Introduction to Spreadsheet

Modelling
PGP
Agenda
• Introduction to the Course
• Course Outline
• Course Evaluation
• Ground Rules
Problems
• What price should we set for our product to generate the highest
possible profit this coming year?
• Should we launch a new product line or not?
• What should be the advertising budget for the coming year?
• Should we expand the business or not?
• What is the optimal product mix that maximizes profit?
• Is going for higher studies worth it? Or, should we go for a job?
• Should we rent an apartment or buy a house?
Rent or Buy?
• Your situation, related to income and location
• Rent amount
• Loan repayment, interest rate
• Down payment
• Location, growth potential of the area, convenience
• Maintenance costs
• Monthly expenses
• Possibility of renting out the apartment you buy
Rent or Buy?
• What is the decision?
• How to evaluate the impact of your decision? How do you know
whether the decision you made is a good one?
• Experimentation
• Systematic thinking
Rent or Buy?
Income
• Your income now
• Family member’s income now
• The income in 2 years will also be affected by any increment in the
income during that period.
Rent or Buy?
Expenses
Rent Buy
Rent amount (includes utility?) Down payment (builder, new/old
(location, furnished or not, etc., apartment, location, etc.)
conditions of the housing market)
Any increase in rent (location, Loan repayment (loan amount,
conditions of the housing market, interest rate)
etc.)
Home insurance Repair and maintenance expenses
Home insurance
Utility bills

Non-Housing Living expenses (food, medical, etc.)

Modeling
• The process of creating a simplified representation of reality
• Working with this representation to understand or control some
aspects of the world
• A fundamental way to in which humans understand their
environment

