CHAPTER

1 Introduction to
Data Analysis and
Decision Making

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USING QUANTITATIVE METHODS TO SOLVE

REAL BUSINESS PROBLEMS

A s you embark on your study of data analysis and

decision making, you might question the usefulness of
quantitative methods to the “real
world.” A front-page article in the December 31, 1997, edition
of USA Today entitled “Higher Math Delivers Formula for
Success” provides some convinc-ing evidence of the
applicability of the methods you will be learning.The sub-
heading of the article,“Businesses turn to algorithms to solve
complex problems,” says it all.Today’s business problems
tend to be very complex. In the past, many managers and
executives used a “by the seat of your pants” approach to
solve problems—that is, they used their business experience,
their intuition, and some thoughtful guesswork to obtain
solutions. But com-mon sense and intuition go only so far in
the solution of the complex prob-lems businesses now
face.This is where data analysis and decision making— and
the algorithms mentioned in the title of the article—are so
useful.When the methods in this book are implemented in
user-friendly computer soft-ware packages and are then
applied to complex problems, the results can be
amazing. Robert Cross, whose company, DFI Aeronomics, sells
algorithm-based systems to airlines, states it succinctly:“It’s
like taking raw information and spinning money out of it.”
 The power of the methods in this book is that they are
applicable to so many problems and environments.The
article mentions the following

1
 “success stories” where quantitative analysis has been applied; others
will be discussed throughout this book.
1. United Airlines installed one of DFI’s systems, which cost between
$10 million and $20 million. United expects the system to add $50
million to $100 million annually to its revenues.
2. The Gap clothing chain uses quantitative analysis to determine
exactly how many employees should staff each store during the
holiday rush.
3. Quantitative analysis has helped medical researchers test
potentially dangerous drugs on fewer people with better
results.
4. IBM obtained a $93-million contract to build a computer system for
the Department of Energy that would do a once-impossible
task: make exact real-time models of atomic blasts. It won the
contract—and convinced the DOE that its sys-tem was cost
effective—only by developing quantitative methods that would cut
the processing time by half.
5. Hotels, airlines, and television broadcasters all use quantitative
analysis to implement a new method called “yield management.” In
this method, different prices are charged to different
customers, depending on their willingness to pay.The effect is that
more customers are attracted, and revenues increase.
The article concludes by stating that Microsoft’s Excel spreadsheet
software contains a mini-optimization program called Solver.This is a
key statement. Many of the algorithms that enable the successes
discussed in the article are very complex mathematically.They are well
beyond the grasp of the typical user, including most readers of this
book. However, users
no longer need to understand all of the details behind the
algorithms.They need only to know how to model business problems
so that appropriate algorithms can be applied and then how to apply
them with user-friendly software. For example, we see in Chapters 14
and 15 how to apply Excel’s Solver to a variety of complex
problems.You will not learn the intricacies of how Solver does its
optimization, but you will learn how to use Solver very productively.The
same statement applies to the other methods discussed in this
book.You might not understand exactly what is happening in the
computer’s “black box” as it per-forms its calculations, but you will
learn how to become a very effective problem solver by taking
advantage of powerful software. ■

1.1 INTRODUCTION
We are living in the age of technology. This has two important implications for
everyone entering the business world. First, technology has made it possible to collect
huge amounts of data. Retailers collect point-of-sale data on products and customers
every time a trans-action occurs; credit agencies have all sorts of data on people who
have or would like to obtain credit; investment companies have a limitless supply of
data on the historical pat-terns of stocks, bonds, and other securities; and government
agencies have data on eco-nomic trends, the environment, social welfare, consumer
product safety, and virtually everything else we can imagine. It has become relatively
easy to collect the data. As a result, data are plentiful. However, as many organizations
are now beginning to discover, it is quite a challenge to analyze and make sense of all the
data they have collected.
A second important implication of technology is that it has given many more people
the power and responsibility to analyze data and make decisions on the basis of
 quantitative analysis. Those entering the business world can no longer pass all of the
quantitative analy-sis to the “quant jocks,” the technical specialists who have
traditionally done the number crunching. The vast majority of employees now have a
desktop or laptop computer at their

2 Chapter 1 Introduction to Data Analysis and Decision Making

disposal, they have access to relevant data, and they have been trained in easy-to-use
soft-ware, particularly spreadsheet and database software. For these employees,
statistics and other quantitative methods are no longer forgotten topics they once
learned in college. Quantitative analysis is now an integral part of their daily jobs.
A large amount of data already exists and will only increase in the future. Many com-
panies already complain of swimming in a sea of data. However, enlightened
companies are seeing this expansion as a source of competitive advantage. By using
quantitative methods to uncover the information in the data and then acting on this
information—again guided by quantitative analysis—they are able to gain advantages
that their less enlight-ened competitors are not able to gain. Several pertinent examples
of this follow.
■ Direct marketers analyze enormous customer databases to see which customers are
likely to respond to various products and types of promotions. Marketers can then
target different classes of customers in different ways to maximize profits—and give
their customers what the customers want.
■ Hotels and airlines also analyze enormous customer databases to see what their cus-
tomers want and are willing to pay for. By doing this, they have been able to devise
very clever pricing strategies, where not everyone pays the same price for the same
accommodations. For example, a business traveler typically makes a plane reserva-
tion closer to the time of travel than a vacationer. The airlines know this. Therefore,
they reserve seats for these business travelers and charge them a higher price (for the
same seats). The airlines profit, and the customers are happy.
■ Financial planning services have a virtually unlimited supply of data about security
prices, and they have customers with widely differing preferences for various types
of investments. Trying to find a match of investments to customers is a very chal-
lenging problem. However, customers can easily take their business elsewhere if
good decisions are not made on their behalf. Therefore, financial planners are under
extreme competitive pressure to analyze masses of data so that they can make
informed decisions for their customers.
■ We all know about the pressures U.S. manufacturing companies have faced from
foreign competition in the past couple of decades. The automobile companies, for
example, have had to change the way they produce and market automobiles to stay in
business. They have had to improve quality and cut costs by orders of magnitude.
Although the struggle continues, much of the success they have had can be attributed
to data analysis and wise decision making. Starting on the shop floor and moving up
through the organi-zation, these companies now measure almost everything they do,
analyze these measure-ments, and then act on the information from these
measurements.
We talk about companies analyzing data and making decisions. However, companies
don’t really do this; people do it. And who will these people be in the future? They will be
you! We know from experience that students in all areas of business, at both the
undergraduate and graduate level, will soon be required to describe large complex data
sets, run regression analyses, make quantitative forecasts, create optimization models, and
run simulations. You are the person who will soon be analyzing data and making
important decisions to help gain your company a competitive advantage. And if you are
not willing or able to do so, there will be plenty of other technically trained people who
will be more than happy to replace you.
Our goal in this book is to teach you how to use a variety of quantitative methods to
analyze data and make decisions. We plan to do so in a very hands-on way. We discuss
a number of quantitative methods and illustrate their use in a large variety of realistic
busi-ness problems. As you will see, this book includes many examples from finance,
market-ing, operations, accounting, and other areas of business. To analyze these
examples, we take advantage of the Microsoft Excel spreadsheet package, together
with a number of
1.1 Introduction 3
 powerful Excel add-ins. In each example we will provide step-by-step details of the
method and its implementation in Excel.
This is not a “theory” book. It is also not a book where you can lean comfortably
back in your chair, prop your legs up on a table, and read about how other people use
quantita-tive methods. It is a “get your hands dirty” book, where you will learn best by
actively fol-lowing the examples throughout the book at your own PC. In short, you
will learn by doing. By the time you have finished, you will have acquired some very
useful skills for today’s business world.

