Decision trees

Decision trees are diagrams which illustrate the choices and possible outcomes of
a decision. The possible outcomes are usually given associated probabilities of
occurrence.

Rollback analysis evaluates the EV of each decision option. You have to work
from right to left and calculate EVs at each outcome point.

Decision trees are a useful means of analysing a probability problem.

A decision trees is a pictorial method of showing the different decision options in a

given situation, and the possible outcomes from each decision option. Decision trees
can incorporate the probabilities of both the expected outcomes and the EV of each
decision option. Decision trees can also show both initial decisions and
subsequent decisions, where a decision is taken in two stages, at two different
times.

• All the possible choices that can be made are shown as branches on the tree.
• All the possible outcomes of each choices are shown as subsidiary branches
on the tree.

Every decision tree starts from a decision point with the decision options that are
currently being considered, and the decision that must be made 'how'.

a) We shall use a square shape to indicate that a decision must be made at

this point.

b) There should be a line or branch, for each option or alternative.

If the outcome from any choice is certain, the branch of the decision tree for that
decision option is complete.
If the outcome of a particular choice is uncertain, the various possible outcomes
must be shown.

We show the various possible outcomes on a decision tree by inserting an outcome

point on the branch of the tree. Each possible outcome is then shown as a
subsidiary branch, coming out from the outcome point. The probability of each
outcome occuring should be written on to the branch of the tree which represents
that outcome.

When several outcomes are possible, it may be simpler to show or more stages of
outcome points on the decision tree.

Sometimes, a decision taken now will lead to other decisions to be taken in the
future. When this situation arises, the decision tree can be drawn as a two-stage tree.

The decision tree should be in chronological order from left or right. When there are
two-stage decision trees, the first decision in time should be drawn on the left.

Rollback analysis

Rollback analysis evaluates the EV of each decision option. You have to work from
right to left and calculate EVs at each outcome point.

a) We start on the right-hand side of the tree and work back towards the left
hand side and the current decision under consideration. This is sometimes
known as the rollback technique or rollback analysis.

b) Working from right to left, we calculate the EV of revenue, cost,

contribution or profit at each outcome point on the tree.

Decision trees has a number of limitations.

a) Decision trees are not very suitable for use with complex decisions because
the decision tree becomes too big and complicated to follow.

b) Decision trees are just a graphical way of making a decision based on the
expected value rule. So the decision tree method has all the benefits and
limitations of EV as a decision rule.
c) The possibilities associated with different branches of the tree are likely to be
estimates, and possibly unreliable or inaccurate.

The value of information.

Perfect information is guaranted to predict thee future with 100% accuracy.

Imperfect information is better than no information at all but could be wrong in its
prediction of the future.

The value of perfect information is the difference between the EV of profit with
perfect information and the EV of profit without perfect information.

The risk or uncertainty in a decision can be reduced by obtaining information about

the likely outcome situation.
The value of information can be calculated on the assumption that the EV decision
criterion is used. The value of information is the difference between the EV of a
decision if a decision if no information is available and the EV of the decision if the
information is made available.

Information may be either perfect or imperfect.

Perfect information is information that predicts with 100% accuracy what the
outcome situation will be. Having perfect information removes all doubt and
uncertainty from a decision, and enables managers to make decisions with complete
confidence that they have selected the best decision option.

The value of perfect information.

Step 1: If we do not have perfect information and we must choose between

two or more decision option, we could select the decision option
which offers the highest EV of profit(or lowest EV of cost).

Step 2: With perfect information, the best decision option will always be
selected.
Step 3: The value of perfect information is the difference between the EV of
profit with perfect information and the EV of profit with the
information.