BALIUAG UNIVERSITY

College of Business Administration and Accountancy

Operations Auditing

Lesson 4: Quantitative Techniques in Business LVC

Introduction to Quantitative Techniques

 Definition
 Quantitative techniques – The application of mathematics in business operations or any complex
system
 Operation Research – The discipline of applying quantitative methods in organizational planning and
control.

 Applications of quantitative techniques in business

a. Corporate planning models
b. Forecasting mechanism
c. Productivity and efficiency measure
d. Inventory planning and control
e. Resource allocation

I. Regression and Correlation Analysis

 Definition
 Regression analysis – Determines the functional relationship between variables with a measure of
probable error.
a. Simple regression – Regression analysis with only one independent variable
Regression model: Y = α + βX
Where: Y = Dependent variable
X = Independent variable
α = Y-intercept or a
β = slope or b

Coefficients derivation:

b. Multiple regression – Regression analysis with more than one independent variables
Regression model: Y = α + β1X1 + β2X2 +…. βnXn

 Correlation – The relationship between variables. If the variables move with each other, they have a direct
relationship (positive correlation) as in A. If the variables move in opposite directions, they have an
inverse relationship (negative correlation).
a. Coefficient of Correlation (R) – Measures the relative strength of linear relationship between the
dependent and independent variables. The closer the value of R to +1.0 or –1.0, the stronger the
relationship between the variables X and Y.
b. Coefficient of Determination (R2) – The proportion of total variation in dependent variable (Y) that is
explained or accounted for by the independent variable (X). The goodness of the least squares fit (i.e.,
how well the regression line fits the observed data) is measured by R2.

 Practice Problem 1
A company develop a regression model to estimate its repairs and maintenance cost per month.
Y = P15,000 + 55X1 + 4.2X2 – 80X3
Where: Y = repairs and maintenance cost
X1 = machine hours
X2 = units produced
X3 = no. of machine testing
For the current month, the company expect to produce 6,000 units by consuming 200 machine hours and
performing 30 machine testing.

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 Lesson 4: Quantitative Techniques in Business LVC
Requirements:
1. What is the budgeted repairs and maintenance cost for the month?
2. If the does not produced any products and the machine was left unused without any testing done, what
is the expected repairs and maintenance cost for the month?
3. Which variable(s) has/have direct and inverse relationship with repairs and maintenance cost?
4. If the regression model has 0.92 coefficient of multiple correlation, describe the correlation among
variables? (Indicate whether the relationship is weak, moderate or weak and determine whether the
relationship is positive or negative)
5. Given the 0.92 coefficient of multiple correlation, what is the coefficient of multiple determination?
Explain the briefly what does this vale entail.

 Practice Problem 2
ABC Inc. manufactures product X. Production data for the past six months are as follows:
Month Units produced Production costs
April 500 P 4,000
May 700 8,000
June 900 6,000
July 600 7,500
August 800 8,500
September 550 7,250

Using the linear regression model the following variables are determined as:
y= total monthly production costs
x= number of units produced per month
a= fixed production cost per month
b = variable production cost per unit
n= number of months
= summation

Requirements:
1. What is the variable cost per unit?
2. What is the total fixed cost per month?
3. How much is the total variable cost next month if ABC produces 750 units of X on October?.
4. How much is the projected total production costs next month if ABC produces 1,000 units of X on
October?
5. How much is the projected total production costs next year if ABC produces 9,000 units of X the following
year?

II. Linear Programming

 Definition
 Linear programming – A technique used to optimize an objective function (i.e. maximize revenue or profit
function, or minimize cost function), subject to constraints (i.e. scarce resources, maximum/minimum
production level, etc.).
 Simplex method – A linear programming method especially useful in maximizing a linear function of
several variables under several constraints.
 Linear programming is the process of taking various linear inequalities relating to some situation, and
finding the "best" value obtainable under those conditions.
 A typical example would be taking the limitations of materials and labor, and then determining the "best"
production levels for maximal profits under those conditions.

 Basic steps (two variables and two constraints)

1. Establish the objective function.
Z = αX + βY
Where:
Z = profit/revenue to be maximized or cost to be minimized
X = Number of units of product 1
Y = Number of units of product 2
α = profit/revenue per unit of product 1 or cost per unit of product 1
β = profit/revenue per unit of product 2 or cost per unit of product 2
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 Lesson 4: Quantitative Techniques in Business LVC

2. Define the constraints functions of inequality.

a. α1X + β1Y < C1
b. α2X + β2Y < C2
c. C1 > 0
d. C2 > 0
Where:
X = Number of units of product 1
Y = Number of units of product 2
α1 = Number of resource 1 needed per unit of product 1
β1 = Number of resources 1 needed per unit of product 2
α2 = Number of resource 2 needed per unit of product 1
β2 = Number of resource 2 needed per unit of product 2
C1 = Total units of resource 1 available
C2 = Total units of resource 2 available

3. Use simultaneous equations to solve for the variables.

 Practice Problem 3
A company produces two products that both use two raw materials during production. Available quantity of
material A every production period is 120 lbs while material B is 80lbs. Details of production follows:
Product X Product Y
Contribution margin per unit P3 P4
Raw materials:
Material A 2 lbs. 5 lbs.
Material B 4 lbs. 2 lbs.