1.2 AN OVERVIEW OF THE BOOK

This book is packed with quantitative methods and examples, probably more than can be
covered in any single course. Therefore, we purposely intend to keep this introductory
chapter brief so that you can get on with the analysis. Nevertheless, it is useful to
introduce the methods you will be learning and the tools you will be using. In this section
we provide an overview of the methods covered in this book and the software that is used
to implement them. Then in the next section we preview some of the examples we cover
in much more detail in later chapters. Finally, we present a brief discussion of models
and the modeling process. Our primary purpose at this point is to stimulate your interest
in what is to follow.

1.2.1 The Methods

This book is rather unique in that it combines topics from two separate fields: statistics
and management science. In a nutshell, statistics is the study of data analysis, whereas
man-agement science is the study of model building, optimization, and decision making.
In the academic arena these two fields traditionally have been separated, sometimes
widely. Indeed, they are often housed in separate academic departments. However, from
a user’s standpoint it makes little sense to separate them. Both are useful in
accomplishing what the title of this book promises: data analysis and decision making.
Therefore, we do not distinguish between the “statistics” and “management science”
parts of this book. Instead, we view the entire book as a collection of useful quantitative
methods that can be used to analyze data and help make business decisions. In addition,
our choice of software helps to integrate the various topics. By using a single package,
Excel, together with a number of add-ins, we see that the methods of statistics and man-
agement science are similar in many important respects. Most importantly, their combina-
tion gives us the power and flexibility to solve a wide range of business problems.
Three important themes run through this book. Two of them are in the title: data
analysis and decision making. The third is dealing with uncertainty.1 Each of these
themes has sub-themes. Data analysis includes data description, data inference, and
the search for relationships in data. Decision making includes optimization techniques
for problems with no uncertainty, decision analysis for problems with uncertainty, and
structured sensitivity analysis. Dealing with uncertainty includes measuring uncertainty
and modeling uncertainty explicitly into the analysis. There are obvious overlaps between
these themes and subthemes. When we make inferences from data and search for
relationships in data, we must deal with uncertainty. When we use decision trees to help
make decisions, we must deal with uncer-tainty. When we use simulation models to help
make decisions, we must deal with uncertainty, and we often make inferences from the
simulated data.
1
The fact that the uncertainty theme did not find its way into the title of this book does not detract from its
impor-tance. We just wanted to keep the title reasonably short!

4 Chapter 1 Introduction to Data Analysis and Decision Making

 Figure 1.1 shows where you will find these themes and subthemes in the remaining
chap-ters of this book. In the next few paragraphs we discuss the book’s contents in more
detail.

Themes Subthemes Chapters Where Emphasized

Figure 1.1
Themes and
Subthemes

We begin in Chapters 2 and 3 by illustrating a number of ways to summarize the

infor-mation in data sets. These include graphical and tabular summaries, as well as
numerical summary measures such as means, medians, and standard deviations. The
material in these two chapters is elementary from a mathematical point of view, but it is
extremely impor-tant. As we stated at the beginning of this chapter, organizations are
now able to collect huge amounts of raw data. The question then becomes, What does it
all mean? Although there are very sophisticated methods for analyzing data sets, some
of which we cover in later chapters, the “simple” methods in Chapters 2 and 3 are crucial
for obtaining an initial understanding of the data. Fortunately, Excel and available add-
ins now make what was once a very tedious task quite easy. For example, Excel’s pivot
table tool for “slicing and dicing” data is an analyst’s dream come true. You will be
amazed at the complex analysis it enables you to perform—with almost no effort!
After the analysis in Chapters 2 and 3, we step back for a moment in Chapter 4 to
see how we get the data we need in the first place. We know from experience that many
students and businesspeople are able to perform appropriate statistical analysis once they
have the data in a suitable form. Often the most difficult part, however, is getting the right
data, in the right form, into a software package for analysis. Therefore, in Chapter 4 we
present a num-ber of extremely useful methods for doing this within Excel. Specifically,
we discuss meth-ods for using Excel’s built-in filtering tools to perform queries on Excel
data sets, for using Microsoft Query (part of Microsoft Office) to perform queries on
external databases (such as Access) and bring the resulting data into Excel, for
importing data directly into Excel from Web sites, and for “cleansing” data sets (getting
rid of “bad” data values). This chapter provides tools that many analysts need but are
usually not even aware of.
Uncertainty is a key aspect of most business problems. To deal with uncertainty, we
need a basic understanding of probability. We provide this understanding in Chapters 5
and 6.
1.2 An Overview of the Book
5
 Chapter 5 covers basic rules of probability and then discusses the extremely important
con-cept of probability distributions. Chapter 6 follows up this discussion by focusing on
two of the most important probability distributions, the normal and binomial
distributions. It also briefly discusses the Poisson and exponential distributions, which
have many applications in probability models.
We have found that one of the best ways to make probabilistic concepts “come alive”
and easier to understand is by using computer simulation. Therefore, simulation is a com-
mon theme that runs through this book, beginning in Chapter 5. Although the final two
chapters of the book are devoted entirely to simulation, we do not hesitate to use simula-
tion early and often to illustrate difficult statistical concepts.
In Chapter 7 we apply our knowledge of probability to decision making under uncer-
tainty. These types of problems—faced by all companies on a continual basis—are
charac-terized by the need to make a decision now, even though important information
(such as demand for a product or returns from investments) will not be known until later.
The mate-rial in Chapter 7 provides a rational basis for making such decisions. The
methods we illustrate do not guarantee perfect outcomes—the future could unluckily
turn out differ-ently than we had expected—but they do enable us to proceed rationally
and make the best of the given circumstances. Additionally, the software we use to
implement these methods allows us, with very little extra work, to see how sensitive
the optimal decisions are to inputs. This is crucial because the inputs to many business
problems are, at best, educated guesses. Finally, we examine the role of risk aversion in
these types of decision problems. In Chapters 8, 9, and 10 we discuss sampling and
statistical inference. Here the basic problem is to estimate one or more characteristics of a
population. If it is too expensive or time consuming to learn about the entire population—
and it usually is—we instead select a random sample from the population and then use
the information in the sample to infer the characteristics of the population. We see this
continually on news shows that describe the results of various polls. We also see it in
many business contexts. For example, auditors typically sample only a fraction of a
company’s records. Then they infer the characteristics of the entire population of records
from the results of the sample to conclude whether the
company has been following acceptable accounting standards.
In Chapters 11 and 12 we discuss the extremely important topic of regression
analysis, which is used to study relationships between variables. The power of regression
analysis is its generality. Every part of a business has variables that are related to one
another, and regression can often be used to estimate possible relationships between
these variables. In managerial accounting, regression is used to estimate how overhead
costs depend on direct labor hours and production volume. In marketing, regression is
used to estimate how sales volume depends on advertising and other marketing
variables. In finance, regression is used to estimate how the return of a stock depends
on the “market” return. In real estate studies, regression is used to estimate how the
selling price of a house depends on the assessed valuation of the house and
characteristics such as the number of bedrooms and square footage. Regression analysis
finds perhaps as many uses in the business world as any method in this book.
From regression, we move to times series analysis and forecasting in Chapter 13.
This topic is particularly important for providing inputs into business decision
problems. For example, manufacturing companies must forecast demand for their
products to make sen-sible decisions about quantities to order from their suppliers.
Similarly, fast-food restau-rants must forecast customer arrivals, sometimes down to the
level of 15-minute intervals, so that they can staff their restaurants appropriately.
There are many approaches to forecasting, ranging from simple to complex. Some
involve regression-based methods, in which one or more time series variables are used
to forecast the variable of interest, whereas other methods are based on extrapolation. In
an extrapolation method the historical patterns of a time series variable, such as
product

