- Decision tree analysis is a tool used in decision-making to evaluate different options and potential outcomes.
- It involves creating a diagram that shows the options connected with a decision and the possible outcomes and economic returns that may result.
- Decision Trees are graphical in nature i.e. they are mainly diagrams.
Main features of a decision tree
- As already said a decision tree is a graphical representation of a decision problem that shows the different options available, the possible outcomes that could result from each option, and the probability of each outcome occurring.
- The tree is constructed from left to right, with the options represented as branches that emanate from a decision node on the left-hand side of the tree.
- Each option branch is then subdivided into further branches, which represent the different possible outcomes that could result from that option.
- At the end of each outcome branch, shown as a circle (or another shape) is used to represent the potential outcome.
- Alongside each potential outcome, the probability of that outcome occurring is shown, often as a percentage.
- The economic returns associated with each outcome are also typically shown alongside the outcome and probability, such as in terms of revenue or profit.
- Decision-making trees can be helpful for breaking down complex decision problems into manageable parts and for making explicit the underlying assumptions and probabilities associated with different options and outcomes.
- The accuracy of data used in decision tree analysis is crucial, as probabilities may not always be true for the future.
- Decision trees aid the decision-making process, but they cannot replace the consideration of non-numerical and qualitative factors.
A fictitious example
Below are some steps an example of a company considering opening a branch in rural Zimbabwe can use to carry out decision tree analysis:
- Identify the decision to be made:
- Whether or not to open a new branch in rural Zimbabwe.
- Identify the options available:
- Option 1: Open the new branch in rural Zimbabwe.
- Option 2: Do not open the new branch in rural Zimbabwe.
- Identify the possible outcomes of each option:
- Option 1 outcomes:
- Outcome 1: The new branch is successful and generates a profit of $100,000 per year.
- Outcome 2: The new branch is moderately successful and generates a profit of $50,000 per year.
- Outcome 3: The new branch is not successful and generates a loss of $50,000 per year.
- Option 2 outcomes:
- Outcome 4: The company does not expand and maintains its current profit of $500,000 per year.
- Determine the probabilities of each outcome:
- Outcome 1: 30% chance of occurring.
- Outcome 2: 50% chance of occurring.
- Outcome 3: 20% chance of occurring.
- Outcome 4: 100% chance of occurring.
- Calculate the expected values for each option:
- Option 1 expected value: (0.3 x $100,000) + (0.5 x $50,000) + (0.2 x -$50,000) = $35,000
- Option 2 expected value: (1 x $500,000) = $500,000
- Determine the best decision based on the expected values:
- Option 1 has an expected value of $35,000.
- Option 2 has an expected value of $500,000.
- Therefore, the best decision would be to not open the new branch in rural Zimbabwe, as it has a higher expected value.
Note: These figures are purely hypothetical and do not reflect the actual market conditions or financial situation of any specific company.