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© Cengage Learning


TopRank is a “what-if” add-in used for sensitivity analysis. It starts with any spreadsheet model, where a set of inputs, along with a number of spreadsheet formulas, leads to one or more outputs. TopRank then performs a sensitivity analysis to see which inputs have the larg- est effect on a given output. Unlike @RISK, TopRank does not explicitly model uncertainty.

So ware Guide

Figure 1.2 illustrates how these add-ins are used throughout the book. Excel doesn’t appear

Figure 1.2

Software Guide

explicitly in this gure because it is used extensively in all

of the chapters.

Developer Albright
Add-In Chapter(s) Where Used SolverTable 13, 14
Chapter(s) Where Used
13, 14
Frontline Solver Systems, Inc. @RISK PrecisionTree Palisade Corp. StatTools NeuralTools BigPicture
Systems, Inc.
Palisade Corp.
13, 14
13, 14
15–16 6 2, 3, 7–12, 17, 19–20
2, 3, 7–12, 17, 19–20
17 13–16

With Excel and the add-ins available with the book, you have a wealth of software at your disposal. The examples and step-by-step instructions throughout the book will help you become a power user of this software. Admittedly, this takes plenty of practice and a willingness to exper- iment, but it is certainly within your grasp. When you are nished, it is very possible that you will rate “improved software skills” as the most valuable thing you have learned from the book.

as the most valuable thing you have learned from the book. 1-3 MODELING AND MODELS The
as the most valuable thing you have learned from the book. 1-3 MODELING AND MODELS The



The term model

process are key elements throughout the book, so we explain them here in more detail. 6 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 brie y describe three types of models here: graphical models, algebraic models, and spreadsheet models.

has already appeared several times in this chapter. Models and the modeling


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

6 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 de nitely applications of modeling.

10 Chapter 1

Introduction to Business Analytics

what. A fairly simple graphical model for an ordering decision appears in Figure 1.3. (It was created with Palisade’s BigPicture add-in.)

Figure 1.3

Graphical Model of an Ordering Decision

Parameters of Demand Func on Unit Price Demand Unit Cost to Produce Cost Revenue Maximize
Parameters of
Demand Func on
Unit Price
Unit Cost to
© Cengage Learning

This diagram indicates fairly intuitively what affects what. It does not provide enough quantitative details to “solve” the company’s problem, but this is usually not the purpose of a graphical model. Instead, its purpose is usually to show the important elements of a problem and how they are related. For complex problems, this can be very enlightening information for management.


Algebraic Models

Algebraic models are at the opposite end of the spectrum. Using algebraic equations and

inequalities, they specify a set of relationships in a very precise way. Their preciseness and lack of ambiguity are very appealing to people with a mathematical background. In addi- tion, algebraic models can usually be stated concisely and with great generality. A typical example is the “product mix” problem in Chapter 13. A company can make several products, each of which contributes a certain amount to pro t and consumes certain amounts of several scarce resources. The problem is to select the product mix that maxi-

product mix problems

mizes pro t subject to the limited availability of the resources. All can be stated algebraically as follows:

Algebraic Product Mix Model n max a p j x j (1.1) j = 1
Algebraic Product Mix Model
max a p j x j
j = 1
subject to a a ij x j ≤ b i ,
1 ≤ i ≤ m
j = 1
0 ≤ x j ≤ u j , 1 ≤ j ≤ n

1-3 Modeling and Models


Here x j is the amount of product j produced, u j is an upper limit on the amount of product j that can be produced, p j is the unit pro t margin for product j, a ij is the amount of resource i consumed by each unit of product j, b i 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 concisely that we should maximize total pro t [Expression (1.1)], subject to consuming no more of each resource than is available [Inequality (1.2)], and all production quantities should be between 0 and their upper limits [Inequality (1.3)]. Algebraic models appeal to mathematically trained analysts. They are concise, they spell out exactly which data are required (the values of the u j ’s, the p j ’s, the a ij ’s, and the b j ’s would need to be estimated 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 ve products and three 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.


