3.3.3 Decision Trees

• What is a decision tree?

  • a quantitative method of tracing the outcomes of a decision so that the most profitable decision can be identified
• What key advantages does the tree provide?

  • Reveal options that haven't previously been considered
  • Forced to consider risks associated with their choice, ahead of implementation
  • The quantitative approach requires deep research to be carried out
• Key elements in decision tree diagram

  • Decision points
  • Outcomes
  • Probabilities
  • Expected monetary values
• Decision Tree

  .

  A) Nodes

  
• What does square represent


  • Decisions
• What does the circle represent?

  • Points where there are different outcomes are represented by circles called nodes
• What other aspects are shown on the diagram

  The probability or likelihood of each outcome is shown on the diagram

  The monetary value of each decision is based on the expected profit or loss of the outcome
• How should a business compare the results?

  • To compare the options, a business should take into account the expected values of each decision presented in the decision tree diagram
• Formula for decision tree

  • (Expected value of success x Probability) + (Expected value of failure x Probability)
• Limitations of decision trees

  • Construction requires skill to avoid bias.
  • Time-consuming to gather data.
  • Is constructed using estimates which rarely take full account of external factors and cannot include all possible eventualities
  • Qualitative elements may affect the probability of success of a decision & are not considered.
  • Time lag between construction of a decision tree diagram & implementation of decision is likely to further affect the reliability of the expected values.
• Advantages of decision trees

  • Choices are set in a logical way.
  • Potential options & choices are considered at the same time.
  • Use of nodes enable 'risk' of options to be considered.
  • Likely costs & potential benefits are considered.
  • Easy to understand.
  • Tangible results.