Decision trees 3.3.3 Flashcards
What is a decision tree?
It is a mathematical model and it is used to help managers make decisions. Uses estimates and probabilities to calculate likely outcomes. It helps decide whether the net gain from a decision is worthwhile.
What is probability?
The likelihood of an outcome being picked. The percentage chance a possibility that an event will occur. Ranges from one to 0. If all the outcomes of the event are considered, the total probability must add up to 1.
What is an expected value?
The financial value of an outcome is calculated by multiplying the estimated financial effect by its probability.
What is net gain?
The value to be gained from taking a decision. Calculated by adding together the expected value of each outcome and deducting the costs associated with a decision.
What are the benefits of a decision tree?
- Choices are set out in a logical way.
- Potential options & choices are considered at the same time.
- The use of probabilities enables the “risk” of the options to be addressed.
- Likely costs are considered as well as potential benefits.
- Easy to understand & tangible results.
What are the drawbacks of a decision tree?
- Probabilities are just estimates – always prone to error.
- Uses quantitative data only – ignores qualitative aspects of decisions.
- Assignment of probabilities and expected values prone to bias.
- Decision-making technique doesn’t necessarily reduce the amount of risk.
What is an example?
Option: Launch loyalty card:
High sales: (0.6 x £1,000,000) = £600,000
Low sales: (0.4 x £750,000) = £300,000
Total expected value = £900,000
Net gain: £900,000 - £500,000 = £400,000
Option: Cut prices:
High sales: (0.8 x £800,000) = £640,000
Low sales: (0.2 x £500,000) = £100,000
Total expected value = £740,000
Net gain: £740,000 - £300,000 = £440,000
