Decision Tree

Decision Tree
A decision tree is a graphic display of various
decision alternatives and the sequence of events
as if they were branches of a tree. In construction
of decision tree, the use of symbol to indicate
the decision point and to denote the situation of
uncertainty or ‘event’. Branches coming out of a
decision point are nothing but representation of
immediate mutually exclusive alternative acts open
to the decision-maker. Branches emanating form
the ‘event’ point represent all possible situations
(events). These events are not fully under the
control of the decision-maker and may represent
consumer demand, etc.
 Decision Tree
The basic advantage of a tree diagram is that
another act (called second act) subsequent to the
happening of each event may also be represented.
The resulting outcome (payoff) for each act-event
combination may be indicated in the tree diagram
at the outer end of each branch.
 Decision Tree
When probabilities of various events are known, they
are written along the corresponding branches,
Multiplying the probabilities along the branches
results in the joint probabilities for the
corresponding act-event sequence. Thus in a
decision-maker lists all possible alternatives,
possible events and resulting payoff values along
with their probabilities for each act-event
sequence. This enables him to determine
expected payoff values and hence the EMV for
each act.
Thus In decision tree analysis, a problem is depicted
as a diagram which displays all possible acts,
events, and payoffs (outcomes) needed to make
choices at different points over a period of time.
 Decision Tree
 Example of Decision Tree Analysis:
A Manufacturing Proposal
Your corporation has been presented with a new product
development proposal. The cost of the development
project is $500,000. The probability of successful
development is projected to be 70%. If the development is
unsuccessful, the project will be terminated. If it is
successful, the manufacturer must then decide whether to
begin manufacturing the product on a new production line
or a modified production line. If the demand for the new
product is high, the incremental revenue for a new
production line is $1,200,000, and the incremental
revenue for the modified production line is $850,000. If
the demand is low, the incremental revenue for the new
production line is $700,000, and the incremental revenue
for the modified production line is $720,000. All of these
incremental revenue values are gross figures, i.e., before
subtracting the $500,000 development cost, $300,000 for
the new production line and $100,000 for the modified
production line. The probability of high demand is
estimated as 40%, and of low demand as 60%.
Decision Tree
Decision Tree
 Decision Tree
The second step requires the payoff values to be developed for
each end-position on the decision tree. These values will be in
terms of the net gain or loss for each unique branch of the
diagram. The net gain/loss will be revenue less expenditure.
If the decision to not develop is made, the payoff is $0. If the
product development is unsuccessful, the payoff is - $500,000.
If the development is successful, the decision is to build a new
production line (NPL) or modify an existing production line
(MPL). The payoff for the NPL high demand is ($ 1,200,000
- $500,000 development cost -$300,000 build cost) or
$400,000. For a low demand, the payoff is ($700,000 -
$500,000 development cost -$300,000 build cost) or -$100,000.
The payoff for the MPL high demand is ($850,000 -$500,000
development cost - $100,000 build cost) or $250,000. For a low
demand, the payoff is ($720,000- $500,000 development cost
- $100,000 build cost) or $120,000.
Decision Tree
 Decision Tree
The third step is to assess the probability of occurrence for
each outcome:

Development Successful = 70%

NPL High Demand = 40%
NPL Low Demand = 60%

Development Unsuccessful = 30%

MPL High Demand = 40%
MPL Low Demand = 60%
Decision Tree

60
%
 Decision Tree
The fourth step is referred to as the roll-back and it involves
calculating expected monetary values (EMV) for each
alternative course of action payoff. The calculation is
(probability X payoff) = EMV This is accomplished by
working from the end points of the decision tree and
folding it back towards the start choosing at each decision
point the course of action with the highest expected
monetary value (EMV).
Decision D2:
New Production Line vs. Modified Production Line
New Production Line
high demand + low demand
(4 0% X $400,000) + (60%X -$100,000)
= $ 1,60,000 + (-$ 60,000)
= $ 100,000
 Decision Tree
Modified Production Line
high demand + low demand
(40% X $250,000)+(60% X $120,000)
= $ 100,000 + $ 72,000
= $172,000
Decision Point 2 Decision: Modified Production Line
with an EMV of $172,000
Decision Tree

EM
V
$1
72
,00
0
-$500,000

60
%
 Decision Tree
Decision 1: Develop or Do Not Develop
 Development Successful + Development Unsuccessful
(70% X $172,000) + [30% x (- $500,000)]
$120,400 + (-$150,000)
Decision Point 1 EMV= (-$29,600)

-$29,600

$120,400
EM
V
$1
72
,00
-$500,000 0

Decision: DO NOT DEVELOP the product because the 60%

expected value is a negative number.