decision business
Post on 06-Jul-2018
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A decision tree is a mathematical model used to help managers make decisions. It is a graphical
representation of the alternative course of actions available, their costs, their outcomes and
expected values based on the probability and risks associated with the possible alternatives.
A decision tree helps to decide whether the net gain from a decision is worthwhile.
Let's look at an example of how a decision tree is constructed. We'll use the following data
A decision tree starts with a decision to be made and the options that can be taken. !here is
always an option to decide to do nothing"
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!he first task is to add possible outcomes to the tree #note circles represent uncertain outcomes$
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%ext we add in the associated costs, outcome probabilities and financial results for eachoutcome.
!hese probabilities are particularly important to the outcome of a decision tree.
&robability is
• !he percentage chance or possibility that an event will occur
• anges between ( #())*$ and )
• If all the outcomes of an event are considered, the total probability must add up to (
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+inally we complete the maths in the model by calculating
Expected value:
!he financial value of an outcome calculated by multiplying the estimated financial effect by itsprobability
Net gain:
!he value to be gained from taking a decision.
%et gain is calculated by adding together the expected value of each outcome and deducting thecosts associated with the decision.
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Let's look at the calculations. What do they suggest is the best option
Option: Launch loyalty card:
-igh sales #). x /(,))),)))$ 0 /)),)))
Low sales #).1 x /23),)))$ 0 /4)),)))
!otal expected value 0 /5)),)))
Net gain: £900,000 £!00,000 " £#00,000
Option: $ut prices:
-igh sales #).6 x /6)),)))$ 0 /1),)))
Low sales #).7 x /3)),)))$ 0 /()),)))
!otal expected value 0 /21),)))
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Net gain: £%#0,000 £&00,000 " £'#0,000
8oth options indicate a positive net gain, suggesting that either would be better than doing
nothing.
-owever, launching the loyalty card has a higher net gain 9 looks the best option of the twoconsidered
(ENE)*+ O) -*N /E$**ON +EE
:hoices are set out in a logical way
&otential options 9 choices are considered at the same time
;se of probabilities enables the asy to understand 9 tangible results
/12(1$3 O) -*N /E$**ON +EE
&robabilities are ?ust estimates @ always prone to error
;ses uantitative data only @ ignores ualitative aspects of decisions
Assignment of probabilities and expected values prone to bias
BecisionCmaking techniue doesnDt necessarily reduce the amount of risk
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