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CHAPTER 1
INTRODUCTION

MODELS AND MODELING

Modeling is the process of creating a simplified representation of reality and working
with this representation in order to understand or control some aspect of the world. While
this book is devoted to mathematical models, modeling itself is a ubiquitous human
activity. In fact, it seems to be one of just a few fundamental ways in which humans
understand the world.
As an example, a map is one of the most common models we encounter. Maps are
models because they simplify reality by leaving out most geographic details in order to
highlight the important features we need. A state road map, for example, shows major
roads but not 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 home
across several states requires a regional map, while a trip across town to find a new doc-
tor’s office requires a detailed street map. In the same way, a good model must be appro-
priate for the specific uses intended for it. A complex model of the economy is probably
not appropriate for pricing an individual product. Likewise, a back-of-the-envelope calcu-
lation may be inappropriate for acquiring a multibillion-dollar company.
Models take many different forms: mental, visual, physical, mathematical, and
spreadsheet, to name a few. We use mental models constantly to understand the world and
to predict the outcomes of our actions. Mental models are informal, but they do allow us
to make a quick judgment about the desirability of a particular proposal. For example,
mental models come into play in a hiring decision. One person has a mental model that
suggests that hiring older workers is not a good idea because they are slow to adopt new
ways; someone else has a model that suggests hiring older workers is a good idea because
they have valuable experience. We are often unaware of our own mental models, yet they
can still have a strong influence on the actions we take, especially when they are the pri-
mary basis for decision making.
While everyone uses mental models, some people routinely use other kinds of
models in their professional lives. Visual models include maps, as we mentioned above.
Organization charts are also visual models. They may represent reporting relationships,
reveal the locus of authority, suggest major channels of communication, and identify
responsibility for personnel decisions. Visual models are used in various sports, where
a coach will sketch the playing area and represent team members and opponents as X’s
and O’s. Players seldom stop to think that they are adopting a model for the purposes
of communication.
Physical models are used extensively in engineering to assist in the design of air-
planes, ships, and buildings. They are also used in science, as, for example, in depicting
the spatial arrangement of amino acids in the DNA helix or the makeup of a chemical
compound. Architects use physical models to show how a proposed building fits within
its surroundings.

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2 CHAPTER 1 INTRODUCTION

Mathematical models take many forms and are used throughout science, engineer-
ing, and public policy. For instance, a groundwater model helps determine where flood-
ing is most likely to occur, population models predict the spread of infectious disease,
and exposure-assessment models translate the impact of toxic spills. In other settings,
traffic-flow models predict the buildup of highway congestion, fault-tree models help
reveal the causes of an accident, and reliability models suggest when equipment may
need replacement. Mathematical models can be extremely powerful, especially when
they give clear insights into the driving forces behind a particular result.

Why Study Modeling?

What are the benefits of building and using formal models, as opposed to relying on
mental models or just “gut feel?” The primary purpose of modeling is to generate
insight, by which we mean an improved understanding of the situation or problem at
hand. While mathematical models consist of numbers and symbols, the real benefit of
using them is to make better decisions. Better decisions are most often the result of
improved understanding, not just the numbers themselves.
Thus, the most important reason to study modeling is that modeling improves our
thinking skills. Modeling is a discipline that provides a structure for problem solving. The
fundamental elements of modeling—such as parameters, decisions, and outcomes—are
useful concepts in all problem solving. Modeling provides examples of clear and logical
analysis and helps us set high standards for thinking.
Modeling also helps improve our quantitative reasoning skills. Building models
demands care with units and orders of magnitude, and it teaches the importance of numer-
acy. Many people are cautious about quantitative analysis because they do not trust their
own quantitative skills. In the best cases, a well-structured modeling experience can help
such people overcome their fears, build solid quantitative skills, and improve their per-
formance in a business world that demands (and rewards) these skills.
Any model is a laboratory in which we can experiment and learn. An effective mod-
eler needs to develop an open, inquiring frame of mind to go along with the necessary
technical skills. Just as a scientist uses the laboratory to test ideas, hypotheses, and theo-
ries, a business analyst can use a model to test the implications of alternative courses of
action and develop not only a recommended decision but, equally important, the rationale
for why that decision is preferred. The easy-to-understand rationale behind the recommen-
dation often comes from insights the analyst has discovered while testing a model.

Models and Business

Given the widespread use of mathematical models in science and engineering, it is not sur-
prising to find that they are also widely used in the business world. Quite a number of peo-
ple routinely build and analyze formal models in their professional lives. When this work
is done in the business setting, we call these people business analysts, and they are the
intended audience for this book. In our years of training managers and management stu-
dents, we have found that strong modeling skills are particularly important for consultants,
as well as for financial analysts, marketing researchers, entrepreneurs, and others who face
challenging business decisions of real economic consequence.
Just as there are many types of models in science, engineering, public policy, and
other domains outside of business, many different types of models are used within busi-
ness. We distinguish here one-time decision models, decision-support models, embedded
models, and models used in business education. These categories exemplify different lev-
els of interaction with and participation by the people in the business organization that
uses the models.
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MODELS AND MODELING 3

