Quantitative Methods and Managerial Decision Making Worked example: Regression interpretation

Suppose that you have just been hired as the sales manager of the London Door and Window Company. You are trying to understand what macroeconomic variables determine the sales of replacement windows. These are modern manufactured units that include a frame and screens in addition to one or more glass windows. These replacement windows save energy and they look much nicer. The windows of old houses are usually not very tightly installed and do not keep out the cold of winter or the heat of summer and they also make the house look old. The replacement windows are much better, but you have observed that sales are seasonal and might also be cyclical. To determine what is causing sales to uctuate, you collect data and do a multiple regression. The data that you use are monthly sales of replacement windows and some economic data. The results of the multiple regression are given below:
SUMMARY OUTPUT Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations ANOVA df Regression Residual Total 4 31 35 SS MS F Significance F 2034184360 5.09E+08 16.45375 2.49E-07 958135939 30907611 2992320299 t Stat P-value 2.01072 0.053122 4.627508 6.23E-05 1.873108 0.07051 0.850506 0.401565 5.095862 1.63E-05 Lower 95% Upper 95% -233.78498 32884.55 4.84641954 12.48504 -0.1589462 3.737213 -133305.77 324014.9 184.752756 431.3255

0.824500866 0.679801678 0.638485765 5559.461388 36

Intercept Index of Economic Activity Construction Expenditure Index Interest Rate Price of Energy

Coefficients Standard Error 16325.38096 8119.17015 8.665727397 1.87265533 1.789133467 0.9551683 95354.54309 112115.067 308.0391158 60.448874

a) Write an expression for the relationship between sales and the explanatory variables. Looking at the Coecients column, sales can be expressed as: Sales = 16325.4 + 8.7IEA + 1.8CEI + 95354.5Interest + 308.0Energy + , where is the models error term which is included since the explanatory variables will not collectively explain Sales exactly. b) What is your overall assessment of the results of the multiple regression? To assess the overall results we rst look at the signicance of the F statistic which jointly tests for the signicance of all the explanatory variables simultaneously, i.e. the test of H0 : IEA = CEI = Interest = Energy = 0. 1

We see the p-value is tiny (2.49 107 ), indicating that the model is of some use in explaining uctuations in Sales. We can now examine R2 , the coecient of determination, which conrms that 68% of the variation in Sales can be explained by this model. Is this good or bad? Well, looking at this model in isolation it is not bad, though there is still nearly a third (32%) of the variation which we have failed to explain. Also the adjusted R2 is fairly close to R2 which is reassuring. Of course it would be helpful to have the results of another model for comparison purposes. c) Which explanatory variables are contributing to the explanation of sales? The F test conrmed that there was something of interest in the model. We now turn to assessing the signicance of each factor individually. Index of economic activity: this is a highly signicant explanatory variable as conrmed by the very small p-value. Controlling for all other variables, we would say that a one unit increase in IEA would result in an increase in Sales of 8.7 units. Therefore in qualitative terms, the healthier the economy the higher our sales are likely to be. This seems a reasonable conclusion think about why. Construction expenditure index: this has a p-value of 0.07 which means it is not signicant at the 5% level, but is at the 10% level indicating that it is weakly signicant. One might expect that higher levels of construction expenditure would mean more houses are being built and so builders will probably want to t our new, modern windows in new properties. Each unit increase in CEI translates to an increase in sales of 1.8 units, holding all other variables constant. Interest rate: this is clearly an insignicant variable due to the large p-value (0.40). This strongly suggests that interest rate levels do not contribute to the explanation of sales. Price of energy: like the index of economic activity, this seems to be a highly signicant explanatory variable. Controlling for all other variables, a unit increase in energy prices leads to a 308 unit increase in sales. Again, this seems sensible: as the cost of heating increases it becomes more expensive to heat homes, making our windows seem more cost-eective (in the long run). d) If you eliminated one of the explanatory variables, and then did another multiple regression using only the remaining explanatory variables, would the results be stronger? Based on our analysis in c), we would want to drop interest rate from our model since this was clearly insignicant. Since this will mean there is one less explanatory variable, R2 would fall slightly in this new model. However the (marginal) drop in explanatory power will be more than oset by the reduction in model complexity there is one less parameter to estimate. Hence we would expect adjusted R2 to increase. (Remember adjusted R2 takes into account model complexity in addition to the explained variation of the response variable.) So we would expect the slimmer model to be better. Of course this does not mean it is the best of all models there could be a superior model (perhaps using dierent variables, say) which might better explain uctuations in our sales.