Data Envelopment Analysis (DEA) Solutions Interpretation in Multiplier and in Envelopment Models

November 2013

Introduction 1.1. What is DEA Anderson et al. [1] defined Data envelopment analysis (DEA) as an application of linear programming in measuring the relative efficiency of operating units with the same goals and objectives in order to identify the inefficient units that should be targeted for further study and, if need be, corrective action. Since its introduction in 1978 by Charnes, Cooper and Rhodes [2], DEA has become a handy tool in measuring relative efficiency in organizations. At first it was used to measure efficiency in not for profit and public sector organizations but it was later found to be a useful tool also in measuring efficiency in businesses such as banks, supermarkets and the likes since it has proven to locate ways to improve service delivery (by identifying gaps) and hence increase profitability Sherman and Zhu [3]. Despite being a powerful tool in comparison with other productivity management tools, there are some skepticism shown by some managers to adopt it as they would want to observe confidentiality in reporting their internal methods. Another thing that hinders wide usage of the method is because of comprehensibility issue as majority of DEA publications are in academic journals or books which require knowledge of linear programming and underlying mathematical notations as pointed out by Sherman and Zhu [3]. Economists have also, according to Ray [4], casted their doubts on DEA because it is a nonparametric method; no production, cost, or profit function is estimated from the data. Also it employs linear programming instead of the familiar least squares regression analysis and finally being nonstatistical in nature, the linear programming solution of a DEA problem produces no standard errors and leaves no room for hypothesis testing. Despite all the above criticism, DEA is still a very useful tool because it can provide new insights into activities (and entities) that have previously been evaluated by other methods. For example it has been able to identify numerous sources of inefficiency even in some of the most profitable service units (firms) and identify better benchmarks. Cooper, Seiford and Tone [5] 1.2. What can DEA Accomplish Sherman and Zhu [3] summarize the following as DEA accomplishments: Benchmarking It compares service units (branches, departments, individuals) considering all resources used (also known as inputs) and services provided (outputs), and identifies the most efficient units or best practice units and the inefficient units in which real efficiency improvements are possible. This is achieved by comparing the mix and volume of services provided and the resources used by each unit compared with those of all the other units.

Cost and Resource Savings Calculations DEA calculates the amount and type of cost and resource savings that can be achieved by making each inefficient unit as efficient as the most efficient best practice units. Identification of required changes It can identify specific changes in the inefficient service units that need to be implemented to achieve potential savings located with DEA. DEA also estimates the amount of additional service an inefficient unit can provide without the need to use additional resources. Knowledge sharing Knowledge about performance of service units can be used to help transfer system and managerial expertise from better-managed, relatively efficient units to the inefficient ones. 2. Efficiency Concepts Simply put, efficiency can be defined as the ratio of output to input. It should be borne in mind that, once absolute or optimum efficiency has been achieved then it is not possible for a service unit to become more efficient unless there is a change in the production process such as application of new technology etc. 2.1. Classification of Efficiency Efficiency can be classified as both scale and technical, price or allocative Sherman and Zhu [3]: Scale and Technical Efficiency Technical efficiency is determined by comparing engineered/optimum efficiency with operating efficiency or comparing units that have different engineered efficiencies. Scale efficiency is the same as benchmarking in the sense that, several service unit output-to-input ratios are compared to determine whether one unit is more or less efficient than another. Price Efficiency This is when input and/or outputs are measured in monetary terms rather than physical units. There is a need to separate price efficiency from technical/scale. When a unit is found to be inefficient because it uses high priced resources (inputs) we should not try to technically tune the unit (e.g. apply new technology, engine overhaul etc) because its inefficiency is due to price and not scale or technical. There is a possibility of getting less priced inputs somewhere else. With DEA mangers can look behind the accounting information to separate excess costs due to technical and scale efficiency from price efficiency to understand what type of actions they can initiate to reduce cost and improve profitability.

