Correlation and Linear

Regression
Chapter 13

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Learning Objectives
LO13-1 Explain the purpose of correlation analysis
LO13-2 Calculate a correlation coefficient to test and interpret
the relationship between two variables
LO13-3 Apply regression analysis to estimate the linear
relationship between two variables
LO13-4 Evaluate the significance of the slope of the regression
equation
LO13-5 Evaluate a regression equation’s ability to predict using the
standard estimate of the error and the coefficient of determination
LO13-6 Calculate and interpret confidence and prediction
intervals
LO13-7 Use a log function to transform a nonlinear relationship

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What is Correlation Analysis?
 Used to report the relationship between two variables
CORRELATION ANALYSIS A group of techniques to measure the
relationship between two variables.

 In addition to graphing techniques, we’ll develop

numerical measures to describe the relationships
 Examples
 Does the amount Healthtex spends per month on
training its sales force affect its monthly sales
 Does the number of hours students study for an exam
influence the exam score

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Scatter Diagram
 A scatter diagram is a graphic tool used to portray the
relationship between two variables
 The independent variable is scaled on the X-axis and is
the variable used as the predictor
 The dependent variable is scaled on the Y-axis and is the
variable being estimated

Graphing the data in a scatter

diagram will make the
relationship between sales
calls and copiers sales easier
to see.

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Scatter Diagram Example
North American Copier Sales sells copiers to businesses of all sizes throughout the
United States and Canada. The new national sales manager is preparing for an
upcoming sales meeting and would like to impress upon the sales representatives the
importance of making an extra sales call each day. She takes a random sample of 15
sales representatives and gathers information on the number of sales calls made last
month and the number of copiers sold. Develop a scatter diagram of the data.

Sales reps who make

more calls tend to
sell more copiers!

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Correlation Coefficient
CORRELATION COEFFICIENT A measure of the strength of the linear
relationship between two variables.

 Characteristics of the correlation coefficient are

 The sample correlation coefficient is identified as r
 It shows the direction and strength of the linear
relationship between two interval- or ratio-scale
variables
 It ranges from -1.00 to 1.00
 If it’s 0, there is no association
 A value near 1.00 indicates a direct or positive
correlation
 A value near -1.00 indicates a negative correlation

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Correlation Coefficient
 The following graphs summarize the strength and
direction of the correlation coefficient

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Correlation Coefficient, r
How is the correlation coefficient determined? We’ll use the North American
Copier Sales as an example. We begin with a scatter diagram, but this time we’ll
draw a vertical line at the mean of the x-values (96 sales calls) and a horizontal line
at the mean of the y-values (45 copiers).

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Correlation Coefficient, r, Continued
How is the correlation coefficient determined? Now we find the deviations from
the mean number of sales calls and the mean number of copiers sold; then multiply
the them. The sum of their product is 6,672 and will be used in formula 13-1 to
find r. We also need the standard deviations. The result, r=.865 indicates a strong,
positive relationship.

6672
r = (15−1)(42.76)(12.89) = 0.865

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Correlation Coefficient Example
The Applewood Auto Group’s marketing department believes younger buyers
purchase vehicles on which lower profits are earned and older buyers purchase
vehicles on which higher profits are earned. They would like to use this information as
part of an upcoming advertising campaign to try to attract older buyers. Develop a
scatter diagram and then determine the correlation coefficient. Would this be a useful
advertising feature?

The scatter diagram suggests that a positive

relationship does exist between age and profit. But
it does not appear to be a strong relationship.

Next, calculate r, it is 0.262. The

relationship is positive but weak. The data
does not support a business decision to
create an advertising campaign to attract
older buyers!
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Testing the Significance of r
 Recall that the sales manager from North American
Copier Sales found an r of 0.865
 Could the result be due to sampling error? Remember
only 15 salespeople were sampled
 We ask the question, could there be zero correlation in
the population from which the sample was selected?
 We’ll let ρ represent the correlation in the population
and conduct a hypothesis test to find out

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Testing the Significance of r Example
Step 1: State the null and the alternate hypothesis
H0: ρ = 0 The correlation in the population is zero
H1: ρ ≠ 0 The correlation in the population is different from zero
Step 2: Select the level of significance, we’ll use .05
Step 3: Select the test statistic, we use t
Step 4: Formulate the decision rule, reject H0 if t < 2.160 or > 2.160
Step 5: Make decision, reject H0, t=6.216
Step 6: Interpret, there is correlation with respect to the number of sales calls
made and the number of copiers sold in the population of salespeople.

