Decision Tree Analysis

Elements of Decisions
Every decision has acts. These are the possible choices.
Outcomes are the consequences.
Decisions made under uncertainty involve events.
When there is uncertainty, outcomes are determined partly by
choice (acts) and partly by chance (events).
Decisions are portrayed:
With a decision table or a payoff table.
Or by a decision tree.

2
 Decision Tree
 The decision tree shows acts and events on separate forks,
sequenced chronologically. Each outcome has a path.

3
 Payoffs and Probabilities
 Payoffs for outcomes are found adding partial cash flows on
branches. Event branches have probabilities.

4
 Making the Decision
Using a Payoff Table

 Decision makers want to maximize payoff.

 But, the outcome is uncertain.
 Various criteria exist for making the choice.
 Maximizing expected payoff is commonly used to
make choices.
 First, compute expected payoff for each act.
 An act’s expected payoff is the weighted average value for its
column found by multiplying payoffs by the row’s probability
and summing the products.
 Second, choose the act having the maximum.
5
 Problem 1
• Motor City Auto.Co. must decided whether or not to introduce a new car, which
features a radically new pollution control system. They must also decide whether or
not first to see if results of test marketing a limited production show promise or
not. The test marketing of limited production will cost Rs.4.0 crores.
•  
• The marketing department has estimated that :
• If the new car achieve high acceptance by the public, company profits will increase
by Rs.25 crores.
• Low acceptance will reduce company profits by Rs.15 crores.
• Not introducing the car will not affect the profit.
• Probabilities for different outcomes through alternate actions are :
• If test marketing is done, the possibility of high acceptance is 0.40
• The assumed probability for a favourable result from test marketing is 0.50
• The conditional probability for high acceptance after a favourable result is 0.64
• If the car is introduced inspite of unfavourable test marketing results , probability
for low acceptance is 0.84
•  
• Construct DECISION TREE and determine the optimal course of action.
 HA (0.64)

C2
Introduce
LA (0.36)
D2

Not-Introduce
Favourable (0.5)

C1

Test Un-favourable (0.5) HA (0.16)

C3
Introduce
LA (0.84)
D3
D1
Not-Introduce

NoTest
HA (0.40)

C4
Introduce
LA (0.60)
D4

Not-Introduce
 + 10.6
HIGH ACCEPTANCE: p=0.64
+ 25
INTRODUCE
NEW CAR
C2

- 15
LOW ACCEPTANCE: p=0.36
+ 10.6
FAVOURABLE
RESULTS: p=0.5

D2 DROP PROPOSAL

TEST NIL
MARKET
+ 5.3

- 8.6 HIGH ACCEPTANCE: p=0.16

COST
C1 + 25
Rs.4 crore INTRODUCE
+ 1.3 NEW CAR
C3
D1
- 15
LOW ACCEPTANCE: p=0.84
UNFAVUORABLE
RESULTS: p=0.5
D3

NIL
DROP PROPOSAL

HIGH ACCEPTANCE: p=0.4 + 25

+ 1.0

NO TEST C4
MARKET
- 15
LOW ACCEPTANCE: p=0.6
 Calculations
• Evaluation of Chance points :
•  
• C2 = (0.64 x 25) + (0.36 x –15) = +10.6, hence D2 = +10.6
• C3 = (0.16 x 25) + (0.84 x –15) = - 8.6, hence D3 = 0
• C4 = (0.40 x 25) + (0.60 x –15) = + 1.0, hence D4 = + 1.0
•  
• C1 = (0.50 x D2) + (0.50 x D3) = (0.50x10.6) +(0.50x 0) = +5.3
•  
• Hence D1 : If decision for test marketing then
• = Profit = Payoff – Test Mktg Cost = 5.3-4.0 = Rs. 1.3 crore
• If NO Test Mktg then Profit = Rs 1.0 crores
• Hence the Decision to go for Test Mktg + Introduce New Car
 Detailed Explanation
Evaluation of various chance points and decision points from Right to Left is as under:
 
C2 = (+25 X 0.64) + (-15 X 0.36) = (+16.0) + (–5.4) = + 10.6
D2 Comparing + 10.6 with ‘Nil’ value by dropping the proposal, +10.6 is accepted at D2 being
higher
 
C3 = (+25 X 0.16) + (-15 X 0.84) = (+4.0) + (-12.6) = - 8.6
D3 Comparing – 8.6 with ‘Nil’ value by dropping the proposal, ‘Nil’ value outcome is accepted at
D3
 
C1 = (+10.6 X 0.5) + (0.0 X 0.5) = (+5.3) + (0.0) = + 5.3
C4 = (+25 X 0.4) + (-15 X 0.6) = (+10.0) + (-9.0) = + 1.0
 
D1 Evaluation of +5.3 at C1 – 4.0 as cost of test marketing gives net value of +1.3 for this route.
Comparing this with evaluation of C4, Route D1 – C1 – D2 – C2 is accepted.
 
Hence, the decision will be to carry out test marketing and introduce new car if results are
favourable.
Problem 2