6 Chapter 1 Introduction to Data Analysis and Decision Making

demand or customer arrivals, are studied carefully and are then “extrapolated” into the
future to obtain forecasts. A number of extrapolation methods are available. In Chapter 13
we study both regression and extrapolation methods for forecasting.
Chapters 14 and 15 are devoted to spreadsheet optimization, with emphasis on linear
programming. We assume a company must make several decisions, and there are
con-straints that limit the possible decisions. The job of the decision maker is to
choose the decisions such that all of the constraints are satisfied and an objective, such
as total profit or total cost, is optimized. The solution process consists of two steps.
First, we build a spreadsheet model that relates the decision variables to other relevant
quantities by means of logical formulas. In this first step there is no attempt to find the
optimal solution; all we want to do is relate all relevant quantities in a logical way. The
second step is then to find the optimal solution. Fortunately, Excel contains a Solver
add-in that performs this step. All we need to do is specify the objective, the decision
variables, and the constraints; Solver then uses powerful algorithms to find the optimal
solution. As with regression, the power of this approach is its generality. An enormous
variety of problems can be solved by spreadsheet optimization.
Finally, Chapters 16 and 17 illustrate a number of computer simulation models. This
is not our first exposure to simulation—it is used in a number of previous chapters to
illustrate statistical concepts—but here it is studied in its own right. As we discussed
previously, most business problems have some degree of uncertainty. The demand for a
product is unknown, future interest rates are unknown, the delivery lead time from a
supplier is unknown, and so on. Simulation allows us to build this uncertainty
explicitly into spreadsheet models. Essentially, some cells in the model contain random
values with given probability distribu-tions. Every time the spreadsheet recalculates,
these random values change, which causes “bottom-line” output cells to change as well.
The trick then is to force the spreadsheet to recalculate many times and keep track of
interesting outputs. In this way we can see which output values are most likely, and we
can see best-case and worst-case results.
Spreadsheet simulations can be performed entirely with Excel’s built-in tools.
However, this can be quite tedious. Therefore, we use a spreadsheet add-in to streamline
the process. In particular, we learn how the @RISK add-in can be used to run replications
of a simulation, keep track of outputs, create useful charts, and perform sensitivity
analyses. With the inher-ent power of spreadsheets and the ease-of-use of such add-ins as
@RISK, spreadsheet simu-lation is becoming one of the most popular quantitative tools in
the business world.

1.2.2 The Software

The topics we have just discussed are very important. Together, they can be used to solve
a wide variety of business problems. However, they are not of much practical use unless
we have the software to do the number crunching. Very few business problems are
small enough to be solved with pencil and paper. They require powerful software.
The software included in new copies of this book, together with Microsoft Excel,
pro-vides you with a powerful software combination that you will not use for one course
and then discard. This software is being used—and will continue to be used—by leading
com-panies all over the world to solve large, complex problems. We firmly believe
that the experience you obtain with this software, through working the examples and
problems in this book, will give you a key competitive advantage in the marketplace.
It all begins with Excel. All of the quantitative methods that we discuss are imple-
mented in Excel. We cannot forecast the state of computer software in the long-term
future, but as we are writing this book Excel is the most heavily used spreadsheet package
on the market, and there is every reason to believe that this state will persist for many
years. Most companies use Excel, most employees and most students have been trained in
Excel, and Excel is a very powerful, flexible, and easy-to-use package.

1.2 An Overview of the Book

7
 Built-in Excel Features
Virtually everyone in the business world knows the basic features of Excel, but relatively
few know many of its more powerful features. In short, relatively few people are the
“power users” we expect you to become by working through this book. To get you
started, the file Excel Tutorial.doc on the CD-ROM inside new copies of this book
explains some of the “intermediate” features of Excel—features that we expect you to
be able to use. These include the SUMPRODUCT, VLOOKUP, IF, NPV, and
COUNTIF functions. They also include range names, the Data Table command, the
Paste Special command, the Goal Seek command, and a few others. Finally, although we
assume you can perform routine spread-sheet tasks such as copying and pasting, we
include a few tips to help you perform these tasks more efficiently.
Although the In the body of the book we describe several of Excel’s advanced features in
tutorial is more detail. In Chapters 2 and 3 we introduce pivot tables, the Excel tool that enables
presented in a
you to summarize data sets in an almost endless variety of ways. (Excel has many useful
Word file, it
contains tools, but we personally believe that pivot tables are the most ingenious and powerful
“embedded” of all. We won’t be surprised if you agree.) Beginning in Chapter 5, we introduce
Excel Excel’s RAND function for generating random numbers. This function is used in all
spreadsheets that spreadsheet simula-tions (at least those that do not take advantage of an add-in).
allow you to
practice Solver Add-in
spreadsheet
techniques within In Chapters 14 and 15 we make heavy use of Excel’s Solver add-in. This add-in,
Word. developed by Frontline Systems (not Microsoft), uses powerful algorithms—all behind
the scenes— to perform spreadsheet optimization. Before this type of spreadsheet
optimization add-in was available, specialized (nonspreadsheet) software was required
to solve optimization problems. Now we can do it all within a familiar spreadsheet
environment.
StatTools Add-in
Much of this book discusses basic statistical analysis. Here we needed to make an
important decision as we developed the book. A number of excellent statistical software
packages are on the market, including Minitab, SPSS, SAS, StatGraphics, and many others.
Although there are now user-friendly Windows versions of these packages, they are not
spreadsheet-based. We have found through our own experience that students resist the use
of nonspreadsheet pack-ages, regardless of their inherent quality, so we wanted to use
Excel as our “statistics package.” (We briefly discuss SPSS and SAS in Chapter 4, but
they are not used anywhere else in the book.) Unfortunately, Excel’s built-in statistical
tools are rather limited, and the Analysis ToolPak (developed by a third party) that ships
with Excel has significant limitations.
Therefore, we developed an add-in called StatTools that accompanies this
book.2 StatTools is powerful, easy to use, and capable of generating output quickly in
an easily interpretable form. We do not believe you should have to spend hours each time
you want to produce some statistical output. This might be a good learning experience the
first time, but after that it acts as a strong incentive not to perform the analysis at all! We
believe you should be able to generate output quickly and easily. This gives you the
time to interpret the output, and it also allows you to try different methods of analysis.
A good illustration involves the construction of histograms, scatterplots, and time
series graphs, discussed in Chapter 2. All of these extremely useful graphs can be created in
a straight-forward way with Excel’s built-in tools. But by the time you perform all the
necessary steps and “dress up” the charts exactly as you want them, you will not be very
anxious to repeat the whole process again. StatTools does it all quickly and easily. (You
still might want to “dress up” the

2
Users of the previous edition of the book will note the change from StatPro to StatTools. Palisade Corporation
has redeveloped StatPro as a commercial package under the name StatTools. The user interface has changed
con-siderably (for the better), but the statistical functionality is virtually the same.

