Dr. K.

Anbumani
Associate Professor

Decision Tree Analysis

 DECISION TREE ANALYSIS
Decision Tree involves the construction of a diagram
that shows - in what sequence the decisions will be
made, what will be their consequences, and payoffs. It
consists of nodes, branches, probability estimates and
payoffs.

Nodes: A decision (act) node is represented by a

square where a decision maker must select one
alternative course of action among the available
actions. A chance (event) node is represented by a
circle and indicates a point at which the decision
maker will discover the response to his decision.
 DECISION TREE ANALYSIS
Branches: Each branch leading away from a decision
node represents a course of action or strategy that
can be chosen at a decision point whereas each
branch leading away from a chance node represents
the state of nature of a set of chance events.

The assumed probabilities of the state of nature are

written alongside their respective branches.

Any branch that makes the end of the decision tree,

i.e., it is not followed by either a decision node or
chance node is called a terminal branch.
 DECISION TREE ANALYSIS
Payoffs: The payoffs may be positive (revenue or sales) or
negative (expenditure or cost) and it can be associated
either with decision or chance branches. The optimal
sequence of decisions in a tree is found by starting at
the right hand side and rolling backwards.
If the node is a decision node, then the expected return is
calculated for each of its branches and the highest return
is selected.
If the node is a chance node, then the position value is
calculated as the sum of the products of the probabilities
or the branches emanating from the chance node and
their respective position values.
 Decision Tree Analysis- Example 1
A businessman has two independent investment portfolio A
and B available to him, but he lacks the capital to undertake
both of them together.
He can either choose A first and if A is successful after
completing it, terminate the activity or then take B and vice
versa. The probability of success of A is 0.6, while for B it is 0.4.
Both investment schemes require an initial capital of Rs.10000
and both return nothing if the venture fails. Successful
completion of A will return Rs.20000 (over cost) and B will
return Rs.24000 (over cost).

Draw decision tree to determine the best strategy.

 Decision Tree Analysis- Example 1
A businessman has two independent investment portfolio A
and B available to him, but he lacks the capital to undertake
both of them together.

He can either choose A first and the stop or if A is not

successful, then take B and vice versa. The probability of
success of A is 0.6, while for B it is 0.4.
Both investment schemes require an initial capital of
Rs.10000 and both return nothing if the venture fails.
Successful completion of A will return Rs.20000 (over cost)
and B will return Rs.24000 (over cost).

Draw decision tree to determine the best strategy.

 1
A
ept
c
Ac

Do Nothing
D1
Ac
ce
pt
B

2
 Stop
3
Success

ss D2
ucc e 4
S Accept B
Failure
1
A
c ept Fai
lu r
Ac e

Do Nothing
D1
Ac
ce
pt
B

2
 Stop
3
Success

ss D2
ucc e 4
S Accept B
Failure
1
A
c ept Fai
lu r
Ac e 5
Do Nothing
D1
Ac
ce
pt
B

2
 Stop
3
Success

ss D2
ucc e 4
S Accept B
Failure
1
A
c ept Fai
lu r
Ac e 5
Do Nothing
D1
6
re
Ac

ilu
ce

Fa
pt
B

2
 Stop
3
Success
9
ss D2
ucc e 4
S Accept B 10
Accept B Failure
1
A
c ept Fai
lu r
Ac e 5
Do Nothing
D1
6
Ac
ce re
pt ilu
B Fa

2 Success
11
Accept A
Su
cce 7 12
ss D3
Failure

8
Stop
 Stop
3
Success 0.4
0 .6 9
ess D2
Su
c c 4
Accept B 10
Failure 0.6
1
A
c ept Fai
lu
Ac re
0.4 5
Do Nothing
D1

6
6
Ac 0.
ce re
pt il u
B Fa

2 Success 0.6
11
Su Accept A
cce
ss 7 12
0.4 D3
Failure 0.4

8
Stop
0.4 X (20000 + 3600) = 14160 Stop
14160 – 4000 = 10160 3
EMV = 3600 Rs. 0
Success 0.4
EMV = 3600 9 0.4 X 24000 = 9600
0.6 Rs. 24000
ss D2
c ce 4
Su 0 - Rs. 10000
EMV = 10160 00 Accept B 10 0.6 X -10000 = - 6000
0
1 .2 Failure 0.6
Rs 3600
A
c ept Fai - Rs. 10000
lu
Ac re
0.4 5 0.4 X -10000 = - 4000

Do Nothing
D1

6
6
Ac 0.
ce re
pt il u
B Fa

2 Success 0.6
11
Su Accept A
cce
ss 7 12
0.4 D3
Failure 0.4

8
Stop
0.4 X (20000 + 3600) = 14160 Stop
14160 – 4000 = 10160 3
EMV = 3600 Rs. 0
Success 0.4
EMV = 3600 9 0.4 X 24000 = 9600
0.6 Rs. 24000
ss D2
c ce 4
Su 0 - Rs. 10000
EMV = 10160 00 Accept B 10 0.6 X -10000 = - 6000
0
1 .2 Failure 0.6
Rs 3600
A
c ept Fai - Rs. 10000
lu
Ac re
0.4 5 0.4 X -10000 = - 4000

Do Nothing Rs. 0
D1

6
6 0.6 X -10000 = - 6000
Ac 0. - Rs. 10000
ce re
pt
B ail u
F

2 Rs.
Success 0.6
11 0.6 X 20000 = 12000
EMV = 6800 240
Su 00 Accept A Rs. 20000
cce
ss 7 - Rs. 10000
12 0.4 X-10000 = -4000
0.4 D3
EMV = 8000 Failure 0.4
Rs. 0 8000
0.4 X (24000 + 8000) = 12800 EMV = 8000 8
12800 - 6000 = 6800 Stop
 Decision Point Outcome Prob. Conditional Value Exp.Value
D1 1. Accept A Success 0.6 20000 + 3600 14160
    Failure 0.4 -10000 -4000
          10160
  2. Accept B Success 0.4 24000 + 8000 12800
    Failure 0.6 -10000 -6000
          6800
  3. Do nothing       0
           
