1.3 ORGANIZATIONAL PLANNING & DECISION MAKING

INTRODUCTION TO

DECISION TREES(HIGHER LEVEL CONTENT)

DECISION TREES Often feature in HL Exams!!

• A decision tree is a diagram setting out the key features of a decision making problem

• Examiners really like decision trees.• Setting a decision tree question is relatively easy and can

be adapted to most papers and time frames. • There are also two obvious follow-up questions.• First, candidates may be asked to examine the advantages

and disadvantages of using decision trees. • Secondly a student may be required to examine non-

numerate or additional information, other than that on a decision tree. This information can be used to support a decision.

Decision Trees Can Look Complicated!

• Students are sometimes worried by decision trees because they look complicated and contain plenty of information and lots of numbers.

• The thing to remember when learning to construct and interpret decision trees, is that they merely repeat the same process over and over again through the diagram.

• When you start with a basic process, the decision tree suddenly begins to look easier to manage.

CONSTRUCTING A DECISION TREE

• Decision trees are particularly helpful in situations supporting complex business decisions or problems, involving more than one decision.

• A decision is constructed from left to right with events laid out in the sequence which they occur, but the calculation of financial results is always from right to left

CONSTRUCTING A DECISION TREESquares

• Squares represent decision points which are under the control of the business. • The lines that come out of each

square show all the available options that can be selected.

The Option of Doing Nothing

• Although doing nothing may not have an immediate direct cost, it certainly may have a negative outcome.

• A failing business left to carry on failing may end up with bankruptcy of the owner and liquidation of the business, unless some miracle happens.

CONSTRUCTING A DECISION TREECircles

• Circles represent probability or chance nodes.

• These show various circumstances that have uncertain outcomes.

• The lines that come out of each circle denote possible outcomes of that uncontrollable circumstance.

How does a business establish the probability of an event happening?

• It is difficult to establish accurate probabilities of an event, especially if that event is beyond the control of the business itself.

• However, estimates of probability can be achieved through market research or experience.

• Nevertheless, the fact that probabilities may be little more than educated guesses is clearly a weakness of the decision tree process.

An Outcome or Financial Return with Decision Trees

• Each branch of the decision tree will have an outcome or financial return.

Success of product A will increase profit by $20 million.

Success of product B will increase profit by $30 million.

Failure of Product A will lead to a loss of $2 million. Failure of Product B will only increase profits by $6

million.

Average Outcome Calculations with Decision Trees

• A calculation is required of the average outcome given the probabilities.

• This is a weighted average, because the outcome is multiplied by the probability of that result happening.

• In decision trees, these are referred to as expected values (EVs) and are shown at every probability node.

AN EXAMPLE OF A BASIC DECISION TREE

NODE 1: CALCULATION OF EV

Step 1: Outcome x Probability

$20 m x 0.8 = $16 million($2 m) x 0.2 = ($0.4 million)

Step 2: Weighted Average

The EV (or weighted average) is shown by adding the two results together

EV = $16 m + ($.04 million) =

$15.6 million

NODE 2: CALCULATION OF EV Step 1: Outcome x Probability Step 2: Weighted Averaged

$30 million x 0.7 = $21 million $21 million + 1.8 million = $22.8 million$6 million x 0.3 = $1.8 million

Calculations to Understand the Decision Tree

Which outcome / product is best?

Product A• To achieve an EV of $15.6 million, the business has had to

spend $10 million. Therefore the, cost must be deducted from the EV to find the final profit. (net EV)

• $15.6 million - $10 million = $5.6 million (net EV)

Product B• To achieve an EV of $22.8 million, the business had to spend

$15 million. Therefore the cost must be deducted from the EV to find the final profit.

• $22.8 million - $15 million = $7.8 million (net EV)

($20 million)

($30 million)

0.4$1 m

0.6$40 m

0.3

0.7$30 m

$ 3 m

ACTIVITY

Using the information in this diagram, complete appropriate calculations to determine which product should be launched by thecompany.

PRODUCT AOr PRODUCT B??

OUTCOME