8 Chapter 1 Introduction to Data Analysis and Decision Making

resulting charts, but that’s up to you.) Therefore, if we advise you in a later chapter, say, to
look at several scatterplots as a prelude to a regression analysis, you can do so in a matter
of seconds.
SolverTable Add-in
An important theme throughout this book is sensitivity analysis: How do outputs change
when inputs change? Typically these changes are made in spreadsheets with a data table,
a built-in Excel tool. However, data tables don’t work in optimization models, where
we would like to see how the optimal solution changes when certain inputs change.
Therefore, we include an Excel add-in called SolverTable to perform this type of
sensitivity analysis. It works almost exactly like Excel’s data tables, and it is
included with this book. In Chapters 14 and 15 we explain how to use SolverTable.
Decision Tools Suite
In addition to StatTools, SolverTable, and built-in Excel add-ins, we also have included
in this book a slightly scaled-down version of Palisade Corporation’s powerful
Decision Tools suite. Most of the items in this suite are Excel add-ins—so the learning
curve isn’t very steep. There are six separate packages in this suite: @RISK,
PrecisionTree, TopRank, RISKOptimizer, BestFit, and RISKview. The first two are the
most important for our pur-poses, but all are useful for certain tasks.
@RISK
The simulation add-in @RISK enables us to run as many replications of a spreadsheet
sim-ulation as we like. As the simulation runs, @RISK automatically keeps track of the
outputs we select, and it then displays the results in a number of tabular and
graphical forms. @RISK also enables us to perform a sensitivity analysis, so that we can
see which inputs have the most effect on the outputs. Finally, @RISK provides a number
of spreadsheet func-tions that enable us to generate random numbers from a variety of
probability distributions.
PrecisionTree
The PrecisionTree add-in is used in Chapter 7 to analyze decision problems with uncer-
tainty. The primary method for performing this type of analysis is to draw a decision tree.
Decision trees are inherently graphical, and they have always been difficult to implement
in spreadsheets, which are based on rows and columns. However, PrecisionTree does
this in a very clever and intuitive way. Equally important, once the basic decision tree has
been built, it is easy to use PrecisionTree to perform a sensitivity analysis on the model
inputs.
TopRank
Although we will not use the other Palisade add-ins as extensively as @RISK and
PrecisionTree, they are all worth investigating. TopRank is the most general of them.
It starts with any spreadsheet model, where a set of inputs are used, along with a number
of spreadsheet formulas, to produce an output. TopRank then performs a sensitivity
analysis to see which inputs have the largest effect on the output. For example, it
might tell us which input affects after-tax profit the most: the tax rate, the risk-free rate
for investing, the inflation rate, or the price charged by a competitor. Unlike @RISK,
TopRank is used when uncertainty is not explicitly built into a spreadsheet model.
However, it considers uncer-tainty implicitly by performing sensitivity analysis on the
important model inputs.
RISKOptimizer
RISKOptimizer combines optimization with simulation. There are often times when we
want to use simulation to model some business problem, but we also want to optimize a
summary measure, such as a mean, of an output distribution. This optimization can be
performed in a trial-and-error fashion, where we try a few values of the decision vari-
able(s) and see which provides the best solution. However, RISKOptimizer provides
a more automatic (and time-intensive) optimization procedure.

1.2 An Overview of the Book 9

 BestFit
BestFit is used to determine the most appropriate probability distribution for a
spreadsheet model when we have data on some uncertain quantity. For example, a
simulation might model each week’s demand for a product as a random variable. What
probability distribu-tion should we use for weekly demand: the well-known normal
distribution or possibly some skewed distribution? If we have historical data on weekly
demands for the product, we can feed them into BestFit and let it recommend the
distribution that best fits the data. This is a very useful tool in real applications. Instead
of guessing a distribution that we think might be relevant, we can let BestFit point us to
a distribution that fits historical data well. We discuss BestFit briefly in Chapter 6.
RISKview
Palisade Finally, RISKview is a drawing tool that complements @RISK. A number of probability
Corporation dis-tributions are available in @RISK and can be used in simulations. Each has an
originally associated @RISK function, such as RiskNormal, RiskBinomial, and so on. Before
marketed BestFit
and RISKview as selecting any of these distributions, however, it is useful (especially for beginners) to see
separate what these distribu-tions look like. RISKview performs this task easily. For any selected
products. probability distribution (and any selected parameters of this distribution), it creates a graph
Although they of the distribution, and it allows us to find probabilities for the distribution in a completely
still exist as intuitive, graphical manner. We use RISKview in Chapter 16 to help learn about potential
separate
products, input probability distributions for simulation models.
their functionality Software Guide
is now included in
@RISK. Figure 1.2 provides a guide to where these various add-ins appear throughout the book.
We don’t show Excel explicitly in this figure for the simple reason that Excel is used
exten-sively in all chapters.
With Excel and the add-ins included in this book, you have a wealth of software at
your disposal. The examples and step-by-step instructions throughout this book will help
you to become a power user of this software. Admittedly, this takes plenty of practice
and a willingness to experiment, but it is certainly within your grasp. When you are
finished, we will not be surprised if you rate “improved software skills” as the most
valuable thing you have learned from this book.

Figu Developer Add-In Chapter(s) Where Used

re 1.2
StatTools
Software Guide

@RISK 6, 16–17

RISKview

10 Chapter 1 Introduction to Data Analysis and Decision Making

1.3 A SAMPLING OF EXAMPLES
Perhaps the best way to illustrate what you will be learning in this book is to preview a
few examples from later chapters. Our intention here is not to teach you any methods;
that will come later. We only want to indicate the types of problems you will learn how
to solve. Each example below is numbered as in the chapter where it appears.

EXAMPLE 3.9

T he Spring Mills Company produces and distributes a wide variety of manufactured

goods. Because of its variety, it has a large number of customers. The company
classi-
fies these customers as small, medium, and large, depending on the volume of business
each does with Spring Mills. Recently, Spring Mills has noticed a problem with its
accounts receivable. It is not getting paid back by its customers in as timely a manner as it
would like. This obviously costs Spring Mills money. If a customer delays a payment
of $300 for 20 days, say, then the company loses potential interest on this amount. The
com-pany has gathered data on 280 customer accounts. For each of these accounts, the
data set lists three variables: Size, the size of the customer (coded 1 for small, 2 for
medium, 3 for large); Days, the number of days since the customer was billed; and
Amount, the amount the customer owes. What information can we obtain from these
data?

Objective To use charts, summary measures, and pivot tables to understand data on
accounts receivable at Spring Mills.

Solution
It is always a good idea to get a rough sense of the data first. We do this by calculating
sev-eral summary measures for Days and Amount, a histogram of Amount, and a
scatterplot of Amount versus Days. The next logical step is to see whether the different
customer sizes have any effect on either Days, Amount, or the relationship between
Days and Amount. There is obviously a lot going on here. We point out the following:
(1) there are far fewer large customers than small or medium customers; (2) the large
customers tend to owe considerably more than small or medium customers; (3) the
small customers do not tend to be as long overdue as the medium or large customers;
and (4) there is no relationship between Days and Amount for the small customers, but
there is a definite positive relation-ship between these variables for the medium and
large customers. If Spring Mills really wants to decrease its receivables, it might want to
target the medium-size customer group, from which it is losing the most interest. Or it
could target the large customers because they owe the most on average. The most
appropriate action depends on the cost and effec-tiveness of targeting any particular
customer group. However, the analysis presented here gives the company a much better
picture of what’s currently going on.