The company wanted to maximize the contribution margin every production and decided to employ linear
programming method.

Requirements:
1. Objective function (Z = αX + βY where Z is the contribution margin)
2. Constraint function for material A
3. Constraint function for material B
4. Optimal product mix
5. Total contribution margin using the optimal product mix
6. Total contribution margin if only Product X was produced
7. Total contribution margin if only Product Y was produced

III. Probability Analysis (Expected Value)

 Definition
 Probability analysis – The measure of the likelihood that an event will occur. Probability is quantified as
a number between 0 and 1 (where 0 indicates impossibility and 1 indicates certainty). The higher the
probability of an event, the more certain that the event will occur.
 Expected value – Also known as mathematical expectation. The summation or integration of a possible
values from a random variable. The expected vale of an action is the calculated by multiplying the
probability of each outcome by its pay-off and summing the products.
 Decision making under conditions of risk – It occurs when the probability distribution of all possible
future states of nature is known.
 Decision making under conditions of uncertainty – It occurs when the probability distribution of all
possible future states of nature is not known and must be subjectively determined.

 Practice Problem 4
A canteen sells sodas to students throughout the 320-day school year. The frequency distribution of the
demands for sodas per day is presented below:

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 Lesson 4: Quantitative Techniques in Business LVC
Sales Volume Frequency
Expected
(no. of (days) Probability
Value
bottles)
2,000 48
5,000 80
6,000 144
8,000 32
10,000 16
31,000 320

Requirements:
1. Complete the table.
2. Estimated daily demand of sodas using deterministic approach based on the most likely event.
3. Estimated daily demand of sodas using expected value approach.
4. For a 22-day monthly operation, how much would be the sales if the soda is sold for P8 per bottle.
5. The conditional profit per day of having a stock of 5,000 bottles but selling only 4,500 bottles. Unit price
is P8 and unit cost is P3.

IV. Decision Tree

 Decision Tree – A support tool that uses a tree-like graph or model of decisions and their possible
consequences, including chance event outcomes, resource costs, and utility.
 A decision tree consists of 3 types of nodes:
a. Decision nodes - commonly represented by squares
b. Chance nodes - represented by circles (probability of occurrence)
c. End nodes - represented by triangles
 Decision trees are commonly used in operations research, specifically in decision analysis, to help identify
a strategy most likely to reach a goal, but are also a popular tool in machine learning.
 A decision tree is a flowchart-like structure in which each internal node represents a "test" on an attribute
(e.g. whether a coin flip comes up heads or tails), each branch represents the outcome of the test and each
leaf node represents a class label (decision taken after computing all attributes). The paths from root to leaf
represents classification rules.
 Expected value of perfect information (EVPI) – The price that one would be willing to pay in order to gain
access to perfect information.
EVPI = Expected value with perfect information – Max. Expected value without perfect information

 Practice Problem 5

Cost = P1,000/share

*The decision tree diagram illustrates the possible future cash flows that may be received by the company by
choosing either of the two alternatives.

Requirements:
a. What are the decisions (the two alternatives) that must be made by the manager?
b. What is the expected value of Investing in stocks?
c. Which option would be favorable and by how much advantage?

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 Lesson 4: Quantitative Techniques in Business LVC

 Practice Problem 6
A company have options to invest in bonds, stocks or mutual funds. Under each economic conditions, the
monetary return on investments (payoffs) vary. The company wants to determine the investment option mix
that will maximize the payoffs. Below are the information about the investments and the state of enonomy:

State of Economy
Growing Stable Declining
Probability 0.2 0.5 0.3
Investment Payoffs in millions
Alternatives
Bonds P4.0 P4.5 P0.5
Stocks 7.0 3.0 (1.3)
Mutual funds 5.3 4.5 (0.5)

Requirements:
a. The maximum expected value without perfect information
b. The expected value with perfect information
c. The price one is willing to pay for perfect information

V. Learning Curve
 Definition
 Learning curve – A curve plotting performance against practice; especially one graphing decline in unit
costs with cumulative output. It describes efficiencies arising from experience.
 The rate of productivity improvement declines over time until the improvement stops. The required
production time reaches a level where it remains until another change in production occurs.
 Cumulative average-time learning model – is based on the assumption that the cumulative average time
required per unit declines at a constant rate each time the cumulative quantity of units produced doubles.
The cumulative average-time learning model can be used to estimate the average time per unit required
to produce all of a given number of units produced.
 Incremental unit-time learning model – is based on the assumption that the incremental amount of time
required to produce the last unit declines at a constant rate each time the cumulative quantity of units
produced doubles. The incremental unit-time learning model can be used to estimate the time needed
to produce the last unit in a quantity of units.

