Decision trees

A decision tree is another way of analysing risk and uncertainty. The decision tree model is only as good as the information it contains. The main difficulty is of course, as always, accurately predicting the probabilities that determine the uncertainty. However, a decision tree is a simple and visual way of presenting probabilistic information to management and as such can be quite a useful tool. The options that management are seeking to evaluate may be very simple. For example, two alternative business plans, A and B, may be under consideration, both of uncertain outcome. The table below shows the likely possible outcomes of plans A and B.
Possible outcomes of plans A and B

Adverse Favourable Expected profit

Profit 20,000 60,000

Plan A

Probability 0.5 0.5

Profit

Plan B Probability (10,000) 0.3 90,000 60,000 0.7

40,000

When the expected profit is calculated it appears that plan B would be the best option. However plan B has a 0.3 chance of a loss of 10,000 whereas plan A will always generate a profit of some sort. The information can be portrayed in a decision tree as shown below:

The squares and circles are symbols that have a special meaning. The square represents a point at which a decision is made; in this case there is only one decision to be made the choice between plan A and plan B at the outset. A circle represents a point at which a chance event takes place. The lines, the branches of the tree, represent the logical sequence between the nodes to the different possible outcomes. The values under the heading Profit represent the possible outcomes. The Pay-off figures are calculated by multiplying the possible outcomes by their probabilities as in the earlier examples.

Activity 1 The management of a business has to decide whether to launch a new product or not. If the product is launched there are two elements of uncertainty: There is a 0.7 probability that sales will be 8,000 units per month but a 0.3 probability that sales will be 5,000 units per month.

If sales are 8,000 units per month, there is a 0.5 probability that the contribution per unit will be 2 and a 0.5 probability that it will be negative - (1). If sales are 5,000 units per month there is a 0.6 probability that the contribution per unit will be 3 and a 0.4 probability that it will be 1.

Requirement Draw a decision tree and advise management as to their best course of action.

Activity 2 A company has prepared the design for a new product. It can either sell the design, for 100,000, or attempt to develop the design into a marketable product at a cost of 150,000. If the company decides to develop the product, the chances of success are 0.7. If the attempt fails the design can only be sold for 20,000. If the attempt succeeds the business has the choice of either selling the design and developed product for 180,000 or marketing the product. If the product is marketed then there is a 0.6 probability that the product will generate a cash inflow of 800,000 and a 0.4 probability that it will generate a cash outflow of (100,000). Both figures exclude items previously mentioned. Requirement Draw a decision tree and advise management as to their best course of action.