Spreadsheet Models

An alternative to algebraic modeling is spreadsheet modeling. Instead of relating various quantities with algebraic equations and inequalities, they are related in a spreadsheet with cell formulas. In our experience, this process is much more intuitive to most people. One of the primary reasons for this is the instant feedback available from spreadsheets. If you enter a formula incorrectly, it is often immediately obvious (from error messages or unreal- istic numbers) that you have made an error, which you can then go back and x. Algebraic models provide no such immediate feedback. A speci c comparison might help at this point. You already saw a general algebraic model of the product mix problem. Figure 1.4, taken from Chapter 13, illustrates a spread- sheet model for a speci c example of this problem. The spreadsheet model should be fairly self-explanatory. All quantities in shaded cells (other than in rows 16 and 25) are inputs to the model, the quantities in row 16 are the decision variables (they correspond to the x j ’s in the algebraic model), and all other quantities are created through appropriate Excel formu- las. To indicate constraints, inequality signs have been entered as labels in appropriate cells. Although a well-designed and well-documented spreadsheet model such as the one in Figure 1.4 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. This can be quite a challenge in complex models. 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 understand what your models do or how they work. The strength of spreadsheets is their exibility—you are limited only by your imagination. However, this exibility can be a liability in spreadsheet modeling unless you design your models carefully. Note the clear design in Figure 1.4. Most of the inputs are grouped at the top of the spreadsheet. All of the nancial calculations are done at the bottom. When there are con- straints, the two sides of the constraints are placed next to each other (as in the range B21:D22). Colored backgrounds (which appear on a computer monitor but not in the book) are used for added clarity, and 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 the book. We have designed our spreadsheet models so that they are as clear as possible.

12 Chapter 1

Introduction to Business Analytics

Figure 1.4 Product Mix Model A B C D E F G 1 Assembling and
Figure 1.4
Product Mix Model
Assembling and tes ng c
oo mm ppuu ttee rr ss
RR aa nn gg ee n ames used:
Cost per labor hour assembling
Cost per labor hour tes ng
Inputs for assembling and tes ng a computer
Labor hours for assembly
Labor hours for testing
Cost of component parts
Selling p ri ce
$4 50
Unit margin
Assembling, tes ng plan (# of computers)
Number to produce
56 0
1 20
Maximum sales
1 20
Constraints (hours per month)
Hours used
Hours available
Labor availability for assembling
Labor availability for tes ng
Net profit ($ this month)

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

then up to you to develop a model that is not only correct but is also intelligible to you and others. This takes a lot of practice and a lot of editing, but it is a skill well worth developing.

spreadsheet. It is


A Seven-Step Modeling Process

Most of the modeling you will do in this book is only part of an overall modeling process typically done in the business world. We portray it as a seven-step process, as discussed here. Admittedly, not all problems require all seven steps. For example, the analysis of survey data might entail primarily steps 2 (data analysis) and 5 (decision making) of the process, without the formal model building discussed in steps 3 and 4.

e 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 identifying 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 examples], this step is not always as straightforward as

1-3 Modeling and Models


it might appear. The company must be sure that it has identified the correct

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 prob- lem was caused by inefficient ground crews; if they were faster, 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 prob- lem obviously lay elsewhere. The trucks that refueled the planes were frequently late, which in turn was due to the inefficient way they were refilled from storage tanks at another location. Once this latter problem 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 different 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 data appropriately—as discussed in detail in Chapters 2 and 3—for use in the model. Collecting the data typically requires asking questions of key peo- ple (such as the accountants) throughout the organization, studying existing data- bases, and performing time-consuming observational studies of the organization’s processes. In short, it entails a lot of legwork. Fortunately, many companies have understood the need for good clean data and have spent large amounts of time and money to build data warehouses for quantitative analysis.