Allocative Efficiency - When more than one input and/or output are involved in the production process, inefficiency can also be due to the mix of inputs used to produce the mix of outputs, which is referred to as allocative efficiency. 3. Mathematical Formulation of DEA Models From the basic definition of efficiency we can say

However, in measuring performance of a service unit with multiple inputs and outputs then the formula above is inadequate as addressed by Farrell [6]. Therefore Farrell and Fieldhouse [7] developed a formula to calculate Relative Efficiency which is based on a hypothetical efficient unit (weighted average of efficient units) to be compared with an inefficient unit.

Let us assume the following: j = number of service units r = number of outputs generated by each service unit i = number of inputs used by each service unit xij = amount of the ith input used by service unit j yrj = amount of the rth output produced by service unit j ur = weight of output r vi= weight of input i SUj = service unit number j = efficiency of the service unit being evaluated (0<= <=1)

(3.1)

3.1.

DEAs Envelopment and Multiplier Models

Charnes, Cooper and Rhodes [2] proposed that each unit should be allowed to take set of weights that will put it the most favourable position when compared with other units. So under these conditions efficiency of a unit under observation SUo (), can be found by solving the following linear programming problem: Maximize efficiency of SUo (), Under the conditions that efficiency of all service units is less than 1. Algebraically: Maximize =

(3.2)

Subject to:

; j = 1,,j

(3.3)

ur,vi 0 In linear programming to maximize an objective function in fraction form, assigning a constant value (say 1) to the denominator and maximize the numerator. The equation (3.3) can be rearranged into linear form. This yields the following: Maximize = Subject to: ur,vi 0 The model above is called the Multiplier Model. ; j = 1,,j (3.5) (3.6) (3.4)

The envelopment model is obtained by finding the Dual to the multiplier model (Primal) obtained above. From the relationship between primal and dual as given by Matouek and Grtner [8] in the following table:

Where, T stands for transpose matrix. Then the dual is: Minimize Subject to: i=1..i r=1.r
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(3.7)

(3.8)

(3.9)

j 0 j=1j The above formulas ((3.7), (3.8) and (3.9)) can be interpreted as follows: The dual seeks to the efficiency rating by minimizing , subject to the condition that the weighted sum of the inputs of the all service units is less than or equal to the inputs of the service unit being evaluated and the weighted sum of the outputs of the all service units is greater than or equal to the service unit being evaluated. values are the weights here (these weights are for the efficient reference set i.e. service units against which inefficient unit is found to be most directly inefficient). 4. Solution to DEA Models and Results Interpretation Let us consider the following example of five (5) dining halls (D) at Beijing Institute of Technology (BIT) with the following fictitious data over a certain period of time, say a day. Dining Hall D1 D2 D3 D4 D5 Customers 1000 1000 1000 1000 1000 Area (sq meters) 20 30 40 20 10 Operating Cost (RMB) 300 200 100 200 400

Our service unit under observation in this example is dining hall number 1 (D1). Inputs: Area of a dining hall in square metres. Operating costs in RMB. Output: Number of customer going to a dining hall The dining hall problem was solved using Excel Solver and results obtained and interpretations are in the subsequent section.

4.1.

Data Envelopment Model Results and Interpretation

Results (See Appendix 1) Efficiency for dining hall D1 () = 0.857. Optimal at D4 = 0.7143 Optimal at D5= 0.2857 Interpretation From the results of the Envelopment model we can say that: Dining hall under observation D1 is inefficient because efficiency , is less than 1 Dining hall D4 and D5 are in the efficiency reference set for dining hall under evaluation D1 with values 0.7143 and 0.2857 respectively. This means that if the inputs used by dining hall D1 are distributed between D4 and D5, its efficiency can be improved. D4 Output Customers Input Area Operation Costs Input & Output 1000 0.7143 20 200 + 0.2857 D5 Input & Output 1000 10 400 = D1 Composite Input & Output 1000 17.143 257.14

Actual D1 compared with the composite D1 D1 D1 Actual Composite Output Customers Input Area Operating Costs 1000 20 300 1000 17.143 257.14 =

Excess 0 2.857 42.86

From the table above, we can say that if D1 could adopt a combination of operating techniques used by D4 and D5 then D1 can be able to attract the same number of customers by reducing its area by 2.857 square metres and operating costs by 42.86 RMB. 4.2. Multiplier Model Results and Interpretation