This example from Chapter 3 is a typical example of trying to make sense out of a
large data set. Spring Mills has 280 observations on each of three variables. By
realistic stan-dards, this is not a large data set, but it still presents a challenge. We
examine the data from a number of angles and present several tables and charts. For
example, the scatterplots in Figures 1.3 through 1.5 clearly indicate that there is a
positive relationship between the amount owed and the number of days since billing
for the medium- and large-size cus-tomers, but that no such relationship exists for the
small-size customers. As we will see, graphs such as these are very easy to construct in
Excel, regardless of the size of the data set.
1.3 A Sampling of Examples
11
Figure Scatterplot of Amount versus Days for Small-size Customers
1.3

Scatterplot of Amount versus Days for Medium-size Customers

Figure
1.4

12 Chapter 1 Introduction to Data Analysis and Decision Making

Figure 1.5 Scatterplot of Amount versus Days for Large-size Customers

EXAMPLE 7.1

S ciTools Incorporated, a company that specializes in scientific instruments, has been

invited to make a bid on a government contract. The contract calls for a specific num-
ber of these instruments to be delivered during the coming year. The bids must be sealed
(so that no company knows what the others are bidding), and the low bid wins the
contract. SciTools estimates that it will cost $5000 to prepare a bid and $95,000 to supply
the instru-ments if it wins the contract. On the basis of past contracts of this type,
SciTools believes that the possible low bids from the competition, if there is any
competition, and the associ-ated probabilities are those shown in Table 1.1. In addition,
SciTools believes there is a 30% chance that there will be no competing bids.

Table Probabilities of Low Bids from Competition

1.1 Probability
Low Bid
Less than $115,000 0.2
Between $115,000 and $120,000 0.4
Between $120,000 and $125,000 0.3
Greater than $125,000 0.1

Solution
This is a typical example of decision making under uncertainty, the topic of Chapter 7.
SciTools has to make decisions now (whether to bid and, if so, how much to bid), without
knowing what the competition is going to do. The company can’t assure itself of a
perfect

1.3 A Sampling of Examples

13
 outcome, but it can make a rational decision in light of the uncertainty it faces. We will
see how decision trees, produced easily with the PrecisionTree add-in to Excel, not only
lay out all of the elements of the problem in a logical manner but also indicate the best
solu-tion. The completed tree for this problem is in Figure 1.6, which indicates that
SciTools should indeed prepare a bid, for the amount $115,000.

Figure 1.6 Decision Tree for SciTools

EXAMPLE 9.5

A n auditor wants to determine the proportion of invoices that contain price errors—
that is, prices that do not agree with those on an authorized price list. He checks 93
ran-
domly sampled invoices and finds that two of them include price errors. What can he
con-clude, in terms of a 95% one-sided confidence interval, about the proportion of all
invoices with price errors?

Solution
This is an important application of statistical inference in the auditing profession.
Auditors try to determine what is true about a population (in this case, all of a company’s
invoices) by examining a relatively small sample from the population. The auditor
wants an upper limit so that he is 95% confident that the overall proportion of invoices
with errors is no

14 Chapter 1 Introduction to Data Analysis and Decision Making

 greater than this upper limit. We show the spreadsheet solution in Figure 1.7, which
shows that the auditor can be 95% confident that the overall proportion of invoices with
errors is no greater than 6.6% (see cell B10).

Figure 1.7
Analysis of Auditing
Example

EXAMPLE 11.2

T
he Bendrix Company manufactures various types of parts for automobiles. The man-ager
of the factory wants to get a better understanding of overhead costs. These over-head
costs include supervision, indirect labor, supplies, payroll taxes, overtime premiums,
depreciation, and a number of miscellaneous items such as charges for building deprecia-
tion, insurance, utilities, and janitorial and maintenance expenses. Some of these overhead
costs are “fixed” in the sense that they do not vary appreciably with the volume of work
being done, whereas others are “variable” and do vary directly with the volume of work.
The fixed overhead costs tend to come from the supervision, depreciation, and miscella-
neous categories, whereas the variable overhead costs tend to come from the indirect
labor, supplies, payroll taxes, and overtime premiums categories. However, it is not easy
to draw
a clear line between the fixed and variable overhead components.
The Bendrix manager has tracked total overhead costs over the past 36 months.
To help “explain” these, he has also collected data on two variables that are related to
the amount of work done at the factory. These variables are
■ MachHrs: number of machine hours used during the month
■ ProdRuns: number of separate production runs during the month
The first of these is a direct measure of the amount of work being done. To understand
the second, we note that Bendrix manufactures parts in fairly large batches. Each batch
corre-sponds to a production run. Once a production run is completed, the factory must
“set up” for the next production run. During this setup there is typically some downtime
while the machinery is reconfigured for the part type scheduled for production in the
next batch. Therefore, the manager believes both of these variables might be responsible
(in different ways) for variations in overhead costs. Do scatterplots support this belief?

Solution
This is a typical regression example, in a cost-accounting setting. The manager is trying
to see what type of relationship, if any, there is between overhead costs and the two
explana-tory variables: number of machine hours and number of production runs. The
scatterplots requested appear in Figures 1.8 and 1.9. They do indeed indicate a positive
and linear rela-tionship between overhead and the two explanatory variables.

1.3 A Sampling of Examples

15
Figure Scatterplot of Overhead versus Machine Hours
1.8

Scatterplot of Overhead versus Production Runs

Figure
1.9

16 Chapter 1 Introduction to Data Analysis and Decision Making

 However, regression goes well beyond scatterplots. It estimates an equation relating
the variables. This equation can be determined from regression output such as that shown
in Figure 1.10. This output implies the following equation for predicted overhead as a
function of machine hours and production runs:
Predicted Overhead 5 3997 1 43.54MachHrs 1 883.62ProdRuns

Figure 1.10 Multiple Regression Output for Bendrix Example

The positive coefficients of MachHrs and ProdRuns indicate the effects these
variables have on overhead. We will not take the example any further at this point but will
simply indicate that it is easy to generate the output in Figure 1.10 with StatTools. The
challenge is learning how to interpret it. We spend plenty of time in Chapters 11 and 12 on
interpretation issues. ■

EXAMPLE 13.3

T he file PCDevices.xls contains quarterly sales data (in millions of dollars) for a chip-
manufacturing firm from the beginning of 1990 through the end of 2004. Are the
com-
pany’s sales growing exponentially through this entire period?

Solution
This example illustrates a regression-based trend curve, one of several possible
forecasting techniques for a time series variable. A time series graph of the company’s
quarterly sales appears in Figure 1.11. It indicates that sales have been increasing steadily
at an increasing rate. This is basically what an exponential trend curve implies. To
estimate this curve we use regression analysis to obtain the following equation for
predicted quarterly sales as a function of time:
Predicted Sales 5 61.376e0.0663Time

This equation implies that the company’s sales are increasing by approximately 6.6%
per quarter during this period, which translates to an annual percentage increase of about
29%! As we see in Chapter 13, this is the typical approach used in forecasting. We look at
a time series graph to discover trends or other patterns in historical data and then use one
of a variety of techniques to fit the observed patterns and extrapolate them into the future.