 Practice Problem 7
A manufacturing company produces 5 units per lot of a new product. During the production of the first lot,
the labor hours totaled 100 hours at a standard rate of P6 per hour. Management expects 80% learning curve.
Cumulative Cumulative Ave. Cumulative Cumulative
Units Labor Hrs. per Total Labor Total Labor Cost
Unit Hrs.

Requirements:
1. Complete the table.
2. Average labor hours per unit on the 2nd lot
3. Total labor hours for the first 4 lots
4. Total labor cost for the first 8 lots
5. Labor cost to be incurred in the production of the 2nd lot
6. Total labor hours consumed in the production of the 3rd and 4th lots
7. Total labor cost in the production of the 5th, 6th, 7th, and 8th lots
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VI. Network Models

 Network models – Involves product scheduling and techniques designed to aid the planning and control of
large-scale projects that have interrelated activities.

 Network models techniques

1. Gantt Chart – A type of bar chart, devised by Henry Gantt in the 1910s, that illustrates a project schedule.
Gantt charts illustrate the start and finish dates of the terminal elements and summary elements of a
project.

 Practice Problem 8
A construction firm prepared the following Gantt chart:
A

C
D

January February March April

Requirements:
a. Which task takes the longest and shortest time to complete?
b. Which will be performed last?
c. Which task will be finished first?
d. Which is busiest month (most number of tasks to be performed)?

2. Program Evaluation & Review Techniques (PERT) – A statistical tool, used in project management, which
was designed to analyze and represent the tasks involved in completing a given project. It is commonly
used in conjunction with the critical path method (CPM).
o PERT event – A point that marks the start or completion of one or more activities. It consumes no
time and uses no resources.
o Predecessor event – an event that immediately precedes some other event without any other events
intervening. An event can have multiple predecessor events and can be the predecessor of multiple
events.
o Successor event – An event that immediately follows some other event without any other intervening
events. An event can have multiple successor events and can be the successor of multiple events.
o PERT activity – The actual performance of a task which consumes time and requires resources (such
as labor, materials, space, machinery). It can be understood as representing the time, effort, and
resources required to move from one event to another. A PERT activity cannot be performed until
the predecessor event has occurred.
o PERT sub-activity – A PERT activity can be further decomposed into a set of sub-activities.

3. Critical Path Method (CPM) – A network technique like PERT. CPM calculates the longest path of planned
activities to logical end points or to the end of the project, and the earliest and latest that each activity
can start and finish without making the project longer.
o This process determines which activities are "critical" (i.e., on the longest path) and which have "total
float" (i.e., can be delayed without making the project longer).
o Critical path – Longest path through the PERT network. The shortest time possible to complete the
entire project.
o Slack time – the amount of time that a task in a project network can be delayed without causing a
delay in the overall project.
Formula: Total Slack = Latest Start - Earliest Start.
o Crashing – Shortening the durations of critical path activities by adding resources. It reduces the slack
time but raises the project costs.
o Crash time – the time to complete an activity assuming that all available resources are devoted to
the task (overtime, extra crew, etc.).

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Lesson 4: Quantitative Techniques in Business LVC
o Optimistic time (To) – The minimum possible time required to accomplish an activity or a path,
assuming everything proceeds better than is normally expected
o Pessimistic time (Tp) – The maximum possible time required to accomplish an activity or a path,
assuming everything goes wrong (but excluding major catastrophes).
o Most likely time (Tm) – The best estimate of the time required to accomplish an activity or a path,
assuming everything proceeds as normal.
o Expected time (Te) – The best estimate of the time required to accomplish an activity or a path.
Formula: Te = (To + 4 Tm + Tp) ÷ 6

 Practice Problem 9
Below is the PERT diagram prepared for the completion of an information system project of XYZ Firm:

Requirements:
a. What paths in the PERT model and the no. of days for completion of each path?
b. What is the critical path(s)?
c. What is the path that will be completed first?
d. What is shortest time to complete the entire project?
e. What is the slack time for path A – D – I?
f. If the critical path was crashed by 2 days, what would be the total slack time of the project?
g. If path D – I has a most likely time of 11 days, pessimistic time of 18 days, and optimistic time of 10
days, calculate the expected time to complete path D – I.

- End of Lesson 4

“But godliness with contentment is great gain. For we brought nothing into the world, and we can take nothing
out of it.” 1 Timothy 6:6-7

“Remember that nothing is small in the eyes of God. Do all that you do with love.” St. Therese of Lisieux

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