Results (See Appendix 2) Efficiency () = 0.85714371 Weight of Output u =0.00085714 Weight of Input 1 (Area) v1 = 0.028571457 Weight of Input 2 (Operating Cost) v2 = 0.001428573 Interpretation From the multiplier model results we extract the following information: If we reduce the area of D1 by 1 square metre, we can increase its efficiency by 2.85% (0.028571457*100%). Also, if we reduce the operating costs of D1 by 1 RMB then efficiency can increase by 0.143% (0.001428573*100%). Efficiency rating of D1 must be increased by 0.14285629 (1 -0.85714371) or 14.3% for it to be relative efficient. Alternatively, we can say if we reduce area by 5 square metres (5*2.85% = 14.3%) or if we reduce operating costs by 100 RMB (100*0.143%=14.3%) then D1 can become relative efficient. 5. Conclusions We have seen that service units can be provided with alternative paths to improve efficiencies as depicted by the Envelopment model and Multiplier model solutions. The solutions state, if need be, which input measures and by what amount should be reduced in order to make inefficient service unit efficient. Also, which combination of operating techniques an inefficient unit can adopt from its efficiency reference set in order to become efficient. Even though weights assigned by DEA may not correspond to actual weights assigned to inputs and outputs, they are however have been obtained in such a way that they give highest possible efficiency to the unit under observation under the conditions that no service can have efficiency rating greater than 1. Other sets of weights will make the service unit less efficient. It also worth noting that, DEA calculates relative efficiency which means an efficient unit from this model is efficient relative to its peers and may not be necessarily efficient when measured alone.
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References [1] Anderson, D.R., Sweeney, D.J., Williams, T.A., Camm, J.D. and Martin, K. An Introduction to Management Science: Quantitative Approaches to Decision Making [M], Revised 13th Ed. Ohio: South-Western, Cengage Learning. 2012 [2] Charnes, A., Cooper, W.W. and Rhodes, E., Measuring the efficiency of decision making units [J], European Journal of Operational Research. 1978. 2, 429-444. [3] Sherman, H.D. and Zhu, J. Service Productivity Management: Improving Service Performance using Data Envelopment Analysis (DEA) [M]. New York: Springer. 2006 [4] Ray, S.C. Data Envelopment Analysis: Theory and Techniques for Economics and Operations Research [M]. New York: Cambridge University Press. 2004 [5] Cooper, W.W., Seiford, L.M. and Tone, K. Data Envelopment Analysis: A Comprehensive Text with Models, Applications, References and DEA-Solver Software [M]. Boston: Kluwer Academic Publishers. 2000 [6] Farrell, M.J. The Measurement of Productive Efficiency [J], Journal of the Royal Statistical Society Series A. 1957. 120, 253-281. [7] Farrell, M.J. and Fieldhouse, M. Estimating Efficient Production Functions under Increasing Returns to Scale [J], Journal of the Royal Statistical Society Series A. 1962. 125, 252-267. [8] Matouek, J. and Grtner, B. Understanding and Using Linear Programming [M]. Berlin Heidelberg: Springer-Verlag. 2007, 91.

Appendices Appendix 1: Envelopment Model Results Using Excel Solver for D1 Output Dining Hall D1 D2 D3 D4 D5 Customers 1000 1000 1000 1000 1000 Area (sq. metres) 20 30 40 20 10 Inputs Operating Cost (RMB) 300 200 100 200 400 0 0 0 0.71429 0.28571

Conditions Area Operating Cost Customer

Efficiency Reference Set 17.14285714 257.1428571 1000

Unit Under Evaluation 17.14285714 257.1428571 1000

1 Efficiency 0.857143

Appendix 1: Multiplier Model Results Using Excel Solver for D1 Output Dining Hall D1 D2 D3 D4 D5 Customers 1000 1000 1000 1000 1000 Area (sq. metres) 20 30 40 20 10 Inputs Operating Cost (RMB) Constraints 300 -0.1428573 200 -0.2857146 100 -0.4285719 200 0 400 0 Weighted Input 1.000001

Multiplier 0.00085714 Unit Under Evaluation 1 Efficiency 0.85714371

0.028571457

0.001428573

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