1.3 A Sampling of Examples

17
Figure 1.11
Time Series Graph
of Quarterly Sales
at a PC Chip
Manufacturer

EXAMPLE 15.6

A t the present time, the beginning of year 1, the Barney-Jones Investment Corporation
has $100,000 to invest for the next 4 years. There are five possible investments,
labeled A through E. The timing of cash outflows and cash inflows for these investments
is somewhat irregular. For example, to take part in investment A, cash must be invested at
the beginning of year 1, and for every dollar invested, there are returns of $0.50 and
$1.00 at the beginnings of years 2 and 3. Similar information for the other investments
are as fol-lows, where all returns are per-dollar invested:
■ Investment B: Invest at the beginning of year 2, receive returns of $0.50 and $1.00
at the beginnings of years 3 and 4.
■ Investment C: Invest at the beginning of year 1, receive return of $1.20 at the
begin-ning of year 2.
■ Investment D: Invest at the beginning of year 4, receive return of $1.90 at the
begin-ning of year 5.
■ Investment E: Invest at the beginning of year 3, receive return of $1.50 at the
begin-ning of year 4.
We assume that any amounts can be invested in these strategies and that the returns are
the same for each dollar invested. However, to create a diversified portfolio, Barney-
Jones decides to limit the amount put into any investment to $75,000. The company
wants an investment strategy that maximizes the amount of cash on hand at the beginning
of year 5. At the beginning of any year, it can invest only cash on hand, which includes
returns from previous investments. Any cash not invested in any year can be put in a
short-term money market account that earns 3% annually.

Solution
This is one of many optimization examples we present in Chapters 14 and 15. The
typical situation is that a company such as Barney-Jones must make several decisions,
subject to certain constraints, that optimize some objective. In this case, Barney-Jones
needs to decide the amounts to invest, subject to some constraints, to maximize its ending
cash 4 years from

18 Chapter 1 Introduction to Data Analysis and Decision Making

 now. Our job is to formulate a spreadsheet model, similar to the one shown in Figure
1.12, that relates the various elements of the problem.
The investment amounts in row 26 are the decision variables, called “changing cells”
in Excel’s terminology. When we formulate the model, we can enter any values in these
changing cells; we do not need to guess “good” values. Then we turn it over to Excel’s
Solver add-in. The Solver uses a powerful algorithm to find the optimal values in the
changing cells—that is, the values that optimize the objective while satisfying the con-
straints. The values shown in Figure 1.12 are actually the optimal values. They imply that
Barney-Jones can end with final cash of $286,792 by investing as indicated in row 26.

Figure 1.12 Investment Model

EXAMPLE 17.9

W e assume that there are two dominant companies in the soft drink industry: “us” and
“them.” For this example, we will view everything from the point of view of
“us.”
We start with a 45% market share. During each of the next 20 quarters, each company
pro-motes its product to some extent. To make the model simple, we will assume that
each company each quarter either promotes at a “regular” level or at a “blitz” level.
Depending on each company’s promotional behavior in a given month, the change in our
market share from this month to the next is triangularly distributed, with parameters
given in Table 1.2. For example, if we blitz and they don’t, then we could lose as much
as 1% market share, we could gain as much as 6% market share, and our most likely
outcome is an increase of 2% market share. We want to develop a simulation model that
allows us to gauge the long-term change in our market share for any pattern of blitzing
employed by us and them.

1.3 A Sampling of Examples

19
 Table 1.2 Parameters of Market Share Change Distributions
Blitzer Minimum Most Likely Maximum
Neither -0.03 0.00 0.03
Both -0.05 0.00 0.05
Only us -0.01 0.02 0.06
Only them -0.06 -0.02 0.01

Solution
This is a typical example of computer simulation. We make a number of assumptions,
build a spreadsheet model around these assumptions, explicitly incorporate uncer-
tainty into some of the cells, and see how this uncertainty affects “bottom-line” out-
puts. The simulation model appears in Figure 1.13. Several cells in this model are
random, including all of the numerical values in rows 21 through 24. Therefore, the
numbers you see in this figure represent just one possible scenario of how market
shares might evolve through time. By generating new random values, we see different
scenarios.
Our job is to build the logic and randomness into the spreadsheet model. Then we can
use Excel’s built-in tools or an add-in such as @RISK to replicate the model and keep
track of selected outputs. A typical result from @RISK appears in Figure 1.14. It shows a
time series graph of how our market share might evolve, given a certain strategy of
blitzing by our company and theirs.

Figure 1.13 Spreadsheet Simulation for Market Share Example

20 Chapter 1 Introduction to Data Analysis and Decision Making

Figure 1.14 Summary Chart of Our Market Share for One Set of Strategies

1.4 MODELING AND MODELS

We have already used the term model several times in this chapter. In fact, we have
shown several spreadsheet models in the previous section. Models and the modeling
process are key elements throughout this book, so we explain them in more detail in this
section.3
A model is an abstraction of a real problem. A model tries to capture the essence and
key features of the problem without getting bogged down in relatively unimportant
details. There are different types of models, and, depending on an analyst’s preferences
and skills, each can be a valuable aid in solving a real problem. We describe three types
of models here: (1) graphical models, (2) algebraic models, and (3) spreadsheet models.

1.4.1 Graphical Models

Graphical models are probably the most intuitive and least quantitative type of model.
They attempt to portray graphically how different elements of a problem are related—what
affects what. A very simple graphical model appears in Figure 1.15. It is called an
“influence diagram.” (It can be constructed with the PrecisionTree add-in discussed in
Chapter 7, but we will not use influence diagrams in this book.)

Figure 1.15
Influence Diagram
for Souvenir
Example

3
Management scientists tend to use the terms model and modeling more than statisticians. However, many tradi-
tional statistics topics such as regression analysis and forecasting are clearly applications of modeling.

1.4 Modeling and Models

21
 This particular influence diagram is for a company that is trying to decide how many
souvenirs to order for the upcoming Olympics. The essence of the problem is that the
com-pany will order a certain supply, customers will request a certain demand, and the
combi-nation of supply and demand will yield a certain payoff for the company. The
diagram indicates fairly intuitively what affects what. As it stands, the diagram does
not provide enough quantitative details to enable us to “solve” the company’s problem.
But this is usu-ally not the purpose of a graphical model. Instead, its purpose is usually to
show the impor-tant elements of a problem and how they are related. For complex
problems this can be very helpful and enlightening information for management.

1.4.2 Algebraic Models

Algebraic models are at the opposite end of the spectrum. By means of algebraic
equations and inequalities, they specify a set of relationships in a very precise way, and
their precise-ness and lack of ambiguity are very appealing to people with a mathematical
background. In addition, algebraic models can usually be stated concisely and with great
generality.
A typical example is the “product mix” problem we discuss in Chapter 14. A
company can make several products, each of which contributes a certain amount to profit
and con-sumes certain amounts of several scarce resources. The problem is to select the
product mix that maximizes profit subject to the limited availability of the resources. All
product mix problems can be stated algebraically as follows:
n
max ^ pj x j (1.1)
j51
n
subject to ^ a ij x j # bi, 1 # i# m (1.2)
j51

0 # xj # uj, 1# j# n (1.3)

Here xj is the amount of product j produced, uj is an upper limit on the amount of product
j that can be produced, j p is the unit profit margin for product
ij j, a is the amount of
resource i consumed by each unit of product
i j, b is the amount of resource i available, n is
the number of products, and m is the number of scarce resources. This algebraic model
states very con-cisely that we should maximize total profit [expression (1.1)], subject
to consuming no more of the resources than is available [inequalities (1.2)], and all
production quantities should be between 0 and the upper limits [inequalities (1.3)].
Algebraic models such as this appeal to mathematically trained analysts. They are
concise, they spell out exactly which data are required (we would need to estimate the j
u ’s, the
j p ’s, the
ij a ’s, and the
i b ’s from company data), they scale well (a problem
with 500 products and 100 resource constraints is just as easy to state as one with only 5
prod-ucts and 3 resource constraints), and many software packages accept algebraic
models in essentially the same form as shown here, so that no “translation” is required.
Indeed, alge-braic models were the preferred type of model for years—and still are by
many analysts. Their main drawback is that they require an ability to work with
abstract mathematical symbols. Some people have this ability, but many perfectly
intelligent people do not.

