)

Example 9.3 Using Excel Functions to Find Least-
Squares Coefficients
 Slope = b1 = 35.036
=SLOPE(C4:C45, B4:B45)
 Intercept = b0 = 32,673 Figure 9.2
=INTERCEPT(C4:C45, B4:B45)
 Estimate Y when X = 1800 square feet
^
Y = 32,673 + 35.036(1800) = $95,737.80
=TREND(C4:C45, B4:B45, 1800)
Excel Regression tool
Data
Data Analysis
Regression
Input Y Range
Input X Range
Labels
Excel outputs a table

with many useful Figure 9.7
regression statistics.

Regression Statistics in Excel’s Output
 Multiple R
| r | where r is the sample correlation coefficient

r varies from -1 to +1 (r is negative if slope is negative)
 R Square
coefficient of determination, R2
varies from 0 (no fit) to 1 (perfect fit)
 Adjusted R Square
adjusts R2 for sample size and number of X variables

 Standard Error
variability between observed & predicted Y variables

Example 9.4 Interpreting Regression Statistics for
Simple Linear Regression (Home Market Value)
53% of the variation in home market values

can be explained by home size.
The standard error of $7287 is less than
standard deviation (not shown) of $10,553.
Figure 9.8

Regression Analysis of Variance
ANOVA conducts an F-test to determine whether
variation in Y is due to varying levels of X.
ANOVA is used to test for significance of regression:
H0: population slope coefficient = 0
H1: population slope coefficient ≠ 0
Excel reports the p-value (Significance F).
Rejecting H0 indicates that X explains variation in Y.
From Figure 9.8

Example 9.5 Interpreting Significance of Regression
Home size is not a significant variable
Home size is a significant variable
p-value = 3.798 x 10-8
Reject H0.
The slope is not equal to zero.
Using a linear relationship, home size is a significant
variable in explaining variation in market value.
From Figure 9.8

Testing Hypotheses for Regression Coefficients

 An alternate method for testing
is to use a t-test:
 Excel provides the p-values for tests on the slope

and intercept.
From Figure 9.8

Example 9.6 Interpreting Hypothesis Tests for

Regression Coefficients (Home Market Value)
 p-value for test on the intercept = 0.000649
 p-value for test on the slope = 3.798 x 10-8
 Both tests reject their null hypotheses.

 Both the intercept and slope coefficients are
significantly different from zero.
From Figure 9.8


From Figure 9.8

Residual Analysis and Regression Assumptions
Residual Analysis
 Residuals are observed errors.
 Residual = Actual Y value − Predicted Y value
 Standard residual = residual / standard deviation
 Rule of thumb: Standard residuals outside of ±2
or ±3 are potential outliers.
 Excel provides a table and a plot of residuals.
Figure 9.9
Figure 9.10
Example 9.8 Interpreting Residual Output

 None of the residuals in the table of 5 homes
shown below appear to be outliers.

 In the full data set of 42 homes, there is a
standardized residual larger than 4.

 This small home may have a pool or unusually
large piece of land.
Figure 9.9
Figure 9.3

Checking Assumptions
 Linearity
- examine scatter diagram (should appear linear)

- examine residual plot (should appear random)
 Normality of Errors
- view a histogram of standard residuals

- regression is robust to departures from normality
 Homoscedasticity
- variation about the regression line is constant

 Independence of Errors
- successive observations should not be related

Example 9.9 Checking Regression Assumptions for

the Home Market Value Data
 Linearity - linear trend in scatterplot
- no pattern in residual plot
Figure 9.3 Figure 9.10

Example 9.9 (continued) Checking Regression

Assumptions for the Home Market Value Data
 Normality of Errors – residual histogram appears
slightly skewed but is not a serious departure
Figure 9.11

 Homoscedasticity – residual plot shows no serious
difference in the spread of the data for different X

values.
Figure 9.10


 Independence of Errors – Because the data is
cross-sectional, we can assume this assumption

holds.
 All 4 regression assumptions are reasonable for
the Home Market Value data.

Multiple Linear Regression
Multiple Regression has more than one independent

variable.
 The multiple linear regression equation is:
 The ANOVA test for significance of the entire

model is:
 One can also test for significance of individual

regression coefficients.

Example 9.10 Interpreting Regression Results for
the Colleges and Universities Data
 Colleges try to predict student graduation rates
using a variety of characteristics, such as:

1. Median SAT 3. Acceptance rate
2. Expenditures/student 4. Top 10% of HS class
Figure 9.12

Example 9.10 (continued) Interpreting Regression
Results for the Colleges and Universities Data
Figure 9.13

Example 9.10 (continued) Interpreting Regression

Results for the Colleges and Universities Data
All of the slope
coefficient p-values
are < 0.05.
From Figure 9.13
The residual plots (only one shown

here) show random patterns about 0.
Normal probability plots (not shown)

also validate assumptions.
Figure 9.14

Analytics in Practice:
Using Linear Regression and
Interactive Risk Simulators to
Predict Performance at ARAMARK
 ARAMARK, located in Philadelphia, is an award-
winning provider of professional services

 They developed an on-line tool called “interactive
risk simulators” (shown on next slide) that allows

users to change various business metrics and
immediately see the results.
 The simulators use linear regression models.