• Example: A physical model of a building, a map

Example: Maps
• Maps are models because they simplify reality by leaving out most
geographic details to highlight the important features we need
• A state road map shows major roads but not the minor ones, gives
rough locations of cities but not individual addresses, and so on.
• The map we choose must be appropriate for the need we have.
• A long trip across several states requires a regional map
• A trip across the town requires detailed street map
• A good model must be appropriate for the specific uses intended for
it.
Models are of many forms
• Models may take different forms: mental, visual, physical,
mathematical, spreadsheet, etc.
• We are constantly using mental models (informal in nature) to
understand the world and to predict the outcomes of our actions.
E.g., in hiring decisions
• Visual models include maps, organizational charts, etc.
• Physical models are extensively used in engineering to assist the
design of ships, buildings, etc. Architects use physical models to show
how a proposed building fits with its surroundings.
Models are of many forms
• Mathematical models are used in science, engineering, public policy.
• For example, population models can predict the spread of infectious
diseases, traffic flow models predict the buildup of highway
congestion, etc.
• Mathematical models can be extremely powerful, especially when
they give clear insights into the forces driving a particular outcome.
Why study modeling
Why should we build and use formal models, instead of relying on
mental models or gut feeling?
• Generate insights, that is, having an improved understanding of the
situation or problem at hand.
• Make better decisions, which often results from improved
understanding.
Why study modeling
Why should we build and use formal models, instead of relying on
mental models or gut feeling?
• Modeling improves our thinking skills by providing a structure for
problem solving.
• Modeling improves our quantitative reasoning skills
• Models allow us to experiment and learn. One can test the
implications of alternative courses of action and develop not only a
recommended decision but the rationale for why that decision is
preferred.
Models in Business
• Strong modeling skills are particularly important for consultants,
financial analysts, marketing researchers, entrepreneurs, and others
who face challenging business decisions of real economic
consequence.
Models in Business
• One-time decision models
• Often built by decision makers themselves and under time pressure.
• Managerial judgement often used as a substitute for empirical data due to
time constraints/data limitations
• Involves the user intensively as it is usually tailored to a particular decision-
making need.
• Examples: Profit impact of a promotion campaign, selection of a health
insurance provider, etc.
Models in Business
• Decision support models
• Tie together models, data, analysis tools and presentation tools into a single
integrated package.
• Intended for repeated use
• Represent the routine use of what were once one-time decision models
• Such models are used in product line profitability analysis at manufacturing
firms, pricing decisions at oil companies, etc.
Benefits of modeling in business decision making
• Modeling allows us to make inexpensive errors
• Modeling allows us to explore the impossible
• Modeling can improve business intuition
• Modeling provides information in a timely manner
• Modeling can reduce costs
The Role of Spreadsheets
• Spreadsheets are the principal vehicle of model building in business.
• Spreadsheet models are also mathematical models.
Challenges
• Errors in spreadsheet models can be costly.
• Spreadsheets that are overly complex and difficult to understand and
use, even if technically correct, may be the cause of some costly
mistakes.
• Complexities may arise from:
• Excessively long and involved formulae in cells
• Poorly designed worksheets that are difficult to navigate and understand.
Model Formulation
• An exercise in simplifying the actual situation and capturing its
essence, with a specific purpose in mind
• Real world: a messy problem to solve
• Model world: abstraction, simplification of real world, keep only
essential features, leave behind inessential detail and complexities,
make suitable assumptions
Four Features of a Model
• Decisions
• Outcomes
• Structure
• Data
Decisions
• Possible choices or courses of action that we might take
• Controllable variables such as quantities to buy, manufacture, spend
or sell
• In contrast, uncontrollable variables such as tax rates or cost of
materials are not decision variables
Outcomes
• Consequences of the decisions – the performance measures we use
to evaluate the results of taking action.
• Profit, cost, efficiency
Structure
• Logic and mathematics that link the elements of our model together
• Profit = Revenue – Cost
• Final inventory = Initial inventory + Production - Shipment
Data
• Numerical assumptions
• Actual observations of the real world – raw or empirical data
• Estimates of uncontrollable variables in the problem’s environment
• Interest rate on borrowed funds, production capacity of a
manufacturing facility, first quarter sales of a new product
Analysis after Model Building
• Once the model is built, we can test ideas and evaluate solutions
• We apply logic to take us from our assumptions and abstractions to a
set of derived conclusions
• Relies on mathematics and reason in order to explore the implications
of our assumptions
• Exploration leads to insights about the problem
• An understanding of why one solution is beneficial, and the other is
not, or the sources of risk in a particular solution
• Insights derived from model world
Course Motivation
• Acquire the spreadsheet knowledge needed to tackle the many
analytical questions that arise during your course work.
• Acquire the skills to develop spreadsheet models that will help you
and your organization make better decisions.
 Course Outline
• Making sense of problems visually
• Influence diagrams, Blackbox diagrams
• Structure of a spreadsheet model and best practices
• Build some basic spreadsheet models
• Asking what-if questions
• Data tables, scenario manager
• Presenting results of what-if analysis using charts
• Use of financial functions in spreadsheet models
• How to arrive at optimal outcomes?
• Excel solver
• Considering uncertainty in our models
Knowledge of Excel
• Basic familiarity with Excel
• Knowledge of basic functions like SUM, SUMPRODUCT, IF, Nested IF,
VLOOKUP, etc.
• How to write and copy formulae
• How to use absolute and relative references
• Any Excel feature that we require for our tasks will be discussed
before we use them
• The focus is on the essential modeling tasks for effective and simple
representation of the problem at hand, rather than finding some
Excel trick
Course Evaluation
• End-Term 50%, hands-on
• Class participation 10%
• Assignments 40% (best n-1 out of n)
Ground Rules
• Grade is not everything. Are you learning?
• Be attentive in class.
• Do not copy assignments, during exams.
• Participate in class with valuable inputs.
• Ask your doubts.
References
• Powell, S. G., & Barker, K. R. (2008). Management Science: The Art Of
Modeling With Spreadsheets. John Wiley & Sons.
• Leong, T. Y., & Cheong, M. L. F. (2008). Business Modeling with
Spreadsheets: Problems, Principles, and Practice. McGraw Hill.