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Regression and
correlation

Home / Students / Study resources / Performance Management (PM) / Technical articles / Regression and correlation
 Being able to understand the relationship between different factors is
very important for organisations. For example, it would be useful to
understand the relationship between advertising spend and sales  Related Links

generated from that advertising spend or between the production level

 and the total production costs. Understanding these relationships
allows organisations to make better predictions of what sales or costs • Student Accountant hub

will be in the future. This will be invaluable when budgeting or
 forecasting.

 This article will look at how the relationships between variables can be Advertisement
analysed using the ‘line of best fit’ method and regression analysis,

and how the strength of these relationships can be measured using
correlation.

Relationship between variables

In any relationship between two variables there is an independent

variable and a dependent variable, the size of the movements in the
dependent variable depending on the size of the movements of the
independent variable. For example; the total cost of a production
process would be dependent on the level of activity.

Consider the following data produced by a company over the last two
years.

Activity level (000 Total production cost ($000)

units)

20X1 Q1 15 300
 20X1 Q2 45 615

20X1 Q3 25 470

20X1 Q4 55 680

20X2 Q1 30 520

20X2 Q2 20 350

20X2 Q3 35 590

20X2 Q4 60 740

The company wants to understand the relationship between the

activity level and total production cost so that it can forecast total
production costs going forward.

Line of best fit

One method of understanding the relationship between the variables is

the line of best fit method. All the data given is plotted on a chart. The
activity level is the independent variable (as described above) and it is
shown on the x (horizontal) axis. The total production cost is the
dependent variable and it is shown on the y (vertical) axis.
Once all the data is plotted on the graph, a line of best fit can be
drawn:

In this case some of the points are on the line and some are above
and below, but most are close to the line which suggests that there is a
relationship between activity level and the total production cost.
This ‘line of best fit’ can be used to predict what will happen at other
levels of production. For levels of production which don’t fall within the
range of the previous levels, it is possible to extrapolate the ‘line of
best fit’ to forecast other levels by reading the value from the chart.

This is a straightforward technique, but it has some limitations. The

main one being that the ‘line of best fit’ is estimated from the data
points plotted and different lines may be drawn from the same set of
data points. A method which can overcome this weakness is
regression analysis.

Regression analysis

Regression analysis also uses the historic data and finds a line of best
fit, but does so statistically, making the resulting line more reliable.

We assume a linear (straight line) relationship between the variables

and that the equation of a straight line is:

y = a + bx

where:

a is the fixed element (where the line crosses the y axis)

b is the variable element (gradient of the line) and

x and y relate to the x and y variables.

a and b are calculated using the following formulae:

These formulae are given on the PM formulae sheet.

The easiest way to tackle these calculations is to first set up a table

with columns for x, y, xy and x2.

(note: the table also contains a column for y2. This will be required in a
later calculation)

Units Total cost

(000s) ($000) xy x2 y2
x y

20X1
15 300
Q1 4,500 225 90,000

20X1
45 615
Q2 27,675 2,025 378,225

20X1
25 470
Q3 11,750 625 220,900

20X1
55 680
Q4 37,400 3,025 462,400
 20X2 30 520 270,400
Q1 15,600 900

20X2
20 350
Q2 7,000 400 122,500

20X2
35 590
Q3 20,650 1,225 348,100

20X2
60 740
Q4 44,400 3,600 547,600

Totals
(∑) 285 4,265 168,975 12,025 2,440,125

The equation of the regression line (in the form y = a + bx) becomes:

y = 208.90 + 9.1x
Using this equation, it is easy to forecast total costs at different levels
of production, for example for a production level of 80,000 units, the
estimate of total cost will be:

208.90 + (9.1 x 80) = 936.90, or $936,900.

How reliable this estimate is will depend on the strength of the

relationship between the two variables; how much of the change in y
can be explained by the change in x?

The stronger the relationship between the variables, the more reliance
can be placed on the equation calculated and the better the forecasts
will be.

A measure of the strength of the relationship between the variables is

correlation.

Correlation

Two variables are said to be correlated if they are related to one

another and if changes in one tend to accompany changes in the
other. Correlation can be positive (where increases in one variable
result in increases in the other) or negative (where increases in one
variable result in decreases in the other).

The chart shown in the ‘line of best fit’ section above shows a strong
positive correlation. Some other relationships are shown below:
It is possible that there is no correlation between the variables. A
horizontal line would suggest no correlation, as would the following:

Where a company wants to use past data to forecast the future, the
stronger the correlation, the better the estimates will be.

The strength of correlation between variables can be measured by the

correlation coefficient which can be calculated using the following
formula:
r = 1 denotes perfect positive linear correlation

r = -1 denotes perfect negative linear correlation

r = 0 denotes no linear correlation

The value of the correlation coefficient must lie between -1 and 1. The
closer the value is to 1 and -1, the stronger the correlation.

Using the previous example to calculate r:

r = 0.965 which indicates a strong positive correlation.

A further calculation is the coefficient of determination which is

calculated as r2.

The coefficient of determination gives the proportion of changes in y

(the dependent variable) that can be explained by changes in x (the
independent variable). In this example, r2 = 0.931, so 93.1% of the
changes in total production cost can be explained by changes in
activity levels. This means that 6.9% of the changes must be due to
other factors.

Conclusion
Care must be taken however when using regression analysis and
correlation to make future forecasts. The calculations performed can
only suggest that a relationship exists between the factors, it cannot
prove the relationship. It is possible that there are other factors
involved in the changes in the variables which may not have been
considered.

Also, like time series analysis, which is dealt with in a separate article,
regression analysis uses past observations to attempt to predict what
will happen in the future. The assumption that what has happened in
the past is a good indicator of what will happen in the future is a
simplistic assumption. In the real world, changes in the environment
(technological, social, environmental, political, economic etc) can all
create uncertainty, making forecasts made from past observations
unrealistic.

Written by a member of the Performance Management examining

team

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