Chapter 1
Introduction to Quantitative Analysis
Learning
Objectives:
After the completion of the chapter, the students will be able to:
describe the quantitative analysis approach and discuss its application to a
real situation;
describe the three categories of business analytics;
explain the use of modeling in quantitative analysis;
prepare a quantitative analysis model;
identify possible problems in using quantitative analysis; and
recognize implementation concerns of quantitative analysis.
What is Quantitative Analysis?
Quantitative analysis is the scientific approach to managerial decision making.
This field of study has several different names, including management science and
operations research. In solving a problem, managers must consider both qualitative and
quantitative factors.
In solving a problem, managers must consider both qualitative and quantitative
factors. For example, we might consider several different investment alternatives, including
certificates of deposit at a bank, investments in the stock market, and an investment in real
estate. We can use quantitative analysis to determine how much our investment will be worth
in the future when deposited at a bank at a given interest rate for a certain number of years.
Quantitative analysis can also be used in computing financial ratios from the balance sheets
for several companies whose stock we are considering. Some real estate companies have
developed computer programs that use quantitative analysis to analyze cash flows and rates of
return for investment property.
In addition to quantitative analysis, qualitative factors should be considered. Because
of the importance of qualitative factors, the role of quantitative analysis in the decision-
making process can vary. When there is a lack of qualitative factors and when the problem,
model, and input data remain the same, the results of quantitative analysis can automate the
decision-making process.
Quantitative analysis has been particularly important in many areas of management.
The field of production management, which evolved into production/operations management
(POM) as society became more service oriented, uses quantitative analysis extensively.
The Origin of Quantitative Analysis
Quantitative analysis has been in existence since the beginning of recorded history, but it was
Frederick Winslow Taylor who in the late 1800s and early 1900s pioneered the
application of the principles of the scientific approach to management. Dubbed the “Father of
Industrial Engineering,” Taylor is credited with introducing many new scientific and
quantitative techniques. These new developments were so successful that many companies
still use his techniques in managerial decision making and planning today. Indeed, many
organizations employ a staff of operations research or management science personnel or
consultants to apply the principles of scientific management to the challenges and
opportunities of the twenty-first century.
Business Analytics
Business analytics is a data-driven approach to decision making that allows companies to
make better decisions. The study of business analytics involves the use of large amounts of
data, which means that information technology related to the management of the data is very
important. Statistical and quantitative methods are used to analyze the data and provide useful
information to the decision maker.
Three Categories of Business Analytics
1. Descriptive Analytics - involves the study and consolidation of historical data for
a business and an industry. It helps a company measure how it has performed in the
past and how it is performing now.
2. Predictive Analytics - is aimed at forecasting future outcomes based on patterns in
the past data. Statistical and mathematical models are used extensively for this
purpose.
3. Prescriptive Analytics - involves the use of optimization methods to provide new
and better ways to operate based on specific business objectives.
Table 1.1. Three Categories of Business Analytics and its Quantitative Analysis Technique
Business Analytics Category Quantitative Analysis Technique
Descriptive Analytics Statistical measures
Statistical quality control
Predictive Analytics Decision analysis and decision trees
Regression Models
Forecasting Project
Scheduling
Waiting line models
Markov analysis
Prescriptive Analytics Inventory models
Linear programming
Transportation and assignment models
Integer programming, goal programming and non-
linear programming
Network models
The Origin of Quantitative Analysis
Quantitative analysis has been in existence since the beginning of recorded history, but it was
Frederick Winslow Taylor who in the late 1800s and early 1900s pioneered the
application of the principles of the scientific approach to management. Dubbed the “Father of
Industrial Engineering,” Taylor is credited with introducing many new scientific and
quantitative techniques. These new developments were so successful that many companies
still use his techniques in managerial decision making and planning today. Indeed, many
organizations employ a staff of operations research or management science personnel or
consultants to apply the principles of scientific management to the challenges and
opportunities of the twenty-first century.
The Quantitative Analysis Approach
The quantitative analysis approach consists of defining a problem, developing a
model, acquiring input data, developing a solution, testing the solution, analyzing the results,
and implementing the results (see Figure 1.1). One step does not have to be finished
completely before the next is started; in most cases, one or more of these steps will be
modified to some extent before the final results are implemented. This would cause all of the
subsequent steps to be changed. In some cases, testing the solution might reveal that the
model or the input data are not correct. This would mean that all steps that follow defining the
problem would need to be modified.
