Chapter 12- decision trees

Question 1

Decision tree

Answer 1

• a technique that is used to aid the decision making process
• whenever a business is considering two or more options decision trees can be used to show the likely financial return for undertaking each of the options

Question 2

What do decision trees combine?

Answer 2

• the risk (costs) and the likely return (revenues) from a given undertaking

Question 3

What two aspects is the decision based on?

Answer 3

1. The probability of a particular outcome (risk)
2. The estimated monetary reward of a given option (reward)

Question 4

What do decision trees consider?

Answer 4

• the risk in relation to the possible level of reward

Question 5

Advantages of using decision trees

Answer 5

• the technique is usually drawn allowing for a visual representation of the choices and their likely returns
• visual approach allows the business to see the options available along with the likely outcomes and their possible monetary values

Question 6

The diagrams

Answer 6

Particular symbols are used
- square represents a decision; to do something or not to do something, or to do one thing or another
- the number of lines drawn from the square represents the number of options from which one will eventually be chosen

• circle represents the possible outcomes once an option is selected
• outcomes may be simple such as success or failure
• however the outcomes could be for different products or even on days which particular goods are sold
• whatever the possible outcomes once a decision is made, a line represents such outcome from the circle
• if a decision is made to sell for example, it is necessary to end the alternative choice
• this is done by drawing parallel lines on the option that is not selected

To build a decision tree the information available has to be ‘converted’ into a diagram

Question 7

Converting information into a diagram

Answer 7

E.g. building company has some land and it needs to decide whether to build some houses on the land or do nothing

1. First step is to draw the initial decision: to build or not to build. Action: draw a square to represent the decision
2. Now consider how many outcomes there are of building the houses. E.g. 2 possible outcomes
3. Houses are built and successfully sold
4. Houses are not sold
   Action: draw a circle to represent the outcomes and label each option
5. Also important to state the probability of the outcome occurring
6. Final piece of information to be put on the diagram is the likely monetary value of a particular outcome (called the estimated monetary value or the likely revenue)

Question 8

Calculating the expected values

Answer 8

Expected value= EMV x probability
Outcomes are added together to gain an expected value
Expected value is then placed in the outcome circle
If one of the outcomes is negative then this figure is subtracted from the positive outcome
Finally cost of particular decision selected is subtracted from the expected value to give an amount that is the likely result of taking the decision to build houses e.g.
this figure is then placed in the decision box
This figure can be compared with any of the other possible decisions

Question 9

Benefits of decision trees

Answer 9

• simplistic, visual method to aid the decision making process when faced with several alternatives
• relatively quick and therefore cost effective method of aiding the decision making process
• by applying the probabilities, the technique does attempt to account for the level of risk involved which other decision marking techniques do not
• may be accurate if a similar selection of choices has been considered before making the figures more reliable

Question 10

Limitations of using decision trees

Answer 10

• much depends upon the accuracy/ reliability of the figures used
• when ‘selecting’ the probabilities the management may be in favour of one particular choice and therefore be tempted to load the probabilities in the favour of that choice
• similarly the ability to gauge the EMV of an outcome may be difficult as there are so many variables that could affect the financial outcome
• there is often no mention of a time period over which the decision is based. The longer the ‘life’ of the outcome, the less reliable the figures are likely to be
• decision trees concentrate on the quantitative and consequently, qualitative evidence it not considered, which may be crucial
• there is no reference to the ‘human element’ even though a decision does not have a financial implication, it may affect how the business operates and therefore have an implication for employees