Many of the models business analysts create are used in one-time decision problems.
A corporate valuation model, for example, might be used during merger negotiations to
make a go/no-go decision, but the model may never be used again. In other situations, a
one-time model might be created to evaluate the profit impact of a promotion campaign,
or to help select a health insurance provider, or to structure the terms of a supply contract.
One-time models are usually built by decision makers themselves, often under time pres-
sure. Managerial judgment is often used as a substitute for empirical data in such models,
due to time constraints and data limitations. Most importantly, this type of model involves
the user intensively, because the model is usually tailored to a particular decision-making
need. One major benefit of studying modeling is to make the use of one-time models much
more effective.
Decision-support systems are computer systems that tie together models, data, analy-
sis tools, and presentation tools into a single integrated package. These systems are
intended for repeated use, either by executives themselves or by their analytic staff.
Decision-support systems are used in research and development planning at pharmaceuti-
cal firms, pricing decisions at oil companies, and product-line profitability analysis at
manufacturing firms, to cite just a few examples. Decision-support systems are usually the
province of computer personnel, but they represent the routine use of what were once one-
time decision models. After a one-time model is established, it can be adapted for broader
and more frequent use in the organization. Thus, the models within decision-support sys-
tems may initially be developed by managers and business analysts, but subsequently
streamlined by information systems staff for a less intensive level of human interaction.
An additional benefit of studying modeling is to recognize possible improvements in the
design and operation of decision-support systems.
Embedded models are models that are contained within computer systems that per-
form routine, repeated tasks with little or no human involvement. Many inventory replen-
ishment decisions are made by automated computer systems. Loan payments on auto
leases or prices for stock options are also determined by automated systems. Routine real
estate appraisals may also be largely automated. In these cases, the models themselves are
somewhat hidden behind the software. Many users of embedded models are not aware of
the underlying models, but simply assume that somehow the “system” knows how to make
the right calculations. One ancillary benefit of studying modeling is to become more
aware, and perhaps more questioning, of these embedded models.
Models are useful not only in the business world, but also in the academic world in
which business analysts are educated. The modern business curriculum is heavily depend-
ent on models for delivering basic concepts as well as for providing numerical results. An
introductory course in Finance might include an option-pricing model, a cash-management
model, and the classical portfolio model. A basic Marketing course might include demand
curves for pricing analysis, a diffusion model for new-product penetration, and clustering
models for market segmentation. In Operations Management, we might encounter inven-
tory models for stock control, allocation models for scheduling production, and the
newsvendor model for trading off shortage and surplus outcomes. Both micro- and macro-
economics are taught almost exclusively through models. Aggregate supply-and-demand
curves are models, as are production functions. Most of the models used in education are
highly simplified, or stylized, in order to preserve clarity. Stylized models are frequently
used to provide insight into qualitative phenomena, not necessarily to calculate precise
numerical results. In this book, we frequently use models from business education as exam-
ples, so that we can combine learning about business with learning about models.
Modeling can benefit business decision making in a variety of ways. For one thing, it
can provide more timely information than alternative approaches. For example, while
extensive surveys could be used to determine the potential demand for a product, effective
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4 CHAPTER 1 INTRODUCTION

modeling can often give useful bounds on the likely range of demand in far less time.
Modeling can also save costs: surveys are expensive to create, distribute, and process. An
effective modeler may be able to provide the same level of information at much lower
cost. Another way in which modeling reduces cost is that it allows us to make inexpensive
errors. Wind-tunnel tests are used in airplane design partly because if every potential wing
design had to be built into a full-scale aircraft and flown by a pilot, we would lose far too
many pilots. Similarly, using a model, we can propose ideas and test them in the model,
without having to suffer the consequences of bad ideas in the real world. Yet another ben-
efit of modeling is that it allows us to explore the impossible. Many companies have poli-
cies, procedures, or habits that prevent them from making certain choices. Sometimes,
these habits prevent them from discovering better ways of doing business. Modeling can
be used to explore these “impossible” alternatives, and if some of them prove attractive,
modeling can be used to convince the skeptics to try them out.
A final benefit from studying modeling is that it can improve business intuition. As
we have said, a model is a laboratory in which we perform experiments to learn. We can
usually learn faster from laboratory experiments than from experience in the real world.
With a model, we can try thousands of combinations that would take many years to test in
the real world. We can also try extreme ideas that would be too risky to test in the real
world. And we can learn about how the world works by simulating a hundred years of
experience, all in an afternoon.
Even among those who do not build models, skill in working with models is very
important. Most students eventually find themselves on a team charged with recommend-
ing a course of action. If these teams do not build models themselves, they often work with
internal or external consultants who do. Experience in building and analyzing models is,
in our minds, the best training for working effectively on problem-solving teams. People
who have not actually built a few models themselves often accept model results blindly or
become intimidated by the modeling process. A well-trained analyst not only appreciates
the power of modeling but also remains skeptical of models as panaceas.
We believe that modeling skills are useful to a very broad range of businesspeople,
from junior analysts without a business degree working in consulting to senior vice pres-
idents of start-ups who do their own analysis. Many recent MBAs have only a superficial
knowledge of these tools, because the typical MBA program still emphasizes passive
consumption of other people’s models rather than active model building. Thus, there is
considerable potential even among those who hold MBAs to improve their modeling
skills so they can become more capable of carrying out independent analyses of impor-
tant decisions. The only absolute prerequisite for using this book and enhancing this skill
is a desire to use logical, analytic methods to reach a better level of understanding in the
decision-making world.

Organization of the Book

This book is organized around the three skills we believe business analysts most need in
their modeling work:
■ spreadsheet engineering
■ modeling craft
■ management science and statistics
Spreadsheet engineering deals with how to design, build, test, and perform analysis
with a spreadsheet model. Modeling craft refers to the nontechnical but critical skills that
an expert modeler employs, such as abstracting the essential features of a situation in a
model, debugging a model effectively, and translating model results into managerial