Defining the Problem
Developing a Model
Acquiring Input Data
Developing a Solution
Testing the Solution
Analyzing the Results
Implementing the Results
Figure 1.1 The Quantitative Analysis Approach
Defining the Problem
The first step in the quantitative approach is to develop a clear, concise statement of the
problem. This statement will give direction and meaning to the following steps. Defining the
problem is the most important and the most difficult step. It is essential to go beyond the
symptoms of the problem and identify the true causes. One problem may be related to other
problems; solving one problem without regard to other, related problems can make the entire
situation worse. Thus, it is important to analyze how the solution to one problem affects other
problems or the situation in general. The importance of selecting the right problems to solve
cannot be overemphasized. When the problem is difficult to quantify, it may be necessary to
develop specific, measurable objectives.
Developing a Model
Once we select the problem to be analyzed, the next step is to develop a model. Simply stated,
a model is a representation (usually mathematical) of a situation. What sets quantitative
analysis apart from other techniques is that the models that are used are mathematical. A
mathematical model is a set of mathematical relationships. In most cases, these
relationships are expressed in equations and inequalities, as they are in a spreadsheet model
that computes sums, averages, or standard deviations. There is considerable flexibility in the
development of models, most of the models contain one or more variables and parameters. A
variable, as the name implies, is a measurable quantity that may vary or is subject to change.
Variables can be controllable or uncontrollable. A controllable variable is also called a
decision variable. An example would be how many inventory items to order. A parameter is
a measurable quantity that is inherent in the problem. In most cases, variables are unknown
quantities, while parameters are known quantities. All models should be developed carefully.
They should be solvable, realistic, and easy to understand and modify, and the required input
data should be obtainable. The model developer has to be careful to include the appropriate
amount of detail to be solvable yet realistic.
Acquiring Input Data
Once we have developed a model, we must obtain the data that are used in the model (input
data). Obtaining accurate data for the model is essential; even if the model is a perfect
representation of reality, improper data will result in misleading results. This situation is
called garbage in, garbage out. For a larger problem, collecting accurate data can be one of
the most difficult steps in performing quantitative analysis. There are a number of sources that
can be used in collecting data. In some cases, company reports and documents can be
used to obtain the necessary data. Another source is interviews with employees or other
persons related to the firm. These individuals can sometimes provide excellent information,
and their experience and judgment can be invaluable.
Developing a Solution
Developing a solution involves manipulating the model to arrive at the best (optimal) solution
to the problem. In some cases, this requires that an equation be solved for the best decision. In
other cases, you can use a trial-and-error method, trying various approaches and picking the
one that results in the best decision. For some problems, you may wish to try all possible
values for the variables in the model to arrive at the
best decision. This is called complete enumeration. A series of steps or procedures that
are repeated is called an algorithm, named after Algorismus (derived from Muhammad ibn
Musa al-Khwarizmi), a Persian mathematician of the ninth century. The accuracy of a
solution depends on the accuracy of the input data and the model. If the input data are
accurate to only two significant digits, then the results can be accurate to only two significant
digits.
Testing the Solution
Before a solution can be analyzed and implemented, it needs to be tested completely. Because
the solution depends on the input data and the model, both require testing. Testing the input
data and the model includes determining the accuracy and completeness of the data used
by the model. Inaccurate data will lead to an inaccurate solution. There are several ways to
test input data. One method of testing the data is to collect additional data from a different
source. If the original data were collected using interviews, perhaps some additional data can
be collected by direct measurement or sampling. These additional data can then be compared
with the original data, and statistical tests can be employed to determine whether there are
differences between the original data and the additional data. If there are significant
differences, more effort is required to obtain accurate input data. If the data are accurate but
the results are inconsistent with the problem, the model may not be appropriate. The model
can be checked to make sure that it is logical and represents the real situation.
Analyzing the Results and Sensitivity Analysis
Analyzing the results starts with determining the implications of the solution. In most cases, a
solution to a problem will result in some kind of action or change in the way an organization
is operating. The implications of these actions or changes must be determined and analyzed
before the results are implemented. Because a model is only an approximation of reality, the
sensitivity of the solution to changes in the model and input data is a very important part of
analyzing the results. This type of analysis is called sensitivity analysis or post-optimality
analysis. It determines how much the solution will change if there are changes in the model or
the input data. When the solution is sensitive to changes in the input data and the model
specification, additional testing should be performed to make sure that the model and input
data are accurate and valid. If the model or data are wrong, the solution could be wrong,
resulting in financial losses or reduced profits.
Implementing the Results
The final step is to implement the results. This is the process of incorporating the solution
into the company’s operations. This can be much more difficult than you would imagine.
