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02 Decision Trees

The document discusses decision trees which are diagrams that set out options for making decisions and the likelihood of outcomes. It provides examples of decision trees and how they work including using probabilities and calculations to determine the best option. The advantages are that they ensure all outcomes are considered and encourage logical decision making while disadvantages include potential bias in the data.

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ronaldthemusictechfrog
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22 views

02 Decision Trees

The document discusses decision trees which are diagrams that set out options for making decisions and the likelihood of outcomes. It provides examples of decision trees and how they work including using probabilities and calculations to determine the best option. The advantages are that they ensure all outcomes are considered and encourage logical decision making while disadvantages include potential bias in the data.

Uploaded by

ronaldthemusictechfrog
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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UNIT 2: MANAGEMENT, LEADERSHIP AND DECISION MAKING

Decision Trees

DEFINITION:

 Decision trees are diagrams that set out all options available when making a decision, plus an estimate
of their likelihood of occurring.
.

 Provide a logical process for decision making.


.

 Chance can be estimated by assigning a probability.

HOW A DECISION TREE WORKS:

 The tree is a diagram setting out the key features of a decision-making problem.
 The tree is shown lying on its side, roots on the left, branches on the right.
 The decision problem is set out from left to right with events laid out in the sequence in which they occur.
 The branches consist of:
o A decision to be made – shown by a square

o Chance events or alternatives beyond the decision-maker’s control, shown by a circle (node).

SQUARE = Decision to be made. CIRCLE = Chance event.

Therefore:

 There must be a probability attaching to each of the chance events (circles)


 Probabilities must add up to 1.

EXAMPLE DECISION TREE:

The branch not taken is


crossed out as shown
below:
DRAWING DECISION TREES

For example: Bantox plc must decide whether or not to launch a new product.

Launch

Don’t launch

Research suggests that there will be a 70% chance of success in a new product launch. This would be shown as a
probability of 0.7.

0.7 Success

Launch

0.3 Failure

Don’t launch

To make a final decision, based on the tree above, estimates are needed of the financial costs and returns. In this
case let’s assume:

 The new product launch will cost £10 million


 A new product success will generate £15 million
 A new product failure will generate only £3 million
 No launch means no movement in net cash.

The full tree looks like:

_______________________________________________________________________________________________
MAKING CALCULATIONS

To work out average:

Total of all the numbers / The amount of numbers


EG: (£15m + £3m) / 2 = £9 million

*This assumes that there is an equal chance of gaining £15m and £3m. In fact the probabilities are 70/30. Therefore
the correct average is:

£15m x 0.7 = £10.5m


CALCULATIONS ON DECISION TREES ARE
£3 x 0.3 = £0.9m MADE FROM: RIGHT TO LEFT

TOTAL: £11.4 million.


EXAMPLE OF TREE WITH CALCULATIONS:

THEREFORE:

It is preferable to launch this product. This is indicated by crossing out the ‘don’t launch’ option.
ADVANTAGES AND DISADVANTAGES OF DECISION TREES

ADVANTAGES: DISADVANTAGES:
 Allows for uncertainty  Can be biased. Data can be inaccurate.

 Ensure managers consider all possible  Difficult to get meaningful data


outcomes
 Less useful in the case of completely new
 Set out the problem clearly and encourage a problems or strategic problems.
logical approach
 Relatively easy for a manager to manipulate
 Force assessments of the implications of data. Proves a pre-desired result.
success and failure
 Does not take into account the variability of the
 Set out the probability of a specific outcome business environment.
occurring.
 May divert managers from the need to take
 Most useful when similar scenarios have been account of qualitative as well as quantitative
used before. information when making a decision.

 Useful for tactical decisions.

KEY TERMS:

Key word Definition


Actual values The forecasts of the net cash flows which result from following a sequence of decisions
and chance events through a decision tree. Should be shown at the ends of branches.
Node A point in the decision tree where chance takes over. It is denoted by a circle and it should
be possible to calculate the expected value of this pathway.
Expected values The forecast actual values adjusted by the probability of their occurrence. They are not the
actual cash flows which result. Expected = actual x probability.
Net gains Subtracting initial outlay from the expected value to find out whether or not a decision is
likely to produce a gain or a loss.
Probability The likelihood of something occurring. Represented in decimals and must add up to 1.

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