Decision Trees

• Enable a business to quantify decision

making
• Useful when the outcomes are uncertain
• Places a numerical value on likely or
potential outcomes
• Allows comparison of different possible
decisions to be made
 Decision Trees
• Limitations:
– How accurate is the data used
in the construction of the tree?
– How reliable are the estimates
of the probabilities?
– Data may be historical – does this data relate to real
time?
– Necessity of factoring in the qualitative factors –
human resources, motivation, reaction, relations with
suppliers and other stakeholders
Process
 The Process
Economic growth rises Expected outcome
0.7 £300,000

Expand by opening new outlet

Economic growth declines Expected outcome
-£500,000
0.3

Maintain current status

£0

The circle denotes the point where different outcomes could occur. The estimates of the probability and the
knowledge of the expected outcome allow the firm to make a calculation of the likely return. In this
A square
example it is: denotes the point where a decision is made, In this example, a business is contemplating
There is also
opening the outlet.
a new option The
to douncertainty
nothing andis maintain
the state the current
of the status– quo!
economy if theThis wouldcontinues
economy have an outcome
to grow of
£0.
Economic growth
healthily rises: is
the option 0.7 x £300,000
estimated = £210,000
to yield profits of £300,000. However, if the economy fails to grow as
expected, the potential loss is estimated at £500,000.
Economic growth declines: 0.3 x £500,000 = -£150,000
The calculation would suggest it is wise to go ahead with the decision ( a net ‘benefit’ figure of +£60,000)
 The Process
Economic growth rises Expected outcome
0.5 £300,000

Expand by opening new outlet

Economic growth declines Expected outcome
-£500,000
0.5

Maintain current status

£0

Look what happens however if the probabilities change. If the firm is unsure of the potential for growth, it
might estimate it at 50:50. In this case the outcomes will be:
Economic growth rises: 0.5 x £300,000 = £150,000
Economic growth declines: 0.5 x -£500,000 = -£250,000
In this instance, the net benefit is -£100,000 – the decision looks less favourable!
Advantages
Disadvantages