Even if the solution is optimal and will result in millions of dollars in additional profits, if
managers resist the new solution, all of the efforts of the analysis are of no value. Experience
has shown that a large number of quantitative analysis teams have failed in their efforts
because they have failed to implement a good, workable solution properly. After the solution
has been implemented, it should be closely monitored. Over time, there may be numerous
changes that call for modifications of the original solution. A changing economy, fluctuating
demand, and model enhancements requested by managers and decision makers are only a few
examples of changes that might require the analysis to be modified.
How to Develop a Quantitative Analysis Model
Developing a model is an important part of the quantitative analysis approach. Let’s see how
we can use the following mathematical model, which represents profit:
Profit = Revenue – Expenses
In many cases, we can express revenue as the selling price per unit multiplied times the
number of units sold. Expenses can often be determined by summing fixed cost and
variable cost.
Variable cost is often expressed as the variable cost per unit multiplied times the number of
units. Thus, we can also express profit in the following mathematical model:
Profit = Revenue – (Fixed cost + Variable cost) Profit =
(Selling price per unit) (Number of units sold)
– [Fixed cost + (Variable cost per unit) (Number of units sold)]
Profit = sX – [f + vX]
Profit = sX - f – vX (1-1)
s = selling price per unit
f = fixed cost
v = variable cost per unit
X = number of units sold
The parameters in this model are f, n, and s, as these are inputs that are inherent in the model.
The number of units sold (X) is the decision variable of interest.
Example: The Precious Time and Watch Pieces. We will use the Precious Time
and Watch clock repair shop example to demonstrate the use of mathematical models. This
repair shop buys, sells and even repairs old clocks and clock parts. It sells rebuilt springs for
price per unit of PhP 8.00. The fixed cost of the equipment to build the springs is PhP
1,000.00 The variable cost per unit is PhP 3.00 for the spring material. In this example,
s = 8
f = 1,000
v = 3
The number of springs sold is X, and our profit model becomes:
Profit = 8X - 1,000 - 3X
If sales are 0, the shop owner will realize a PhP 1,000.00 loss. If sales are 1,000 units, the
owner will realize a profit of 4,000 [4,000 = (8) (1,000) – (3) (1,000)]. See if you can
determine the profit for other values of the units sold.
In addition to the profit model shown here, decision makers are often interested in the break-
even point (BEP). The BEP is the number of units sold that will result in PhP 0 profits. We
set profits equal to PhP 0 and solve for X, the number of units at the BEP:
0 = sX - f - vX
This can be written as:
0 = (s – v) X - f
Solving for X, we have
f = (s - v) X
X = f
s-v
This quantity (X) that results in a profit of zero is the BEP, and now we have this model for
the BEP:
BEP = Fixed cost
(selling price per unit) – (variable cost per unit)
= f
s -v (1-2)
For the Precious Time and Watch example, the BEP can be computed as: BEP
= 1,000 / (8 - 3)
= 200 units or springs
The Advantages of Mathematical Modeling
There are a number of advantages of using mathematical models:
1. Models can accurately represent reality. If properly formulated, a model can be
extremely accurate. A valid model is one that is accurate and correctly represents the
problem or system under investigation. The profit model in the example is accurate
and valid for many business problems.
2. Models can help a decision maker formulate problems. In the profit model, for
example, a decision maker can determine the important factors or contributors to
revenues and expenses, such as sales, returns, selling expenses, production costs, and
transportation costs.
3. Models can give us insight and information. For example, using the profit model, we
can see what impact changes in revenue and expenses will have on profits.
4. Models can save time and money in decision making and problem solving. It usually
takes less time, effort, and expense to analyze a model. We can use a profit model to
analyze the impact of a new marketing campaign on profits, revenues, and expenses.
In most cases, using models is faster and less expensive than actually trying a new
marketing campaign in a real business setting and observing the results.
5. A model may be the only way to solve some large or complex problems in a timely
fashion. A large company, for example, may produce literally thousands of sizes of
nuts, bolts, and fasteners. The company may want to make the highest profits possible
given its manufacturing constraints. A mathematical model may be the only way to
determine the highest profits the company can achieve under these circumstances.
6. A model can be used to communicate problems and solutions to others. A decision
analyst can share his or her work with other decision analysts. Solutions to a
mathematical model can be given to managers and executives to help them make
final decisions.
Mathematical Models Categorized by Risk
Some mathematical models, like the profit and break-even models previously discussed, do
not involve risk or chance. We assume that we know all values used in the model with
complete certainty. These are called deterministic models. A company, for example,
might want to minimize manufacturing costs while maintaining a certain quality level. If we
know all these values with certainty, the model is deterministic.