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Testing the Significance of the Correlation
Coefficient
In the Applewood Auto Group example, we found an r=0.262 which is positive, but
rather weak. We test our conclusion by conducting a hypothesis test that the
correlation is greater than 0.

Step 1: State the null and the alternate hypothesis

H0: ρ ≤ 0 The correlation in the population is negative or zero
H1: ρ > 0 The correlation in the population is positive
Step 2: Select the level of significance, we’ll use .05
Step 3: Select the test statistic, we use t
Step 4: Formulate the decision rule, reject H0 if t > 1.653
Step 5: Make decision, reject H0, t=3.622
Step 6: Interpret, there is correlation with respect to profits and age of the buyer

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Regression Analysis
 In regression analysis, we estimate one variable based on
another variable
 The variable being estimated is the dependent variable
 The variable used to make the estimate or predict the
value is the independent variable
 The relationship between the variables is linear
 Both the independent and the dependent variables must
be interval or ratio scale
REGRESSION EQUATION An equation that expresses the linear
relationship between two variables.

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Least Squares Principle
 In regression analysis, our objective is to use the data to
position a line that best represents the relationship
between two variables
 The first approach is to use a scatter diagram to visually
position the line

 But this depends on judgement, we would prefer a

method that results in a single, best regression line
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Least Squares Regression Line
LEAST SQUARES PRINCIPLE A mathematical procedure that uses the
data to position a line with the objective of minimizing the sum of the
squares of the vertical distances between the actual y values and the
predicted values of y.

 To illustrate, the same data are plotted in the three charts

below

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Least Squares Regression Line
 This is the equation of a line

 yො is the estimated value of y for a selected value of x

 a is the constant or intercept
 b is the slope of the fitted line
 x is the value of the independent variable
 The formulas for a and b are

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Least Squares Regression Line Example
Recall the example of North American Copier Sales. The sales manager gathered
information on the number of sales calls made and the number of copiers sold. Use
the least squares method to determine a linear equation to express the relationship
between the two variables.

The first step is to find the slope of the least squares regression line, b

Next, find a

Then determine the regression line

So if a salesperson makes 100 calls, he or she can expect to sell 46.0432 copiers

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Drawing the Regression Line
The least squares equation can be drawn on the scatter diagram. For example, the fifth
sales representative is Jeff Hall. He made 164 calls. His estimated number of copiers sold
is 62.7344. The plot x = 164 and yො = 62.7344 is located by moving to 164 on the x-axis
and then going vertically to 63.7344. The other points on the regression equation can be
determined by substituting a particular value of x into the regression equation and
calculating yො .

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Regression Equation Slope Test
 For a regression equation, the slope is tested for
significance
 We test the hypothesis that the slope of the line in the
population is 0
 If we do not reject the null hypothesis, we conclude there
is no relationship between the two variables
 When testing the null hypothesis about the slope, the test
statistic is with n – 2 degrees of freedom
 We begin with the hypothesis statements
H0: β = 0
H1: 𝛽 ≠ 0
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Regression Equation Slope Test Example
Recall the North American Copier Sales example. We identified the slope as b and it is
our estimate of the slope of the population, β. We conduct a hypothesis test.
Step 1: State the null and alternate hypothesis
H0: β ≤ 0
H1: 𝛽 > 0
Step 2: Select the level of significance, we use .05
Step 3: Select the test statistic, t
Step 4: Formulate the decision rule, reject H0 if t > 1.771
Step 5: Make decision, reject H0, t = 6.205
Step 6: Interpret, the number of sales calls is useful in estimating copier sales

Highlighted, b is .2606; the standard error is .0420

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Evaluating a Regression Equation’s Ability
to Predict
 Perfect prediction is practically impossible in almost all
disciplines, including economics and business
 The North American Copier Sales example showed a
significant relationship between sales calls and copier
sales, the equation is
Number of copiers sold = 19.9632 + .2608(Number of sales calls)

 What if the number of sales calls is 84, we calculate the

number of copiers sold is 41.8704—we did have two
employees with 84 sales calls, they sold just 30 and 24
 So, is the regression equation a good predictor?
 We need a measure that will tell how inaccurate the
estimate might be

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The Standard Error of Estimate
 The standard error of estimate measures the variation
around the regression line
STANDARD ERROR OF ESTIMATE A measure of the dispersion, or scatter,
of the observed values around the line of regression for a given value of x.

 It is in the same units as the dependent variable

 It is based on squared deviations from the regression line
 Small values indicate that the points cluster closely about
the regression line
 It is computed using the following formula

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The Standard Error of Estimate Example
We calculate the standard error of estimate in this example. We need the sum of
the squared differences between each observed value of y and the predicted value
of y, which is 𝑦.
ത We use a spreadsheet to help with the calculations.

