1

DECISION TREE ANALYSIS • Every intelligent decision maker dealing with uncertainty likes to know the size and nature of the risk he is taking in choosing a course of action. • This is one of the main deficiencies in. the traditional decision making process. • Virtually every decision is based on the interaction of a number of critical variables, many of which have an element of uncertainty but a fairly high degree of probability. • Thus, the wiseness of undertaking the introduction of a new product might depend upon critical variables like the expenses of introducing a new product, cost of production. Capital investment required price obtainable, total market for the product and share of the market that could be obtained by the product.

One of the best ways to analyze a decision, by seeking the possible direction that actions might take from various decision points and the decision points relating to it in the future is called Decision Tree Analysis.

A decision tree depicts the future decision points and possible chance events, usually with a notation of the probabilities of the various uncertain events happening.

When a new products is being introduced into the market, one of the

common problems that occurs in business is to decide whether to

2. • What is needed is an assessment of the probabilities of each course of possible events. . The product life is assumed to be 5 years. • If the probability that product sales will be as much as estimated is 60%. 1. • The decision tree shows the manager in what direction his chance events are and what their values in terms of profits and losses are for each of the two tooling alternatives.000 3. 00. The following are the assumptions of the project. The cost of permanent tooling is Rs. b) If the product sales are slow Rs.000 per year for 5 years. The estimated inflows of cash under permanent tooling are a) If the product succeeds it is Rs. that they will be slow is 20% and that the product may fail to sell is 20%. but lower capital losses if the product does not sell as well as estimated. • But it is not enough to give him the visibility he would like to have in order to decide between going for permanent tooling or temporary tooling. his decision can be greatly helped. 00.000 per year for 5 years. 20.2 introduce it in a major way (Permanent Tooling) so as to assure production at the lowest possible cost or to undertake a cheaper temporary tooling involving a higher manufacturing cost. 10.00. 2.

00.00. • But. 1. c) If the product fails the loss is Rs.6) per year for the 5 years of product life assumed and Rs. 6. b) If the product sales are slow Rs.00.80.000 ( 3.000/(10. a 30% return on 20. • On consideration of rate of return on investment only. 00.000 investment has a predicted worth of Rs.3 c) If the product fails the loss is Rs. 1. depending on the availability of capital.000. 00.000 over 5 years would normally be regarded us greatly preferable to a 180% return on 1.6) per year for 5 years. 1. • The chance events for each of the three is 600/0 that the product will succeed.000 for 5 years.000 per year for 5 years.00. 20% that the product sales will be slow and 20% that the product is likely to fail. 3. 20.000 x .00. 00.000.00.000 per year for 5 years.000x . The cost of temporary tooling is Rs. At the end of the figure Rates of return on investment for permanent tooling = 6. 4. 1. • Taking into account these probabilities the 20.000 temporary tooling alternative has a worth of Rs.00. 00.000 a) If the product succeeds it is Rs. the temporary tooling approach would seem to be preferable.000 . 50. 00.

• On percentage rate of return on investment. ROI on Permanent tooling =----------------------. thus putting squeeze on prices and volume.9% 20.000 1. 18. • As can be seen.18. 3. 00. 00.000 ROI for temporary tooling = 3. 00. 80.6 =--------------x 100 = 180% 1.000 and on the temporary tooling Rs. 19. 19.000 . the larger investment would look all the more better.X 100 = 95.000. the total probability modified return on permanent tooling would be Rs. 00. by calculating the value of each probability over a five year assumed product life and disregarding the cost of interest and discounting of future income.000.6 = ---------------.4 10.000 • There is also the probability that if we drew a decision tree for a longer period and took into account a further chance event that one or more competitors would enter the market. the temporary tooling approach still looks better.x 100 = 30% 20. more far sighted and complete decision tree can be drawn as follows. 00.000 x 0. • With the same basic probabilities mentioned and the further probability that a vigorous competitor would enter the field.90.000 + 0.

000 before a product proved itself in the market. 90.000 on temporary tooling) if the product demand justified doing so.000 ROI on Temporary tooling = -----------------------------. • It can be seen from the above that as chance events increase. 1. 00. . • Whether this course of action is taken or not would largely depend upon the extent to which the decision maker might prefer to avoid the risk of investing Rs.X 100 = 390% 1. 20.00.5 3. • For example the firm might have its options open by initially investing in temporary and them go for permanent tooling (at a loss of Rs.000 • The higher total profits expected plus the possibility of a product life exceeding 5 years and considerations of better meeting competition might indicate that the permanent tooling programme would be more preferable. the decision tree becomes more complicated and the compounding of various probabilities makes the solution much more difficult. 00. • In real life the tree would show various decision points in the future.