Other models involve risk or chance. For example, the market for a new product might be
“good” with a chance of 60% (a probability of 0.6) or “not good” with a chance of 40% (a
probability of 0.4). Models that involve chance or risk, often measured as a probability value,
are called probabilistic models.
Possible Problems in the Quantitative Analysis Approach
We have presented the quantitative analysis approach as a logical, systematic means of
tackling decision-making problems. Even when these steps are followed carefully, there are
many difficulties that can hurt the chances of implementing solutions to real- world problems.
We now take a look at what can happen during each of the steps.
Defining the Problem
One view of decision makers is that they sit at a desk all day long, waiting until a problem
arises, and then stand up and attack the problem until it is solved. Once it is solved, they sit
down, relax, and wait for the next big problem. In the worlds of business, government, and
education, problems are, unfortunately, not easily identified. There are four potential
roadblocks that quantitative analysts face in defining a problem. We use an application,
inventory analysis, as the example.
CONFLICTING VIEWPOINTS. The first difficulty is that quantitative analysts must often
consider conflicting viewpoints in defining the problem. For example, there are at least two
views that managers take when dealing with inventory problems. Financial managers usually
feel that inventory is too high, as inventory represents cash not available for other
investments. Sales managers, on the other hand, often feel that inventory is too low, as high
levels of inventory may be needed to fill an unexpected order. If analysts assume either one of
these statements as the problem definition, they have essentially accepted one manager’s
perception and can expect resistance from the other manager when the “solution” emerges. So
it’s important to consider both points of view before stating the problem. Good mathematical
models should include all pertinent information.
IMPACT ON OTHER DEPARTMENTS. The next difficulty is that problems do not exist in
isolation and are not owned by just one department of a firm. Inventory is closely tied with
cash flows and various production problems. A change in ordering policy can seriously hurt
cash flows and upset production schedules to the point that savings on inventory are more
than offset by increased costs for finance and production. The problem statement should thus
be as broad as possible and include input from all
departments that have a stake in the solution. When a solution is found, the benefits and risks
to all areas of the organization should be identified and communicated to the people involved.
BEGINNING ASSUMPTIONS. The third difficulty is that people have a tendency to state
problems in terms of solutions. The statement that inventory is too low implies a solution that
inventory levels should be raised. The quantitative analyst who starts off with this assumption
will probably indeed find that inventory should be raised. From an implementation standpoint,
a “good” solution to the right problem is much better than an “optimal” solution to the wrong
problem. If a problem has been defined in terms of a desired solution, the quantitative analyst
should ask questions about why this solution is desired. By probing further, the true problem
will surface and can be defined properly.
SOLUTION OUTDATED. Even with the best of problem statements, however, there is a
fourth danger. The problem can change as the model is being developed. In our rapidly
changing business environment, it is not unusual for problems to appear or disappear virtually
overnight. The analyst who presents a solution to a problem that no longer exists can’t expect
credit for providing timely help. However, one of the benefits of mathematical models is that
once the original model has been developed, it can be used over and over again whenever
similar problems arise. This allows a solution to be found very easily in a timely manner.
Developing a Model
FITTING THE TEXTBOOK MODELS. One problem in developing quantitative models is
that a manager’s perception of a problem won’t always match the textbook approach. Most
inventory models involve minimizing the total of holding and ordering costs. Some managers
view these costs as unimportant; instead, they see the problem in terms of cash flow, turnover,
and level of customer satisfaction. Results of a model based on holding and ordering costs are
probably not acceptable to such managers. This is why the analyst must completely
understand the model and not simply use the computer as a “black box” where data are input
and results are given with no understanding of the process. The analyst who understands the
process can explain to the manager how the model does consider these other factors when
estimating the different types of inventory costs. If other factors are important as well, the
analyst can consider these and use sensitivity analysis and good judgment to modify the
computer solution before it is implemented.
UNDERSTANDING THE MODEL. A second major concern involves the trade-off between
the complexity of the model and ease of understanding. Managers simply will not use the
results of a model they do not understand. Complex problems, though, require complex
models. One trade-off is to simplify assumptions in order to make the model easier to
understand. The model loses some of its reality but gains some acceptance by management.
One simplifying assumption in inventory modeling is that demand is known and constant.