The standard error of

estimate is 6.720

If the standard error of estimate is small, this indicates that the data are relatively
close to the regression line and the regression equation can be used. If it is large,
the data are widely scattered around the regression line and the regression
equation will not provide a precise estimate of y.
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Coefficient of Determination
COEFFICIENT OF DETERMINATION The proportion of the total variation in
the dependent variable Y that is explained, or accounted for, by the variation in
the independent variable X.

 It ranges from 0 to 1.0

 It is the square of the correlation coefficient
 It is found from the following formula

 In the North American Copier Sales example, the correlation

coefficient was .865; just square that (.865)2 = .748; this is the
coefficient of determination
 This means 74.8% of the variation in the number of copiers
sold is explained by the variation in sales calls

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Relationships among r, r2, and sy,x
 Recall the standard error of estimate measures how close
the actual values are to the regression line
 When it is small, the two variables are closely related
 The correlation coefficient measures the strength of the
linear association between two variables
 When points on the scatter diagram are close to the
line, the correlation coefficient tends to be large
 Therefore, the correlation coefficient and the standard
error of estimate are inversely related
 As noted earlier, the coefficient of determination is the
correlation coefficient squared

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Inference about Linear Regression
 We can predict the number of copiers sold (y) for a
selected value of number of sales calls made (x)
 But first, let’s review the regression assumptions of each
of the distributions in the graph below
 Follow the normal distribution
 Has a mean on the regression line
 Has the same standard error of estimate, sy,x
 Is independent of the others

𝑦ො ± sy,x will include 68% of the observations

𝑦ො ± 2sy,x will include 95% of the observations
𝑦ො ± 3sy,x will include virtually all the observations

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Constructing Confidence and Prediction
Intervals
 Use a confidence interval when the regression equation is
used to predict the mean value of y for a given value of x
 For instance, we would use a confidence interval to
estimate the mean salary of all executives in the retail
industry based on their years of experience

 Use a prediction interval when the regression equation is

used to predict an individual y for a given value of x
 For instance, we would estimate the salary of a particular
retail executive who has 20 years of experience

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Confidence Interval and Prediction Interval
Example
We return to the North American Copier Sales example. Determine a 95% confidence
interval for all sales representatives who make 50 calls, and determine a prediction
interval for Sheila Baker, a west coast sales representative who made 50 sales calls.

The 95% confidence interval for all sales representatives is 27.3942 up to 38.6122
The 95% prediction interval for Sheila Baker is 17.442 up to 48.5644 copiers

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Transforming Data
 Regression analysis and the correlation coefficient
requires data to be linear
 But what if data is not linear?
 If data is not linear, we can rescale one or both of the
variables so the new relationship is linear
 Common transformations include
 Computing the log to the base 10 of y, Log(y)
 Taking the square root
 Taking the reciprocal
 Squaring one or both variables
 Caution: when you are interpreting a correlation
coefficient or regression equation – it could be nonlinear
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Transforming Data Example
GroceryLand Supermarkets is a regional grocery chain located in the midwestern
United States. The director of marketing wishes to study the effect of price on weekly
sales of their two-liter private brand diet cola. The objectives of the study are
1. To determine whether there is a relationship between selling price and weekly
sales. Is this relationship direct or indirect? Is it strong or weak?
2. To determine the effect of price increases or decreases on sales. Can we effectively
forecast sales based on the price?

To begin, the company decides to price the two-liter diet cola from $0.50 to $2.00.
To collect the data, a random sample of 20 stores is taken and then each store is
randomly assigned a selling price.

A strong, inverse
relationship!

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Transforming Data Example Continued
The director of marketing decides to transform the dependent variable, Sales, by taking
the logarithm to the base 10 of each sales value. Note the new variable, Log-Sales, in
the following analysis as it is used as the dependent variable with Price as the
independent variable.

1. By transforming the dependent

variable, Sales, we increase the
coefficient of determination from
.889 to .989. So now Price explains
almost all of the variation in Log-
Sales
2. The transformed data “fit” the
linear relationship better
3. The regression equation is
yො = 2.685 - .8738x

yො = 2.685 - .8738(x) = 2.685 - .8738 (1.25) = 1.593

Now, undo the transformation by taking the antilog of 1.593; 39.174 or 39 bottles
That is, if they price the cola at $1.25, they’ll sell 39 bottles; at $2.00 they’ll sell 9

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