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Decision Trees

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

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2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

Introduction
Decision trees enable one to look at decisions: with many alternatives and states of nature which must be made in sequence

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

4-2

2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

Decision Trees
A graphical representation where:

a decision node from which one


of several alternatives may be chosen

a state-of-nature node out of


which one state of nature will occur

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

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2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

Thompsons Decision Tree


A State of Nature Node 1 Favorable Market

Unfavorable Market A Decision Node Construct Small Plant2

Favorable Market

Unfavorable Market

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

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2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

Five Steps to Decision Tree Analysis


1. Define the problem 2. Structure or draw the decision tree 3. Assign probabilities to the states of nature 4. Estimate payoffs for each possible combination of alternatives and states of nature 5. Solve the problem by computing expected monetary values (EMVs) for each state of nature node.
To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

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2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

Thompsons Decision Tree


A State of Nature Node 1 EMV =$10,000

Favorable Market (0.5) $200,000


Unfavorable Market (0.5) -$180,000 Favorable Market (0.5) $100,000

A Decision Node Construct Small Plant 2 EMV =$40,000

Unfavorable Market (0.5) -$20,000

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

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2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

Decision Tree Analysis on R&D Projects


Define problem Develop model Discovery of a new, unpatentable process Traditional decision tree with expected net present values (ENPV) as outcomes Collected both probability and monetary values: technical success, significant market, commercial success Traditional decision tree analysis Analyzed risks of the process ENPV was $3.2 million Decision made to investigate further. Field testing resulted in cancellation
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2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

Acquire data

Develop solution Test solution Analyze results Implement results

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

Thompsons Decision Tree

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

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2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

Thompsons Decision Tree

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

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2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

Thompson Decision Tree Problem Using QM for Windows

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

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2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

Thompson Decision Tree Problem using Excel

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

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2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

Expected Value of Sample Information


Expected value of best decision with sample information, EVSI = assuming no cost to gather
it

Expected value of best decision without sample information

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

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2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

Estimating Probability Values by Bayesian Analysis


Management experience or intuition History

Existing data
Need to be able to revise probabilities based upon new data
Bayes Theorem Prior probabilities New data Posterior probabilities

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

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2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

Market Survey Reliability in Predicting Actual States of Nature Actual States of Nature Result of Survey
Positive (predicts favorable market for product) Negative (predicts unfavorable market for product)

Favorable Market (FM)


P (survey positive|FM) = 0.70 P (survey negative|FM) = 0.30

Unfavorable Market (UM)


P (survey positive|UM) = 0.20 P (survey negative|UM) = 0.80

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

4-14

2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

Probability Revisions Given a Positive Survey


Conditional Probability State P(Survey of positive|State Nature of Nature FM 0.70 0.20 * 0.50 * 0.50 0.35 0.35 = 0.78 0.45 0.10 = 0.22 0.45 1.00

UM

0.10
0.45

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

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2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

Probability Revisions Given a Negative Survey


Conditional Probability State P(Survey of negative|State Nature of Nature) FM 0.30 * 0.50 0.15 0.40 0.15= 0.27 0.55

UM

0.80

* 0.50

0.40 = 0.73 0.55


1.00

0.55
To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

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2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

Calculations for Thompson Lumber Sensitivity Analysis


EMV(node 1) = ($106,400)p + ( 1 - p )($2,000)
= $104,000 p + 2,400
Equating the EMV(node 1) to the EMV of not conducting the survey, we have $104,000 p + $2,400 = $40,000 $104,000 p = $37,000 or

p=

$37,000
$104,000

= 0.36

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

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2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

To accompany Quantitative Analysis for Management, 8e by Render/Stair/Hanna

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2003 by Prentice Hall, Inc. Upper Saddle River, NJ 07458