3. Develop 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 must capture the important 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 docu- mented.

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 determin- ing 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 analyst 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, this is 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 be a poor representation of reality. In this case it is up to the analyst to refine the model so that it is more realistic.

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Introduction to Business Analytics

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. 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 models. 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 the model is working correctly, as discussed in step 4, then it can be used to see which decisions produce the best outputs.

6. Present the results to the organization. In a classroom setting you are typically finished when you have developed a model that correctly solves a particular prob- lem. In the business world a correct model, even a useful one, does not always suffice. An analyst 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. 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

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 usually cannot 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 suggestions 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 chal- lenges for a model developer, namely, the ability to develop a model that can be modified as the need arises.

of it. Second, it helps to use a spreadsheet

need arises. of it. Second, it helps to use a spreadsheet 1-4 CONCLUSION In this chapter
need arises. of it. Second, it helps to use a spreadsheet 1-4 CONCLUSION In this chapter



In this chapter we have 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 computer that is loaded with powerful software, you incur a responsibility to use this software to analyze business problems effectively. We have described the types of problems you will learn to analyze in this book, along with the software you will use to analyze them. We also discussed the modeling process, a theme that runs throughout this book. Now it is time for you to get started!

1-4 Conclusion




C ruise ship traveling has become big business.

S HIP C ruise ship traveling has become big business. Many cruise lines are now competing

Many cruise lines are now competing for

customers of all age groups and socioeconomic

levels. They offer all types of cruises, from relatively


to 12


- to
- to

4 -day cruises in the Caribbean,

- to
- 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 six months or more in advance: (1) they

offer a relaxing, everything-done-for-you way

to travel; (2) they serve food that is plentiful,

usually 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 entertainment,

particularly in the evening.

This last feature, the entertainment, presents

a difficult problem for a ship’s staff.

A typical cruise

a difficult problem for a ship’s staff. A typical cruise might have well over 1000 passengers,

might have well over


passengers, including

elderly singles and couples, middle-aged people

with or without children, and young people, often

honeymooners. These various types of passengers

have varied tastes in terms of their after-dinner

preferences in entertainment.


ome 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 customers

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

bar in an intimate lounge, a group of professional

singers and dancers played Broadway-type shows

about twice weekly, and various professional

singers and comedians played occasional single-night

performances. 7

A lthough this entertainment was free

to all of the passengers, much of it had embarrassingly

low attendance. The nightly show band and musical

combos, who were contracted to play nightly

until midnight, often had less than a half-dozen

people in the audience—sometimes literally none.

The professional singers, dancers, and comedians

attracted larger audiences, but there were still plenty

of empty seats. In spite of this, the cruise staff posted

a weekly schedule, and they stuck to it regardless of

attendance. In a short-term financial sense, it didn’t

make much difference. The performers got paid the

same whether anyone was in the audience or not,

the passengers had already paid (indirectly) for the

entertainment as part of the cost of the cruise, and

the only possible opportunity cost to the cruise

line (in the short run) was the loss of liquor sales

from the lack of passengers in the entertainment

lounges. The morale of the entertainers was not

great—entertainers love packed houses—but they

usually argued, philosophically, that their hours were

relatively short and they were still getting paid to see

the world.
the world.

If you were in charge of entertainment on

this ship, how would you describe the problem

with entertainment: Is it a problem with deadbeat

passengers, low-quality entertainment, or a

mismatch between the entertainment offered and

the entertainment desired? How might you try to

solve the problem? What constraints might you have

to work within? Would you keep a strict schedule

such as the one followed by this cruise director, or

would you play it more by ear? Would you gather

data to help solve the problem? What data would

you gather? How much would financial considerations

dictate your decisions? Would they be long-term or

short-term considerations?


There was also a moderately large onboard casino, but it tended to


attract the same people every night, and it was always closed when


the ship was in port.



Chapter 1
Chapter 1

Introduction to Business

A nalytics