Decision Trees (3.3.3) Flashcards
What are decision trees?
It’s a quantitative method of tracing the outcomes of a decision so that the most profitable decision can be identified. Uses research-based estimates and probabilities to calculate likely outcomes. Helps managers out if the net gain from an investment is worth it.
What are the key elements in a decision tree diagram?
-Decision Points
-Outcomes
-Probabilities
-Expected monetary values
What are the characteristics of decision trees?
-Choices are set out in a logical way
-Potential options considered alongside each other
-Use of Probabilities displays risk
-Costs and Benefits considered
-Easy to understand
What are the disadvantages of decision trees?
-Estimates are prone to error
-Quantitative data ignoring Qualitative aspects
-Setting probabilities prone to bias
-Risk is not reduced
What does a decision tree look like?
Look at PowerPoint
Profit or Loss
success 420,000
B
failure (24,000)
A
success 480,000
C
failure (32,000)
Option B-Open new store (sucess-0.7 + failure-0.3)
Option C-Expand website (sucess-0.6 +failure-0.4
What do the numbers in brackets mean?
That means that the number is negative not positive e.g. (32,000)= -32,000
What does this decision tree show?
It shows the likely success and failure of two different options of what a business could do. So in this case the decision tree evaluates the option of either opening a new store or expanding its website
What is that part of the decision tree where decisions need to made?
This is where A is and its usually represented by a box
What is that part of the decision tree where there are different outcomes? What are they called?
This is where B and C are and they are represented by being circles. These are called nodes and the different options have a range of outcomes success or failure
What is that part of the decision tree where probability or likelihood of each outcome is shown?
An outcome has a probability of 1 and so the two options add up to 1.
Option 1 -Open a new store: 0.7 success +0.3 Failure
Option 2- Expand the webiste:0.6 success +0.4 Failure
What is that part of the decision tree where the monetary value of each decision is?
This is all of the end of the decision tree which shows the money earned from each decision
What formula do you have to use to work out the expected monetary value from each decision to decide which one to invest in?
(expected value of success x probability) + (Expected value of failure x probability)
Using the example from before what would the expected value of opening a new store be?
(420,000x0.7) + (-24,000x0.3)=
£294,000 + -£7,200=
£286,800
Using the example from before what would the expected value expanding the businesses website be?
(480,000x0.6) + (-32,000x0.4)=
£288,00+£-12,800=
£275,200
So looking at the two bits of information which would be the better option for this business?
The expected value of opening a new store is higher at £286,000 than that of expanding the website at £275,200 based purely on financial terms the business should choose the option to open a new store
When there is little difference in the monetary value of the two decisions what should a business do?
A business should then look at other factors that may inform their decision as there isn’t much difference in monetary value
What are the limitations of using decision trees?
- Requires skill to avoid bias and takes significant amounts of time to gather reliable data
-Constructed using estimates which rarely take full account of external factors and can’t include all possible eventualities
-Qualitative elements are not considered which may affect probability of success of a decision
-Time lag between construction of decision tree and implementation of the decision is likely to further affect the reliability of the expected values
