Lecture Notes 2

Business Mathematics

Business Mathematics Lecture Notes 02

Topic: Regression and Correlation Analysis

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Lecture Notes 2

Business Mathematics

Chapter 2: Regression and Correlation Analysis

The high-low (H-L) method studied earlier is one of the methods that we may employ to separate total semi-variable cost into fixed and variable cost, but the downside to this H-L method is that it considers only the extreme values (i.e. the highest and the lowest values) in finding the variable and the fixed cost of a semi-variable cost. We can therefore use the regression analysis method to find the variable and fixed cost in the total semi-variable cost, but this method unlike the H-L method uses all available data to calculate the line of best fit by a statistical method.

LINE OF BEST FIT

We can represent a straight line by: Y = a + bx When we draw a scatter diagram, we may wish to draw a straight line through so as to enable us to make future forecast. In doing so, it is necessary to fit a straight line through the points on the scatter diagram which best represents all of the plotted points. We can do this using: Fitting a line by eye The high low method Least square method (the most mathematically correct method)

SCATTER DIAGRAM Scatter diagram is where information about two variables that are considered to be related in some way can be plotted. In plotting such variables, we need to consider which one is independent variable (X) and which one is dependent variable (Y).

LEAST SQUARE METHOD

The least square method, like the high -low method is used to predict linear relationship between two variables but unlike the high-low method, it uses all past data to calculate the line of best fit.

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Lecture Notes 2

Business Mathematics

Total cost
X x x x x x x x x x

Line of best fit (regression line y on x)

x x

Level of Activity

COMPUTING THE REGRESSION LINE Y ON X

Assuming equation of the regression line y on x is: y= a + bx

a = y - bx n b= n

nxy xy nx2 (x)2

b must be calculated first as it is needed to calculate a n= the number of pairs of x, y values (i.e. the number of points on the scatter graph) = Sum of, i.e. add all the numbers under one column to obtain the total under such column.

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Lecture Notes 2 CORRELATION ANALYSIS

Business Mathematics

The relationship derived from linear regression will only be of use in prediction if there is a strong linear correlation (relationship) between the variables (the line is a good fit)

CORRELATION COEFFICIENT (R) Correlation coefficient (r) is used to measure the strength of correlation or the strength of the relationship between two variables. Peasons correlation coefficient is also known as Product moment Correlation coefficient, (r) is completed as:

n xy x y R= (n x2 (x)2)(n y2 (y)2)

INTERPRETATION OF COEFFICIENT OF CORRELATION

The value of r varies between +1 and -1 where R R R = = = +1 means perfect positive linear correlation 0 means no correlation -1 means perfect negative linear correlation

Perfect - ve cc

strong - ve cc

weak - ve cc

no cc

weak + ve cc

strong + ve cc

perfect + ve cc

-1

+1

Note - ve cc = negative correlation + ve cc = positive correlation (this implies that the two variables are inversely related) (this implies that the two variables are directly related)

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Lecture Notes 2
ILLUSTRATION Cost Predictions

Business Mathematics

The following table shows the number of units of a good produced and the total cost incurred for the first halve of the year from January to June. Months January February March April May June (I) (II) (III) Units Produced 10 13 12 16 11 15 Total cost 200 228 219 260 212 247

Calculate the regression line for y on x Find the correlation coefficient Use the high-low method, to derive the line of best fit

SOLUTION Cost Predictions (a) Using regression line y on x, To determine X = independent variable, and Y = dependent variable, Since total cost depends on the number of units produced, total cost = y; and number of units = x Months Jan Units (X) 10 Total cost (Y) 200 XY 10 x 200 = 2,000 Feb March April May June Total () 13 12 16 11 15 X = 77 228 219 260 212 247 Y = XY = X2 Y2 X2 10 x 10 = 200 Y2 200 x 200 = 40,000

Summary of results are as follows: X = 77; Y = 1366; XY = 17,789; X2 = 1,015 Y2 = 313,498; n = 6

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Lecture Notes 2
Using the regression formula above; The variable cost (b) = b = nxyxy n x2 ( x)2 b = 6 (17,789) (77) (1,366) 6 (1,015) (77)2 b = (1552/161) = 9.64

Business Mathematics

= 106,734 105,182 6090 - 5929

Using b= 9.64, and substituting into a, we obtain a = [(1,366) / 6] [9.64 (77)] / 6 = 103.95

(b) Correlation coefficient (R) =

= 6 (17,789) (77) (1,366) [6 (1,015) (77)2] x [6 (313,498) (1366)2]

R = 1552/1556) = 0.997

(c) Using high-low method to derive the line of best fit Variable cost per unit = (260 200) / (16 10) = 10 per unit TC = FC + VC (X) Where X = number of units: Using: Total cost (TC) = 260; Variable cost per unit (VC) = 10 and X = 16

To obtain total fixed cost (FC), 260 = FC + 10 (16) FC = 260 -160 = 100

Using high-low method to derive the line of best fit, TC = 100 + 10X

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