Decision trees 3.3.3

Question 1

What is a decision tree?

Answer 1

It is a mathematical model and it is used to help managers make decisions. Uses estimates and probabilities to calculate likely outcomes. It helps decide whether the net gain from a decision is worthwhile.

Question 2

What is probability?

Answer 2

The likelihood of an outcome being picked. The percentage chance a possibility that an event will occur. Ranges from one to 0. If all the outcomes of the event are considered, the total probability must add up to 1.

Question 3

What is an expected value?

Answer 3

The financial value of an outcome is calculated by multiplying the estimated financial effect by its probability.

Question 4

What is net gain?

Answer 4

The value to be gained from taking a decision. Calculated by adding together the expected value of each outcome and deducting the costs associated with a decision.

Question 5

What are the benefits of a decision tree?

Answer 5

• Choices are set out in a logical way.
• Potential options & choices are considered at the same time.
• The use of probabilities enables the “risk” of the options to be addressed.
• Likely costs are considered as well as potential benefits.
• Easy to understand & tangible results.

Question 6

What are the drawbacks of a decision tree?

Answer 6

• Probabilities are just estimates – always prone to error.
• Uses quantitative data only – ignores qualitative aspects of decisions.
• Assignment of probabilities and expected values prone to bias.
• Decision-making technique doesn’t necessarily reduce the amount of risk.

Question 7

What is an example?

Answer 7

Option: Launch loyalty card:

High sales: (0.6 x £1,000,000) = £600,000

Low sales: (0.4 x £750,000) = £300,000

Total expected value = £900,000

Net gain: £900,000 - £500,000 = £400,000

Option: Cut prices:

High sales: (0.8 x £800,000) = £640,000

Low sales: (0.2 x £500,000) = £100,000

Total expected value = £740,000

Net gain: £740,000 - £300,000 = £440,000