D2 1. Accept B Success 0.4 24000 9600
    Failure 0.6 -10000 -6000
          3600
  2. Stop       0
           
D3 1. Accept A Success 0.6 20000 12000
    Failure 0.4 -10000 -4000
          8000
  2. Stop       0

Decision: Highest EMV is available at node 1, so the best decision is Accept A first and if A
is successful then accept B.
 Decision Tree Analysis- Example 2
A businessman has an option of selling a product in domestic
market or in export market. The available date are given below;
Items Export Market Domestic Market
Probability of selling 0.6 1.0
Prob. of keeping delivery schedule 0.8 0.9
Penalty of not meeting del.schedule 50000 10000
Selling price 900000 800000
Cost of 3rd party inspection 30000 Nil
Prob. of collection of sale amount 0.9 0.9

If the product is not sold in export market, it can always be sold

in domestic market. There are no other implications such as
interest and time. Find optimal solution using decision tree.
 EMV t Collected 0.9
780000 o un 9L -30K = 870000
Am
EMV DS Kept 0.8 Not
770000
7 Collected 0.1
- 30000 Inspection
0
EMV
nt Collected 0.9
3 780000 ou 9L -30K = 870000
.6 Am
EMV rt 0 DS Not Kept 0.2
i n Ex
p o 8 Not
Collected 0.1
749600
Sold - 50000 - 30000 Inspection
EMV
1 720000 o un
t Collected 0.9
A m 800000
t

Ret DS Kept 0.9

ke

urn EMV
ar

to D 9 Not
M

om 719000 Collected 0.1

rt

esti 0 0
po
Select 749600

c EMV
0.4 4
Ex

Collected 0.9
720000 ount
DS Not Kept 0.1 Am 800000
D1
10
Not
EMV - 10000 Collected 0.1
Do

tCollected 0.9 0
m

720000 n
ou
es

EMV 0 m 800000
tic

A
719000 pt 0.9 5 Not Collected 0.1
M

DS Ke
ar

0
ke

EMV
2 t Collected 0.9
t

- 10 0 n 800000
00 720000 ou
DS N
ot K Am
ept 0
.1
6 Not Collected 0.1
0
 EMV (Node 7) 0.9 x 870000 + 0.1 x (30000) = 783000 - 3000 780000
 EMV (Node 8) 0.9 x 870000 + 0.1 x (30000) = 783000 - 3000 780000
 EMV (Node 9) 0.9 x 800000 + 0.1 x (0) = 720000 + 0 720000
EMV (Node 10) 0.9 x 800000 + 0.1 x (0) = 720000 + 0 720000
 
EMV (Node 3)  0.8 x 780000 + 0.2 x (780000-50000) = 624000 + 146000 770000
EMV (Node 4)  0.9 x 720000 + 0.1 x (720000-10000) = 648000 + 71000 719000
EMV (Node 5)  0.9 x 800000 + 0.1 x (0) = 720000 + 0 720000
EMV (Node 6) 0.9 x 800000 + 0.1 x (0) = 720000 + 0 720000
 
EMV (Node 1)  0.6 x 770000 + 0.4 x 719000 = 462000 + 287600 749600
 EMV (Node 2) 0.9 x 720000 + 0.1 x (720000-10000) = 648000 + 71000 719000
 
D1 EMV (Node 1) Select Export Market 749600

Decision: Highest EMV is available at node 1, so the best decision is Accept A first and if A
is successful then accept B.
 DECISION TREE – EXAMPLE 3
A glass factory that specializes in crystal is developing
a substantial backlog and for this the firm’s
management is considering 3 courses of action.
To arrange subcontract (S1)
To begin overtime production (S2)
To construct new facilities (S3)
The correct choice depends largely upon the future
demand, which may be low, medium or high.
By consensus, management ranks the respective
probabilities as 0.10, 0.50 and 0.40. A cost analysis
reveals the effect upon the profits as shown below;
 DECISION TREE – EXAMPLE 3
Course of Action
Demand Probability
Subcontract Overtime Construct
S1 S2 New S3
Low (L) 0.10 10 -20 -150

Medium (M) 0.50 50 60 20

High (H) 0.40 50 100 200

Using the Decision Tree Analysis, find the most

preferred decision and its corresponding expected
value.
 ( p = 0.10) 4 0.10 x 10 = 01
EMV = 46 Low
1 Medium (p= 0.50)
High 5 0.50 x 50 = 25 46
ct (p= 0
.40)
ntra
S2
: Ov
erti
m
e

co 6 0.40 x 50 = 20
b
: Su
S1 0 . 10) 7
w ( p = 0.10 x -20 = -02

Expected Payoff
EMV = 68 Lo
2 Medium (p= 0.50) 8
0 High 0.50 x 60 = 30 68
S2: Overtime ( p= 0
.40)
S3 9 0.40 x 100 = 40
:N
ew
Pla 0.10)
nt w (p = 10 0.10 x -150 = -15
EMV = 75 Lo
Medium (p= 0.50)
3 11 0.50 x 20 = 10
High (p 75
= 0.40)
12 0.40 x 200 = 80
 DECISION TREE – EXAMPLE 3

Decision: Since Node 3 has the highest EMV of Rs. 75

S3 should be taken.

i.e., the firm should opt for constructing new

production facilities.
THANK YOU