Objectives and Strategy – Decision Trees

A decision tree is a mathematical model which can be used by managers to help them make
the right decision.

A square shows a decision has to be made; the lines coming from it show the possible
choices and the circles show that different outcomes are possible, which is then illustrated
by lines coming from the circles. Managers always have the option of doing nothing so this
always has to be an option on a decision tree. The probability of each outcome needs to be
known, the value ranging from 0 to 1, the bigger the number the more likely it is to happen.

A diagram should include;

 Possible decisions a firm could take

 The outcomes of each decisions
 The probability of each outcome
 The financial consequences of each outcome

The next step is to work out the expected value of each decision. This is basically the
weighted average of the outcomes taking into account the probability of each one.

Expected Value =
(The probability X the outcome of each) + answers together = Expected Value

To calculate the expected vale we multiply the probability of each outcome with the
financial consequences of the outcome and then add them all up. This shows how much the
firm would earn on average if the decision was taken repeatedly. A manager would always
choose the one that provided the highest value. The expected values are written in the
outcome circles and the options which are not chosen are shown using a doubled crossed
line.

Using a decision tree can be very useful for managers because it:

 Makes them think about the different options they have and consider the possible
consequences of each one
 Forces them to quantify the impact of each decision
 Helps them to logically compare the options open to them

However decision trees do have various limitations and drawbacks:

 Decision trees use estimates of the probability of different outcomes and the
financial consequences of each outcome. The value of decision tree analysis depends
heavily on how accurate these estimates are.
 Decision trees only include financial and quantifiable data; they do not include
qualitative issues such as the workforce’s reaction to different options or the
impact on the firs image.

Developing Decision Tree Analysis

In reality there may be several different outcomes following any decision; it is also
possible that a particular decision leads to losses if things go wrong. Initial costs of
undertaking a particular course will also need to be included; this is taken of the Expected
Value.

The Role of Risk

It is important to remember that the expected value shows how much the firm would earn
on average if the decision was repeated time and time again. In reality it may well be a one
off decision and therefore only one of the outcomes will actually occur. This may have an
impact on the decision a firm makes.