This means that probability distributions are not needed and it allows us to build simple, easy-
to-understand models. Demand, however, is rarely known and constant, so the model we
build lacks some reality. Introducing probability distributions provides more realism but may
put comprehension beyond all but the most mathematically sophisticated managers. One
approach is for the quantitative analyst to start with the simple model and make sure that it is
completely understood. Later, more complex models can be introduced slowly as managers
gain more confidence in using the new approach. Explaining the impact of the more
sophisticated models (e.g., carrying extra inventory called safety stock) without going into
complete mathematical details is sometimes helpful. Managers can understand and identify
with this concept, even if the specific mathematics used to find the appropriate quantity of
safety stock is not totally understood.
Acquiring Input Data
Gathering the data to be used in the quantitative approach to problem solving is often not a
simple task. One-fifth of all firms in a recent study had difficulty with data access. USING
ACCOUNTING DATA. One problem is that most data generated in a firm come from basic
accounting reports. The accounting department collects its inventory data, for example, in
terms of cash flows and turnover. But quantitative analysts tackling an inventory problem
need to collect data on holding costs and ordering costs. If they ask for such data, they may be
shocked to find that the data were simply never collected for those specified costs.
VALIDITY OF DATA. A lack of “good, clean data” means that whatever data are available
must often be distilled and manipulated (we call it “fudging”) before being used in a model.
Unfortunately, the validity of the results of a model is no better than the validity of the data
that go into the model. You cannot blame a manager for resisting a model’s “scientific”
results when he or she knows that questionable data were used as input. This highlights the
importance of the analyst understanding other business functions so that good data can be
found and evaluated by the analyst. It also emphasizes the importance of sensitivity
analysis, which is used to determine the
impact of minor changes in input data. Some solutions are very robust and do not change at
all following certain changes in the input data.
Developing a Solution
HARD-TO-UNDERSTAND MATHEMATICS. The first concern in developing solutions is
that although the mathematical models we use may be complex and powerful, they may not
be completely understood. Fancy solutions to problems may have faulty logic or data. The
aura of mathematics often causes managers to remain silent when they should be critical.
ONLY ONE ANSWER IS LIMITING. The second problem is that quantitative models
usually give just one answer to a problem. Most managers would like to have a range of
options and not be put in a take-it-or-leave-it position. A more appropriate strategy is for an
analyst to present a range of options, indicating the effect that each solution has on the
objective function. This gives managers a choice, as well as information on how much it will
cost to deviate from the optimal solution. It also allows problems to be viewed from a broader
perspective, since non-quantitative factors can be considered.
Testing the Solution
The results of quantitative analysis often take the form of predictions of how things will work
in the future if certain changes are made now. To get a preview of how well solutions will
really work, managers are often asked how good the solution looks to them. The problem is
that complex models tend to give solutions that are not intuitively obvious. Such solutions
tend to be rejected by managers. The quantitative analyst now has the chance to work through
the model and the assumptions with the manager in an effort to convince the manager of the
validity of the results. In the process of convincing the manager, the analyst will have to
review every assumption that went into the model. If there are errors, they may be revealed
during this review. In addition, the manager will be casting a critical eye on everything that
went into the model, and if he or she can be convinced that the model is valid, there is a good
chance that the solution results are also valid.
Analyzing the Results
Once a solution has been tested, the results must be analyzed in terms of how they will affect
the total organization. You should be aware that even small changes in organizations are often
difficult to bring about. If the results indicate large changes in organization policy, the
quantitative analyst can expect resistance. In analyzing the results, the analyst should
ascertain who must change and by how much, if the people
who must change will be better or worse off, and who has the power to direct the change.
Implementation
We have just presented some of the many problems that can affect the ultimate acceptance of
the quantitative analysis approach and use of its models. It should be clear now that
implementation isn’t just another step that takes place after the modeling process is over. Each
one of these steps greatly affects the chances of implementing the results of a quantitative
study.
Lack of Commitment and Resistance to Change
Even though many business decisions can be made intuitively, based on hunches and
experience, there are more and more situations in which quantitative models can assist. Some
managers, however, fear that the use of a formal analysis process will reduce their decision-
making power. Others fear that it may expose some previous intuitive decisions as
inadequate. Still others just feel uncomfortable about having to reverse their thinking patterns
with formal decision making. These managers often argue against the use of quantitative
methods.
Lack of Commitment by Quantitative Analysts
Just as managers’ attitudes are to blame for some implementation problems, analysts’
attitudes are to blame for others. When the quantitative analyst is not an integral part of the
department facing the problem, he or she sometimes tends to treat the modeling activity as an
end in itself. That is, the analyst accepts the problem as stated by the manager and builds a
model to solve only that problem. When the results are computed, he or she hands them back
to the manager and considers the job done. The analyst who does not care whether these
results help make the final decision is not concerned with implementation.