1.4.3 Spreadsheet Models

A fairly recent alternative to algebraic modeling is spreadsheet modeling. Instead of relat-
ing various quantities with algebraic equations and inequalities, we relate them in a
spread-sheet with cell formulas. This process is much more intuitive to most people (at
least in our experience). One of the primary reasons for this is the instant feedback
available from

22 Chapter 1 Introduction to Data Analysis and Decision Making

 spreadsheets. If you enter a formula incorrectly, it is often immediately obvious (from
error messages or unrealistic numbers) that you have made an error, which you can then
go back and fix. Algebraic models provide no such immediate feedback.
A specific comparison might help at this point. We already saw a general
algebraic model of the product mix problem. Figure 1.16, taken from Chapter 14,
illustrates a spreadsheet model for a specific example of this problem. The spreadsheet
model should be fairly self-explanatory. All quantities in shaded cells are inputs to the
model, the quanti-ties in row 16 are the decision variables (theyj correspond to the x ’s in
the algebraic model), and all other quantities are created through appropriate Excel
formulas. To indicate con-straints, we enter inequality signs in appropriate cells.

Figure 1.16 Optimal Solution for Product Mix Example

A B C D E F G H I
1 Product mix model
2
3 Input data Range names used:
4 Hourly wage rate $8.00 Frames_produced =Model!$B$16:$E$16
5 Cost per oz of metal $0.50 Maximum_sales =Model!$B$18:$E$18
6 Cost per oz of glass $0.75 Profit =Model!$F$32
7 Resources_available =Model!$D$21:$D$23
8 Frame type 1 2 3 4 Resources_used =Model!$B$21:$B$23
9 Labor hours per frame 2 1 3 2
10 Metal (oz.) per frame 4 2 1 2
11 Glass (oz.) per frame 6 2 1 2
12 Unit selling price $28.50 $12.50 $29.25 $21.50
13
14 Production plan
15 Frame type 1 2 3 4
16 Frames produced 1000 800 400 0
17 <= <= <= <=
18 Maximum sales 1000 2000 500 1000
19
20 Resource constraints Used Available
21 Labor hours 4000 <= 4000
22 Metal (oz.) 6000 <= 6000
23 Glass (oz.) 8000 <= 10000
24
25 Revenue, cost summary
26 Frame type 1 2 3 4 Totals
27 Revenue $28,500 $10,000 $11,700 $0 $50,200
28 Costs of inputs
29 Labor $16,000 $6,400 $9,600 $0 $32,000
30 Metal $2,000 $800 $200 $0 $3,000
31 Glass $4,500 $1,200 $300 $0 $6,000
32 Profit $6,000 $1,600 $1,600 $0 $9,200

Although a well-designed and well-documented spreadsheet model such as the one in

Figure 1.16 is undoubtedly more intuitive for most people than its algebraic counterpart,
the art of developing good spreadsheet models is not easy. Obviously, they must be
correct. The formulas relating the various quantities must have the correct syntax, the
correct cell references, and the correct logic. In complex models this can be quite a
challenge.
However, correctness is not enough. If spreadsheet models are to be used in the busi-
ness world, they must also be well designed and well documented. Otherwise, no one
other than you (and maybe not even you after a few weeks have passed) will be able to
under-stand what your models do or how they work. The strength of spreadsheets
is their

1.4 Modeling and Models

23
 flexibility—you are limited only by your imagination. However, this flexibility can be a
liability in spreadsheet modeling unless you plan the design of your models carefully.
Note the clear design in Figure 1.16. Most of the inputs are grouped at the top of
the spreadsheet. All of the financial calculations are done at the bottom. When there are
constraints, the two sides of the constraints are placed next to each other (as in the
range B21:D23). Borders, colors (which appear on the screen but not in this book), and
shading are used for added clarity. Descriptive labels are used liberally. Excel itself
imposes none of these “rules,” but you should impose them on yourself.
We have made a conscious effort to establish good habits for you to follow
throughout this book. We have designed and redesigned our spreadsheet models so that
they are as clear as possible. This does not mean that you have to copy everything we do
—everyone tends to develop their own spreadsheet style—but our models should give you
something to emulate. Just remember that in the business world, you typically start with a
blank spreadsheet. It is then up to you to develop a model that is not only correct but is also
intelligible to you and to others. This takes a lot of practicing and a lot of editing, but it is a
skill well worth developing.

1.4.4 The Seven-Step Modeling Process

Most of the modeling you will do in this book is only part of the overall modeling process
typically done in the business world. We portray it as a seven-step process, as
discussed here. Of course, not all problems require all seven steps. For example, the
analysis of sur-vey data might entail primarily steps 2 (data analysis) and 5 (decision
making), without the formal model building discussed in steps 3 and 4.
The Modeling Process
1. Define the problem. Typically, a company does not develop a model unless it
believes it has a problem. Therefore, the modeling process really begins by identify-
ing an underlying problem. Perhaps the company is losing money, perhaps its market
share is declining, or perhaps its customers are waiting too long for service. Any
number of problems might be evident. However, as several people have warned [see
Miser (1993) and Volkema (1995), for example], this step is not always as straight-
forward as it might appear. The company must be sure that it has identified the right
problem before it spends time, effort, and money trying to solve it.
For example, Miser cites the experience of an analyst who was hired by the military
to investigate overly long turnaround times between fighter planes landing and
taking off again to rejoin the battle. The military was convinced that the problem
was caused by inefficient ground crews; if they were sped up, turnaround times
would decrease. The analyst nearly accepted this statement of the problem and was
about to do classical
time-and-motion studies on the ground crew to pinpoint the sources of their
inefficiency. However, by snooping around, he found that the problem obviously lay
elsewhere. The trucks that refueled the planes were frequently late, which in turn was
due to the ineffi-cient way they were refilled from storage tanks at another location.
Once this latter prob-lem was solved—and its solution was embarrassingly simple—
the turnaround times decreased to an acceptable level without any changes on the part
of the ground crews. If the analyst had accepted the military’s statement of the
problem, the real problem might never have been located or solved.
2. Collect and summarize data. This crucial step in the process is often the most
tedious. All organizations keep track of various data on their operations, but these
data are often not in the form an analyst requires. They are also typically scattered in
dif-ferent places throughout the organization, in all kinds of different formats.
Therefore, one of the first jobs of an analyst is to gather exactly the right data and
summarize the

