 A Visual Representation of

Choices, Consequences,
Probabilities, and
Opportunities.
 A way of breaking down
complicated situations down
to easier-to-understand
scenarios.
Decision Tree
Decision nodes: represented as boxes.
Lines coming from these nodes represent
different choices

Event nodes: represented as circles.

Lines coming from these nodes represent
different outcomes

Terminal nodes: represented as triangles.

Final result of a combination of decisions
and events
• Mary is a manager of a gadget factory. Her factory has been
quite successful the past three years. She is wondering whether
or not it is a good idea to expand her factory this year.
• The cost to expand her factory is $1.5M. If she does nothing
and the economy stays good and people continue to buy lots of
gadgets she expects $3M in revenue; while only $1M if the
economy is bad.
• If she expands the factory, she expects to receive $6M if
economy is good and $2M if economy is bad.
• She also assumes that there is a 40% chance of a good economy
and a 60% chance of a bad economy. Draw a Decision Tree
showing these choices and help her take a decision.
 Good economy
4
0.4

Don’t 2
Expand
0.6 5
Bad economy
1 Good economy
6
0.4
Expand

3
0.6
7
Bad economy
 Terminal Cost Revenue Profit
node

4 0 300,000 300,000

5 0 100,000 100,000

6 150,000 600,000 450,000

7 150,000 200,000 50,000

EMV of Node 2 = 0.4 x 300,000+ 0.6 x 100,000 = 180,000

EMV of Node 3 = 0.4 x 450,000+ 0.6 x 50,000 = 210,000
 Good economy
4
EMV: 180,000 0.4

Don’t 2
Expand
0.6 5
Bad economy
1 Good economy
6
0.4
Expand
EMV: 210,000
3
0.6
7
Bad economy
 Your company is considering whether it should tender for
two contracts (MS1 and MS2) on offer from a government
department for the supply of certain components. The
company has three options:
Tender for MS1 only; or
Tender for MS2 only; or
Tender for both MS1 and MS2
 If tenders are to be submitted, the company will incur
additional costs. These costs will have to be entirely
recouped from the bid price. The risk, of course, is that if a
tender is unsuccessful the company will have made a loss.
 The cost of tendering for contract MS1 only is INR
50000. The component supply cost if the tender is
successful would be INR 18000.
 The cost of tendering for contract MS2 only is INR
14000. The component supply cost if the tender is
successful would be INR 12000.
 The cost of tendering for both contracts MS1 and MS2 is
INR 55000. The component supply cost if the tender is
successful would be INR 24000.
 For each contract, possible tender prices have been
determined. In addition, subjective assessments have
been made of the probability of getting the contract with
a particular tender price as shown below.
 Note here that the company can only submit one tender
and cannot, for example, submit two tenders (at
different prices) for the same contract.
 What do you suggest the company should do and why?
 Possible Probability of
Option tender prices getting
(INR) contract
130,000 0.20
MS 1 only
115,000 0.85
70,000 0.15
MS 2 only 65,000 0.80
60,000 0.90
190,000 0.05
MS1 and MS2
140,000 0.65
 A company faces a decision with respect to a product
(codenamed M997) developed by one of its research
laboratories.
 It has to decide whether to proceed to test market M997 or
whether to drop it completely.
 It is estimated that test marketing will cost £100K. Past
experience indicates that only 30% of products are successful
in test market.
 If M997 is successful at the test market stage then the
company faces a further decision relating to the size of plant
to set up to produce M997.
 A small plant will cost £150K to build and produce 2000 units
a year whilst a large plant will cost £250K to build but produce
4000 units a year.
 The marketing department has estimated that there is a 40%
chance that the competition will respond with a similar
product and that the price per unit sold (in £) will be as
follows (assuming all production sold):

Large plant Small plant

Competition respond 20 35

Competition do not respond 50 65

 Assuming that the life of the market for M997 is
estimated to be 7 years and that the yearly plant running
costs are £50K (both sizes of plant - to make the
numbers easier!) should the company go ahead and test
market M997?
 It is January 10th, and Monica is currently a final year PGP
student at IIMK.
 She has decided to seek out a job as a consultant. She
already has received an offer from ABC consulting for
$72,000 per year. She has until February 1st to decide
whether to accept the offer.
 An old classmate of her’s, Mary Kumar, has told her that she
has recommended her highly to her consulting firm, and
feels that there is an excellent chance that they would give
her an offer for $80,000. However, they are not prepared to
make any decision until February 15th. If they made her an
offer, she would need to decide by March 1.
 Monica also has the option of taking part in the consulting
job fair in the middle of March. Monica is fairly certain that
she could get a consulting job at that time, but is uncertain
as to what she would be paid.
Monica’s best guesses:
 Probability of getting Job at Mary’s firm: 60%
 Different possibilities for consulting fair offers:
$90,000: 10%
$70,000: 50%
$60,000: 40%
 ABC Computer Company is considering submission of a
bid for a government contract to provide 10,000
specialized computers for use in computer-aided design.
 There is only one other potential bidder for this contract,
Complex Computers, Inc., and the low bidder will receive
the contract.
 ABC's bidding decision is complicated by the fact that
ABC is currently working on a new process to
manufacture the computers.
 If this process works as hoped, then it may substantially
lower the cost of making the computers. However, there
is some chance that the new process will actually be
more expensive than the current manufacturing
process.
 Unfortunately, ABC will not be able to determine the
cost of the new process without actually using it to
manufacture the computers.
 If ABC decides to bid, it will make one of three bids: $9,500
per computer, $8,500 per computer, or $7,500 per
computer.
 Complex Computers is certain to bid, and it is equally likely
that Complex will bid $10,000, $9,000, or $8,000 per
computer.
 If ABC decides to bid, then it will cost $1,000,000 to
prepare the bid due to the requirement that a prototype
computer be included with the bid. This $1,000,000 will be
totally lost regardless of whether ABC wins or loses the
bidding competition.
 With ABC's current manufacturing process, it is certain to
cost $8,000 per computer to make each computer.
 With the proposed new manufacturing process, there is a
0.25 probability that the manufacturing cost will be
$5,000 per computer and a 0.50 probability that the cost
will be $7,500 per computer. Unfortunately, there is also a
0.25 probability that the cost will be $8,500 per
computer.
 Should ABC Computer Company submit a bid, and if so,
what should they bid per computer?