Analytics in Practice: (ARAMARK continued)
Risk metrics are adjusted using sliders.
Allows users (managers and directors) to see the
impact of these risks on the business.
Figure 9.15

Building Good Regression Models
 All of the independent variables in a linear
regression model are not always significant.
 We will learn how to build good regression models
that include the “best” set of variables.

 Banking Data includes demographic information
on customers in the bank’s current market.
Figure 9.16

Predicting Average Bank Balance using Regression
Home Value and Education

are not significant.
Figure 9.17

Systematic Approach to Building Good Multiple
Regression Models
1. Construct a model with all available independent
variables and check for significance of each.
2. Identify the largest p-value that is greater than α.
3. Remove that variable and evaluate adjusted R2.
4. Continue until all variables are significant.
 Find the model with the highest adjusted R2.
(Do not use unadjusted R2 since it always
increases when variables are added.)

Example 9.11
Identifying the Best Regression Model
 Bank regression after removing Home Value
Adjusted R2 improves slightly.
All X variables are significant.
Figure 9.18
Multicollinearity
- occurs when there are strong correlations among
the independent variables
- makes it difficult to isolate the effects of
independent variables
- signs of slope coefficients may be opposite of the
true value and p-values can be inflated
 Correlations exceeding ±0.7 are an indication that
multicollinearity might exist.
 Variance Inflation Factors are a better indicator.
 Parsimony is an age-old principle that applies here.

Example 9.12
Identifying Potential Multicollinearity
 Colleges and Universities (full model)
Full model
Adjusted R2 = 0.4921
Figure 9.13
Example 9.12 (continued)
 Correlation Matrix (Colleges and Universities data)
From Figure 9.19
 All of the correlations are within ±0.7
 Signs of the coefficients are questionable for

Expenditures and Top 10%.
 Colleges and Universities (reduced model)
Dropping Top 10%

Adjusted R2 drops to 0.4559

Dropping Expenditures

Dropping Expenditures and Top 10%

Which of the 4 models would you choose?

 Banking Data (full model)
Full Model
Education and Home Value
are not significant.
Figure 9.17
 Correlation matrix for the Banking data
From Figure 9.20

From Figure 9.17
 Some of the correlations exceed 0.7 for Home

Value and Wealth.
 Signs of the coefficients for predicting bank
balance are as expected (positive).

 Banking Data (reduced model)
Dropping Wealth and Home Value

Education is not significant.

 Re-ordered Correlation matrix for Banking data
From Figure 9.20
 By re-ordering the variables, we can see the

correlations for Age, Education, and Wealth are all
within ± 0.7.
 Let’s try a reduced model with the Age, Education,
and Wealth variables.
 Banking Data (reduced model) ** best model
Dropping Income and Home Value.

Adjusted R2 = 0.9345.
All variables are significant.
Multicollinearity is not a problem.
Figure 9.21

Regression with Categorical Variables
Dealing with Categorical Variables

 Must be coded numeric using dummy variables.
 For variables with 2 categories, code as 0 and 1.
 For variables with k ≥ 3 categories, create k−1
binary (0,1) variables.

Interaction Terms
 A dependence between two variables is called
interaction.
 Test for interaction by adding a new term to the
model, such as X3 = X1X2.

Example 9.13 A Model with Categorical Variables

 Employee Salaries provides data for 35 employees
 Predict Salary using Age and MBA (yes=1, no=0)
Figure 9.22

Salary = 893.59 + 1044(Age) for those without MBA
Salary =15,660.82 + 1044(Age) for those with MBA
Figure 9.23
Example 9.14 Incorporating Interaction Terms in a
Regression Model
 Define an interaction between Age and MBA and
include in the regression model.

