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Factor Analysis

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Factor Analysis

Uploaded by

rs6488152
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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What is Factor Analysis?

Factor analysis is a statistical technique that reduces a set of variables by extracting all their
commonalities into a smaller number of factors. It can also be called data reduction.
When observing vast numbers of variables, some common patterns emerge, which are known
as factors. These serve as an index of all the variables involved and can be utilized for later
analysis.
Factor analysis uses several assumptions:
 The variables’ linear relationships
 Absence of multicollinearity
 Relevance of the variables
 The existence of a true correlation between factors and variables

Therefore, it becomes a statistical technique used to see how a group shares a common
variance. While it is mostly used in psychological research, it can also be applied in areas like
business and market study to understand customer satisfaction or employee job satisfaction
and in finance, to study the fluctuation of stock prices.
Features of factor analysis
While studying customer satisfaction related to a product, a researcher will usually pose
several questions about the product through a survey. These questions will consist of
variables regarding the product’s features, ease of purchase, usability, pricing, visual appeal,
and so forth. These are typically quantified on a numeric scale. But, what a researcher looks
for is the underlying dimensions or “factors” regarding customer satisfaction. These are
mostly psychological or emotional factors toward the product that cannot be directly
measured. Factor analysis uses the variables from the survey to determine them indirectly.
When a researcher assumes these variables from the survey, they are condensed into one or
more factors. Some of the methods used to extract these factors could include:
 Principal component analysis
This is the most commonly used method. The first factor is extracted by determining
the maximum variance. This variance is then removed and is replaced by the factor.
The second factor is then determined by the next highest variance, and the process
continues until there are no more variances.
 Common factor analysis
In this method, the factors are extracted from commonly-occurring variances and do
not include the unique variances of all the variables.
 Image factoring
Based on the correlation matrix, this process uses predicted variables using the OLS
regression method.
Once the factors are extracted, the questionnaire’s score is assumed to be related to the
factors in a linear manner. The margin of error is also taken into consideration, along with all
the factors to the equation.
Types of factor analysis
There are essentially two types of factor analysis:
 Exploratory Factor Analysis: In exploratory factor analysis, the researcher does not make any
assumptions about prior relationships between factors. In this method, any variable can be related
to any factor. This helps identify complex relationships among variables and group them based on
common factors.
 Confirmatory Factor Analysis: The confirmatory factor analysis, on the other hand, assumes
that variables are related to specific factors and uses pre-established theory to confirm its
expectations of the model.
Assumptions of factor analysis
Factor analysis makes use of several assumptions in order to produce the outcomes:
 There will not be any outliers in the data.
 The sample size will be greater than the size of the factor.
 Since the method is interdependent, there will be no perfect multicollinearity between any of the
variables.
 When in a sequence of random variables, all the variables have the same finite variance, known as
being homoscedastic. Since factor analysis works as a linear function, it will not need
homoscedasticity between variables.
 There is the assumption of linearity. This means that even non-linear variables can be used, but
once transferred, they become linear variables.
 There is also the assumption of interval data.

How factor analysis is used


Business marketing
In a business model, factor analysis is used to explain complex variables or data using the
matrix of association. It studies the interdependencies of data and assumes that complex
variables can be reduced to a few important dimensions. This is possible because of some of
the relationships between variables and their dimensions. The attribute of one variable might
sometimes be the result of the dimension of another. It breaks down the initial rating, using
statistical algorithms on various components and uses these partial scores to extract various
factors.
Automotive industry
The use of factor analysis in the automotive industry was mentioned as far back as 1997 in an
article by Professor Emeritus Richard B. Darlington of Cornell University. He explained how
a study could be used to identify all the variables that apply to the decision-making of
purchasing a car—size, pricing, options, accessories, and more. The study could then be used
to arrive at a few key variables that actually close a purchase decision. Automotive dealers
can then tailor their offerings to cater to the market.
Investing
The key to a productive investment portfolio is diversification. To ensure a diverse portfolio,
investment professionals use factor analysis to predict movement across a wide sector of
industries and provide insights on factors that may be under the radar. For example, the
average portfolio contains stocks of industries like technology and commodities. A look at
the rise in stock prices of a related industry, like oil, will give investment professionals a
good idea on what to sell and retain.
Human resources
There are many factors that go into a company’s hiring process. With statistics, human
resource professionals will be able to create a comfortable and productive working
environment. Several variables can be compared and analyzed to see which combination in
terms of the number of team members, varied skill sets, and contractual or in-house talent
works, improving the overall functioning of the organization.
Restaurants
For restaurants, factor analysis can be used to understand demographics and target diners in
the creation of menus. A fast-food restaurant opening next to a university campus will have to
plan its menu differently than if it was placed in a high-end shopping location. Factors such
as surrounding competition, foot-traffic, age-groups, and location all determine success.
Education
When hiring teachers and deciding on a curriculum for the school year, factor analysis plays a
huge role. It is used to determine classroom sizes, staffing limits, salary distribution, and a
wide range of other requirements necessary for the school year to run smoothly.
Challenges and solutions of factor analysis
While factor analysis is a useful tool for business research and analysis, there are a few
challenges to keep in mind in order to ensure the right results. The result entirely depends on
the ability of the researcher to gather the right set of variables associated with the business
and the product. Neglecting even a small detail might result in the wrong value of the
procedure.
If the observed variables for a particular item are similar to each other but distinct from other
items, the algorithm might consider this as a single factor to those items, which could result
in inaccurate analysis results. Knowledge of the item and its theory is important in naming
factors accurately. Even dissimilar variables might have dependencies for no reason.
Gathering information using an accurate survey is the key. Besides the knowledge of the
product and its theory, it is also important to know its market.
Research and developments in the field of factor analysis continue to contribute to making
more informed decisions in various sectors. Continuous refinement in confirmatory factor
analysis techniques makes this one of the most important decision-making tools for every
industry in the future.

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