DECISION TREE APPROACH

 Decision making process involves selecting the best

among several available decisions through proper
evaluations of parameters of each decision
 In real life situation, decision making is a multi-stage
process.
 Decision at stage ’i’ is dependent on the decision
made at stage ‘i -1’
 At each stage, there will be a set of alternatives
 For each alternative, there will be a set of chance
events.
 symbol represents decision point at a given stage
from which a set of decision alternatives will originate.
 symbol represents a chance point for a given
alternative from which chance events will originate.
Decision Tree approach helps the decision maker to
perform an analysis before arriving at optimum decision.
PROBLEM
- A company is planning production capacity for next 10
years.
- Demand for product may be High or Low.
- Company can build capacity assuming High Demand,
this will require higher investment.
- In case of High Demand situation, this capacity will be
economical in the long run.
- Second option is to plan the capacity on the basis of
Low Demand.
 - Study market for 4 years and build additional capacity
in 5th year, if market so demands.
- Building additional capacity in 5th year will be more
costly than it would be now.
- Company estimated that High or Low Demand have
equal probabilities.
- If demand during first four years remains High, then
the probability that the demand will remain High in
next 6 years is 0.8.
- Probability of low demand in next 6 years is 0.2
- If demand during first four years remains low, then the
probability that the demand will remain low in next 6
years is 0.8.
- Probability of high demand in next 6 years is 0.2.
- Cash flows in terms of investments, maintenance, and
revenue for both options have time value.
- Present worth of all associated cash flows are given
in the following table.
Demand Year 1 - 4 Year 5 – 10
Low High Low High
Strategy S1 - 1000 5000 - 1500 7000
Strategy S2 200 1000 5000 3000
Find the optimal strategy which will maximize the expected
Pay-off.
 High 0.8
7000

C Low 0.2
(-)1500
High 0.5

High 0.2
7000
B
S1 D
Low 0.5 Low 0.8
(-)1500
A
High 0.8
3000
High 0.5
S2 F
Low 0.2
E 5000
High 0.2
3000
Low 0.5 G Low 0.8
5000

Expected Pay-off at ‘C’ = 7000X 0.8 – 1500 X 0.2 = 5300

Expected Pay-off at ‘D’ = 7000X 0.2 – 1500 X 0.8 = 200
Expected Pay-off at ‘F’ = 3000X 0.8 + 5000 X 0.2 = 3400
Expected Pay-off at ‘G’ = 3000X 0.2 + 5000 X 0.8 = 4600
Expected Pay-off at ‘B’ = 0.5 (5000+5300) + 0.5 (-1000 +200)
= 4750
Expected Pay-off at ‘E’ = 0.5 (1000+3400) + 0.5 (200 +4600)
= 4600
Expected Pay-off at ‘B’ > Expected Pay-off at ‘E’
Thus Strategy ‘S1’ shall be selected,
i.e., Build Capacity based on High Demand