Le Bocage International School IB Business & Management (F7) Decision Trees HL Only

DECISION TREES (HL ONLY)

Decision trees are used as a quantitative tool for making decisions and they provide a logical
process. The technique makes use of diagrams where decisions are represented by Squares and
Outcomes or chances represented by Circles. Chances are estimated by assigning probability
values. The expected values of each decision are calculated to reach the best decision.

RULES TO CONSTRUCT THE DIAGRAM

The diagram is constructed from left to right and calculations are performed from right to
left.
The roots should be on the left while the branches on the right.
The branches consist of: (1) Decision nodes (2) Chance events or Outcomes.

Decision Nodes

These are used when a decision has to be taken. Normally, the decision should be
between at least two alternatives.

Chance Nodes

These are used to show the possible outcomes of a decision. The chances are beyond the
decision maker’s control.

A chance event should have a probability. The summation of all the probabilities for
each chance event should add up to one.
Actual values should be placed at the end of each branch (these are forecasts of the net
cash flow resulting from a sequence of decision and chance events through a decision
tree).
Expected values (these are the forecast actual values adjusted by the probability of their
occurrence) are calculated by taking the Actual Value x Probability.
To calculate the expected profit, the cost should be deducted.
The decision maker should choose the branch producing the best value.
The rejected decision should be cut out with the following symbol ||

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 Le Bocage International School IB Business & Management (F7) Decision Trees HL Only

QUESTION WORKED IN CLASS

Denham Potteries has a capital spending budget of £100, 000. The production manager has put a
bid for £100, 000 for a new tunnel kiln. The marketing manager has countered with a proposal to
spend £80, 000 on the launching of a new product. This new product is in line with the firm’s
objective of diversifying, but may be rather risky given the firm’s past records of only one success
for every five new products.

Ken Cotton, the marketing manager has provided a handy table of figures to summarise the
information.

OUTCOME PROBABILITY ACTUAL VALUE (Surplus

over next 5 years)

NEW PRODUCT

Big Success 0.1 £ 900, 000

Modest Success 0.1 £ 500,000

Failure 0.8 £ 30, 000

TUNNEL KILN

Success 0.8 £ 200, 000

Failure 0.2 £ 60, 000

Business Studies 2nd Edition (Marcouse et al., 2003, pp. 588 Qun B2)

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 Le Bocage International School IB Business & Management (F7) Decision Trees HL Only

CALCULATION OF EXPECTED VALUES

Now that the probability values and actual values have been filled in,

 The first option would give:

(900 000*0.1)+(500 000*0.1)+(30 000*0.8)=£164 000

Since the case study gives costs of £ 80 000 for new product launching, it should be deducted.
164 000-80 000= £84 000

 The second option would give:

(200 000*0.8)+(60 000*0.2)=£172 000

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 Le Bocage International School IB Business & Management (F7) Decision Trees HL Only

Since the case study gives costs of £ 100 000 for tunnel kiln, it should be deducted. 172 000-100
000=£ 72 000.

MAKING THE QUANTITATIVE DECISION

Now that the net expected incomes for both options have been calculated, it is found out
that the option of launching a new product should be selected because it gives a net expected
income of £ 84 000.

QUALITATIVE REASONING FOR DENHAM POTTERIES

Whenever a decision has to be taken, both quantitative and qualitative factors have to be taken
into account. The management must first of all investigate the quality of the data collected by
the marketing manager. They may be less reliable and biased in favour of his department. The
production manager must also verify the validity of the figures collected by the marketing
manager.

The company has as objective to diversify which plays in favour of the marketing manager
especially in addition to the numerate considerations. However the management must not forget
that the probability of failure for the new product is 80 %. This implies that the firm has 80 %
risk of losing £ 50 000 (calculated as 80 000 – 30 000). This represents a high risk. Is the
company ready to take such a high risk?

The state of the existing kiln must also be checked. Is there any problem with the kiln? Is the
quality and efficiency negatively affected? All these areas must be verified before investing in
the new kiln. The new efficiency and productivity level must be known to check whether the
product is really a priority.

The other departments must also be considered and involved in the decision making process. In
the case study, it seems that the other departments have not given their proposals. It must be
well coordinated else the board will be seen as favouring one department and this may result in
low morale and misunderstanding.

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 Le Bocage International School IB Business & Management (F7) Decision Trees HL Only

ADVANTAGES OF DECISION TREES

Help to set out problems in a clear and logical manner and encourages a logical approach
as well.
By considering all outcomes, the decision maker gets all the options in front of him,
thereby speeding up the decision making process.
Risks are not ignored because decision trees consider negative outcomes as well.
The probability of each outcome occurring is an advantage and makes calculations easier.
Decision trees take into consideration the costs of the decision as well.
This method is scientific and does not rely on imagination or intuition. It allows for
informed decision.

DISADVANTAGES OF DECISION TREES

The estimated probabilities might not always be meaningful since forecasting errors may
occur.
Decision trees are numerical/quantitative in nature and ignore qualitative data.
Data can easily be manipulated deliberately in order to justify a particular department’s
preference.
The external business environment is not taken into consideration when drawing decision
trees.
The diagram only helps in calculation but not reduction of risks in decision making.

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