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Understanding Decision Trees for Managers

A decision tree is a model that uses estimates and probabilities to calculate the likely outcomes of different decisions and determine the option with the highest net gain. It starts with the available options and possible outcomes, then adds associated costs, probabilities, and financial results to calculate the expected value and net gain of each option. For the example of launching a loyalty card versus cutting prices, cutting prices has the highest net gain of £440,000, suggesting it is the best option.

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Neeraja Kesavaraj
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100 views6 pages

Understanding Decision Trees for Managers

A decision tree is a model that uses estimates and probabilities to calculate the likely outcomes of different decisions and determine the option with the highest net gain. It starts with the available options and possible outcomes, then adds associated costs, probabilities, and financial results to calculate the expected value and net gain of each option. For the example of launching a loyalty card versus cutting prices, cutting prices has the highest net gain of £440,000, suggesting it is the best option.

Uploaded by

Neeraja Kesavaraj
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Decision 

Trees
A decision tree is a mathematical model used to help managers make decisions.

 A decision tree uses estimates and probabilities to calculate likely outcomes.


 A decision tree helps to decide whether the net gain from a decision is
worthwhile.

Let's look at an example of how a decision tree is constructed. We'll use the following
data:

A decision tree starts with a decision to be made and the options that can be taken.
Don't forget that there is always an option to decide to do nothing!
The first task is to add possible outcomes to the tree (note: circles represent uncertain
outcomes)
Next we add in the associated costs, outcome probabilities and financial results for
each outcome.

These probabilities are particularly important to the outcome of a decision tree.

Probability is

 The percentage chance or possibility that an event will occur


 Ranges between 1 (100%) and 0
 If all the outcomes of an event are considered, the total probability must add up to
1
Finally we complete the maths in the model by calculating:

Expected value:

The financial value of an outcome calculated by multiplying the estimated financial


effect by its probability

Net gain:

The value to be gained from taking a decision.

Net gain is calculated by adding together the expected value of each outcome and
deducting the costs associated with the decision.
Let's look at the calculations. What do they suggest is the best option?

Option: Launch loyalty card:

High sales: (0.6 x £1,000,000) = £600,000

Low sales: (0.4 x £750,000) = £300,000

Total expected value = £900,000

Net gain: £900,000 - £500,000 = £400,000

Option: Cut prices:

High sales: (0.8 x £800,000) = £640,000

Low sales: (0.2 x £500,000) = £100,000

Total expected value = £740,000

Net gain: £740,000 - £300,000 = £440,000


Both options indicate a positive net gain, suggesting that either would be better than
doing nothing.

However, cutting prices has a slightly higher net gain & looks the best option of the two
considered.

BENEFITS OF USING DECISION TREES

 Choices are set out in a logical way


 Potential options & choices are considered at the same time
 Use of probabilities enables the “risk” of the options to be addressed
 Likely costs are considered as well as potential benefits
 Easy to understand & tangible results

DRAWBACKS OF USING DECISION TREES

 Probabilities are just estimates – always prone to error


 Uses quantitative data only – ignores qualitative aspects of decisions
 Assignment of probabilities and expected values prone to bias
 Decision-making technique doesn’t necessarily reduce the amount of risk

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