Example

A company faces a decision with respect to a product

(codenamed M997) developed by one of its research
laboratories. It has to decide whether to proceed to test
market M997 or whether to drop it completely. It is estimated
that test marketing will cost £100K. Past experience indicates
that only 30% of products are successful in test market.
If M997 is successful at the test market stage then the
company faces a further decision relating to the size of plant
to set up to produce M997. A small plant will cost £150K to
build and produce 2000 units a year whilst a large plant will
cost £250K to build but produce 4000 units a year.
The marketing department has estimated that there is a 40%
chance that the competition will respond with a similar
product and that the price per unit sold (in £) will be as
follows (assuming all production sold):
Large plant Small plant
Competition respond 20 35
Competition do not respond 50 65
Assuming that the life of the market for M997 is estimated to
be 7 years and that the yearly plant running costs are £50K
(both sizes of plant - to make the numbers easier!) should the
company go ahead and test market M997?
Solution
Although the above example is somewhat simplified it plainly
represents the type of decision that often has to be made
about new products.
In particular note how we cannot separate the test market
decision from any decisions about the future profitability (if
any) of the product if test marketing is successful.
To enable us to see what is going on consider the figure
below where we have drawn the decision tree for the
problem.

In that figure we have three types of node represented:

• Decision nodes;
• Chance nodes; and
• Terminal nodes.

Decision nodes represent points at which the company has to

make a choice of one alternative from a number of possible
alternatives e.g. at the first decision node the company has
to choose one of the two alternatives "drop M997" or "test
market M997".
Chance nodes represent points at which chance, or
probability, plays a dominant role and reflect alternatives
over which the company has (effectively) no control.
Terminal nodes represent the ends of paths from left to right
through the decision tree.
To ease the discussion of the decision tree we have
numbered the nodes (decision/chance/terminal) 1,2,3...12. At
each decision node we have also numbered the alternatives,
at node 1 we have alternatives 1 and 2 and at node 5
alternatives 3, 4 and 5.
Although the decision tree diagram does help us to see more
clearly the nature of the problem it has not, so far, helped us
to decide whether to drop M997 or whether to test market it.