 Interaction = (Age)(MBA)
Figure 9.24

Example 9.14 (continued) Incorporating Interaction
Terms in a Regression Model
MBA is now insignificant so we

will drop it from the model.
Figure 9.25
Salary = 3,323 + 984(Age) for those without MBA
Salary = 3,323 + 1410(Age) for those with MBA
(a slight improvement)
Figure 9.26

Example 9.15 A Regression Model with Multiple
Levels of Categorical Variables
 Surface Finish data provides measurements for
35 parts produced on a lathe.
Figure 9.27

A Regression Model with
Multiple Levels of
Categorical Variables
 Tool Type (A,B,C,D) is now
coded as 3 dummy variables
Figure 9.28

Example 9.15 (continued) A Regression Model with
Multiple Levels of Categorical Variables
Tool A: Surf. Finish = 24.5 + 0.098 RPM

Tool B: Surf. Finish = 11.2 + 0.098 RPM
Tool C: Surf. Finish = 4.0 + 0.098 RPM
Tool D: Surf. Finish = -1.6 + 0.098 RPM
Figure 9.29
Regression Models with Nonlinear Terms
Curvilinear Regression
 Curvilinear models may be appropriate when
scatter charts or residual plots show nonlinear
relationships.
 A second order polynomial might be used
 Here β1 represents the linear effect of X on Y and

β2 represents the curvilinear effect.
 This model is linear in the β parameters so we can
use linear regression methods.

Example 9.16 Modeling Beverage Sales Using

Curvilinear Regression
 Sales of cold beverages increase when it is hotter
outside.
Figure 9.30

Example 9.16 (continued) Modeling Beverage Sales
Using Curvilinear Regression
U-shape residual plot
Figure 9.31

Example 9.16 (continued) Modeling Beverage
Sales Using Curvilinear Regression
Residual
pattern is
more random
Sales = 142,850
−3643(temperature)
+ 23.3(temperature)2
Figure 9.32

Example 9.16 (continued) Modeling Beverage
Sales Using Curvilinear Regression
Second Order Polynomial Trendline

Chapter 9 - Key Terms
 Autocorrelation
 Coefficient of determination
 Coefficient of multiple determination
 Curvilinear regression model
 Dummy variables
 Homoscedasticity
 Interaction
 Least-squares regression
 Mulitcollinearity
 Multiple correlation coefficient

Chapter 9 - Key Terms (continued)
 Multiple linear regression
 Parsimony
 Partial regression coefficient
 Regression analysis
 Residuals
 Significance of regression
 Simple linear regression
 Standard error of the estimate
 Standard residuals

Case Study
Performance Lawn Equipment (9)
 Recall that PLE produces lawnmowers and a
medium size diesel power lawn tractor.
 Predict what might have happened if PLE never
implemented the 2009 defect reduction initiative.
 Determine the effect of education, GPA, and age
when hired on employee retention.
 Investigate the rate of learning following the
implementation of the new production technology.
 Write a formal report summarizing your results.


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Chapter 9:

Business Analytics: Methods, Models,

Copyright © 2013 Pearson Education, Inc.

Copyright © 2013 Pearson Education, Inc.

Copyright © 2013 Pearson Education, Inc.

Copyright © 2013 Pearson Education, Inc.

Copyright © 2013 Pearson Education, Inc.

Copyright © 2013 Pearson Education, Inc.

The regression model

Copyright © 2013 Pearson Education, Inc.

the sum of the squares of the

observed errors (residuals).

Copyright © 2013 Pearson Education, Inc.

b1 =SLOPE(known ys, known xs)

Copyright © 2013 Pearson Education, Inc.

Excel outputs a table

Copyright © 2013 Pearson Education, Inc.

| r | where r is the sample correlation coefficient

adjusts R2 for sample size and number of X variables

variability between observed & predicted Y variables

Copyright © 2013 Pearson Education, Inc.

53% of the variation in home market values

Copyright © 2013 Pearson Education, Inc.

From Figure 9.8

Copyright © 2013 Pearson Education, Inc.

From Figure 9.8

Copyright © 2013 Pearson Education, Inc.

Testing Hypotheses for Regression Coefficients

 Excel provides the p-values for tests on the slope

From Figure 9.8

Copyright © 2013 Pearson Education, Inc.

Example 9.6 Interpreting Hypothesis Tests for

 Both tests reject their null hypotheses.

significantly different from zero.

From Figure 9.8

Copyright © 2013 Pearson Education, Inc.

From Figure 9.8

Copyright © 2013 Pearson Education, Inc.

Example 9.8 Interpreting Residual Output

shown below appear to be outliers.

standardized residual larger than 4.

large piece of land.

Copyright © 2013 Pearson Education, Inc.

- examine scatter diagram (should appear linear)

- view a histogram of standard residuals

- variation about the regression line is constant

- successive observations should not be related

Copyright © 2013 Pearson Education, Inc.

Example 9.9 Checking Regression Assumptions for

- no pattern in residual plot

Figure 9.3 Figure 9.10

Copyright © 2013 Pearson Education, Inc.

Example 9.9 (continued) Checking Regression

slightly skewed but is not a serious departure

Copyright © 2013 Pearson Education, Inc.

difference in the spread of the data for different X

Copyright © 2013 Pearson Education, Inc.

Example 9.9 (continued) Checking Regression

cross-sectional, we can assume this assumption

the Home Market Value data.