24 Chapter 1 Introduction to Data Analysis and Decision Making

 data appropriately—as we discuss in detail in Chapters 2 and 3—for use in the
model. Collecting the data typically requires asking questions of key people (such as
the accountants) throughout the organization, studying existing organizational
databases, and performing time-consuming observational studies of the
organization’s processes. In short, it entails a lot of leg work.
3. Formulate a model. This is the step we emphasize, especially in the latter chapters
of the book. The form of the model varies from one situation to another. It could be a
graphical model, an algebraic model, or a spreadsheet model. The key is that the
model should capture the key elements of the business problem in such a way that it
is understandable by all parties involved. This latter requirement is why we favor
spreadsheet models, especially when they are well designed and well documented.
4. Verify the model. Here the analyst tries to determine whether the model developed
in the previous step is an accurate representation of reality. A first step in determining
how well the model fits reality is to check whether the model is valid for the current
situation. This verification can take several forms. For example, the analyst could use
the model with the company’s current values of the input parameters. If the model’s
outputs are then in line with the outputs currently observed by the company, the ana-
lyst has at least shown that the model can duplicate the current situation.
A second way to verify a model is to enter a number of input parameters (even if
they are not the company’s current inputs) and see whether the outputs from the
model are reasonable. One common approach is to use extreme values of the inputs
to see whether the outputs behave as they should. If they do, then we have another
piece of evidence that the model is reasonable.
If certain inputs are entered in the model, and the model’s outputs are not as
expected, there could be two causes. First, the model could simply be a poor
representation of reality. In this case it is up to the analyst to refine the model until it
provides reason-ably accurate predictions. The second possible cause is that the
model is fine but our intuition is not very good. In this case the fault lies with us, not
the model.
A typical example of faulty intuition occurs with random sequences of 0’s and 1’s,
such as might occur with successive flips of a fair coin. Most people expect that
heads and tails will alternate and that there will be very few sequences of, say, four or
more heads (or tails) in a row. However, a perfectly accurate simulation model of
these flips will show, contrary to what most people expect, that fairly long runs of
heads or tails are not at all uncommon. In fact, one or two long runs should be
expected if there are enough flips.
The fact that outcomes sometimes defy intuition is an important reason why models
are important. These models prove that our ability to predict outcomes in complex
environments is often not very good.
5. Select one or more suitable decisions. Many, but not all, models are decision mod-
els. For any specific decisions, the model indicates the amount of profit obtained, the
amount of cost incurred, the level of risk, and so on. If we believe the model is work-
ing correctly, as discussed in step 4, then we can use the model to see which deci-
sions produce the best outputs.
6. Present the results to the organization. In a classroom setting you are typically fin-
ished when you have developed a model that correctly solves a particular problem. In
the business world a correct model, even a useful one, is not always enough. An ana-
lyst typically has to “sell” the model to management. Unfortunately, the people in
management are sometimes not as well trained in quantitative methods as the analyst,
so they are not always inclined to trust complex models.

1.4 Modeling and Models

25
 There are two ways to mitigate this problem. First, it is helpful to include relevant
people throughout the company in the modeling process—from beginning to end—so
that everyone has an understanding of the model and feels an ownership for it.
Second, it helps to use a spreadsheet model whenever possible, especially if it is
designed and documented properly. Almost everyone in today’s business world is
comfortable with spreadsheets, so spreadsheet models are more likely to be accepted.
7. Implement the model and update it over time. Again, there is a big difference
between a classroom situation and a business situation. When you turn in a classroom
assignment, you are typically finished with that assignment and can await the next
one. In contrast, an analyst who develops a model for a company can usually not pack
up his bags and leave. If the model is accepted by management, the company will
then need to implement it company-wide. This can be very time consuming and
politically difficult, especially if the model’s prescriptions represent a significant
change from the past. At the very least, employees must be trained how to use the
model on a day-to-day basis.
In addition, the model will probably have to be updated over time, either because of
changing conditions or because the company sees more potential uses for the model
as it gains experience using it. This presents one of the greatest challenges for a
model developer, namely, the ability to develop a model that can be modified as the
need arises. Keep this in mind as you develop models throughout this book. Always
try to make them as general as possible.

1.5 CONCLUSION
In this chapter we tried to convince you that the skills in this book are important for you
to know as you enter the business world. The methods we discuss are no longer the
sole province of the “quant jocks.” By having a PC on your desk that is loaded with
powerful software, you incur a responsibility to use this software to solve business
problems. We have described the types of problems you will learn to solve in this book,
along with the software you will use to solve them. We also discussed the modeling
process, a theme that runs throughout this book. Now it’s time for you to get started!

26 Chapter 1 Introduction to Data Analysis and Decision Making

 C ASE 1.1 E NTERTAINMENT ON A CRUISE SHIP

C ruise ship traveling has become big

business. Many cruise lines are now
competing for cus-
bar in an intimate lounge, a group of
professional singers and dancers played
Broadway-type shows about twice
tomers of all age groups and
socioeconomic levels. They offer all
types of cruises, from relatively inex-
pensive 3- to 4-day cruises in the
Caribbean, to
12- to 15-day cruises in the
Mediterranean, to several-month around-
the-world cruises. Cruises have several
features that attract customers, many of
whom book 6 months or more in
advance: (1) they offer a
relaxing, everything-done-for-you way to
travel; (2) they serve food that is
plentiful, usu-ally excellent, and included
in the price of the cruise; (3) they stop at
a number of interesting ports and offer
travelers a way to see the world; and (4)
they provide a wide variety of entertain-
ment, particularly in the evening.
This last feature, the
entertainment, presents a difficult
problem for a ship’s staff. A typical cruise
might have well over 1000
passengers, including elderly singles and
couples, middle-aged people with or
without children, and young people, often
honey-mooners. These various types of
passengers have varied tastes in terms of
their after-dinner prefer-ences in
entertainment. Some want traditional
dance music, some want comedians, some
want rock music, some want
movies, some want to go back to their
cabins and read, and so on. Obviously,
cruise entertainment directors want to
provide the variety of entertainment their
customers desire— within a reasonable
budget—because satisfied cus-tomers
tend to be repeat customers. The
question is how to provide the right mix
of entertainment.
On a cruise one of the authors and his
wife took a few years ago, the
entertainment was of high quality and
there was plenty of variety. A seven-piece
show band played dance music nightly in
the largest lounge, two other small musical
combos played nightly at two smaller
lounges, a pianist played nightly at a piano
weekly, and various professional singers passengers in the entertainment
and comedi-ans played occasional lounges. The morale of the enter-tainers
single-night performances.4 Although was not great—entertainers love packed
this entertainment was free to all of the houses—but they usually
passengers, much of it had argued, philosophically, that their hours
embarrassingly low atten-dance. The were relatively short and they were still
nightly show band and musical combos, getting paid to see the world.
who were contracted to play nightly If you were in charge of entertainment
until midnight, often had less than a on this ship, how would you describe the
half dozen people in the audi-ence— problem with enter-tainment: Is it a
sometimes literally none. The problem with deadbeat passengers, low-
professional singers, dancers, and quality entertainment, or a mismatch
comedians attracted larger audi- between the entertainment offered and the
ences, but there were still plenty of entertainment desired? How might you try
empty seats. In spite of this, the cruise to solve the problem? What con-straints
staff posted a weekly schedule, and might you have to work within? Would you
they stuck to it regardless of keep a strict schedule such as the one
attendance. In a short-term financial followed by this cruise director, or would
sense, it didn’t make much differ- you play it more “by ear”? Would you
ence.The performers got paid the same gather data to help solve the problem?
whether any-one was in the audience or What data would you gather? How much
not, the passengers had already paid would finan-cial considerations dictate your
(indirectly) for the entertainment as decisions? Would they be long-term or
part of the cost of the cruise, and the short-term considerations? ■
only possible oppor-tunity cost to the 4
There was also a moderately large onboard casino, but it tended to
cruise line (in the short run) was the attract the same people every night, and it was always closed when
loss of liquor sales from the lack of the ship was in port.

Case 1.1 Entertainment on a Cruise Ship

27