Advanced Engineering Project

Management

Dr. Nabil I. El Sawalhi

Assistant professor of Construction
Management

AEPM L11 1
 Decision trees
• Decision trees are tools for classification
and prediction.

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 Decision Trees
• The Payoff Table approach is useful for a
non-sequential or single stage.

• Many real-world decision problems

consists of a sequence of dependent
decisions.

• Decision Trees are useful in analyzing

multi-stage decision processes.
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 DECISION TREES
Used when:
• Single stage decision-making is required;
• Multi-stage decision-making is required;
• Schematic representation is useful.
Consists of:
• Nodes; commonly represented by squares
• Branches; represented by lines
• Chances; represented by circles
• Probability estimates;
• Payoffs.
• End nodes - represented by triangles
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AEPM L11 5
• Decision nodes require a conscious
decision on which branch to choose,
typically shown as a square.

• Chance nodes show different possible

events that can confront a chosen
strategy, typically shown as a circle.

• Decision Branches represent a strategy or

course of action, sometimes shown as two
parallel lines.
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• Chance Branches represent a chance-
determined event, sometimes shown as a
single line.

• Terminal Branches mark the end of the

decision tree.
• Decision trees can be deterministic or
probabilistic (stochastic).
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DETERMINISTIC DECISION TREE
• Example 1.
• Excavator replacement decision
• The site manager for Droflas Construction
has three alternative choices relating to
the replacement of a mechanical
excavator. They are shown in the payoff
matrix:

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 Profit or Payoff (£)

Strategy Year 1 Year 2 Total

S1 : Replace Now 4000 6000 10000

S2 : Replace after 5000 4000 9000

1 year

S3 : Do not 5000 3000 8000

Replace

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Draw the appropriate decision tree and
identify the appropriate solution

Decision Tree

c e now
la 10000
Rep £6000
0
DN#1 Do 400 £
no
tr
£5 ep ce
00 l ac p la 9000
0 e Re £4000
DN#2 Do
rep not
lac
e 8000
£3000

First year AEPM Second

L11 year 10
 Example 2
• A manager has developed a table that shows ($000)
for future store. The payoffs depend on the size of the
store and the strength of demand:
• Small 30 50
• Large 10 80
• The manager estimate that the probability of low
demand is equal to the probability of high demand.
The manager could request that a local research firm
conduct a survey (cost $2000) that would better
indicate wither demand will be low or high. In
discussion with the research firm the manager has
learned the following about the reliability of survey
conducted by the firm.
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 » Actual results
» Low high
• Survey showed low 0.9 0.3
• high 0.1 0.7
• a. if the manager should decide to use the survey, what
would the revised probabilities be demand and what
probabilities should be used for survey results (i.e.
survey shows high demand)
• B. construct a tree diagram
• C. determine the EMV

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• A. the following are revised probabilities if
survey shows low demand

Actual Conditio Prior p Joint p Revised p

demand nal p
low 0.9 x 0.5 = .45 .45/.6=.75

high 0.3 x 0.5 = .15 .15/.6=.25

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 A. the following are revised probabilities if
survey shows low demand

•
Actual Condition Prior p Joint p Revised p
demand al p
low 0.1 x 0.5 = .05 .45/.4=.125

high 0.7 x 0.5 = .35 .15/.4=.875

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 .75
30

Small
.25 50
Low p .6 d2
.75 10

Survey Large .25

HD p .4 80
d1
.125 30

d3 .875
50
No Survey
.125 10

.875
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 .5 30

Small
.5 50

d4
.5 10

No Survey Large
.5
80
d1

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 Example 3
• The Metal Discovery Group (MDG) is a company set up
to conduct geological explorations of parcels of land in
order to ascertain whether significant metal deposits
(worthy of further commercial exploitation) are present or
not. Current MDG has an option to purchase outright a
parcel of land for £3m.
• If MDG purchases this parcel of land then it will conduct
a geological exploration of the land. Past experience
indicates that for the type of parcel of land under
consideration geological explorations cost approximately
£1m and yield significant metal deposits as follows:

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• manganese 1% chance
• gold 0.05% chance
• silver 0.2% chance
• Only one of these three metals is ever found (if at all),
i.e. there is no chance of finding two or more of these
metals and no chance of finding any other metal.
• If manganese is found then the parcel of land can be
sold for £30m, if gold is found then the parcel of land can
be sold for £250m and if silver is found the parcel of land
can be sold for £150m.

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• MDG can, if they wish, pay £750,000 for the right to
conduct a three-day test exploration before deciding
whether to purchase the parcel of land or not. Such
three-day test explorations can only give a preliminary
indication of whether significant metal deposits are
present or not and past experience indicates that three-
day test explorations cost £250,000 and indicate that
significant metal deposits are present 50% of the time.
• If the three-day test exploration indicates significant
metal deposits then the chances of finding manganese,
gold and silver increase to 3%, 2% and 1% respectively.
If the three-day test exploration fails to indicate
significant metal deposits then the chances of finding
manganese, gold and silver decrease to 0.75%, 0.04%
and 0.175% respectively.
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• What would you recommend MDG should do and why?
• A company working in a related field to MDG is prepared
to pay half of all costs associated with this parcel of land
in return for half of all revenues. Under these
circumstances what would you recommend MDG should
do and why?
• Below we carry out step 1 of the decision tree solution
procedure which (for this example) involves working out
the total profit for each of the paths from the initial node
to the terminal node (all figures in £'000000).

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AEPM L11 21
• Step 1
• path to terminal node 8, abandon the project - profit zero
• path to terminal node 9, we purchase (cost £3m),
explore (cost £1m) and find manganese (revenue £30m),
total profit 26 (£m)
• path to terminal node 10, we purchase (cost £3m),
explore (cost £1m) and find gold (revenue £250m), total
profit 246 (£m)
• path to terminal node 11, we purchase (cost £3m),
explore (cost £1m) and find silver (revenue £150m), total
profit 146 (£m)
• path to terminal node 12, we purchase (cost £3m),
explore (cost £1m) and find nothing, total profit -4 (£m)

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• path to terminal node 13, we conduct the three-day test
(cost £0.75m + £0.25m), find we have an enhanced
chance of significant metal deposits, purchase and
explore (cost £4m) and find manganese (revenue £30m),
total profit 25 (£m)
• path to terminal node 14, we conduct the three-day test
(cost £0.75m + £0.25m), find we have an enhanced
chance of significant metal deposits, purchase and
explore (cost £4m) and find gold (revenue £250m), total
profit 245 (£m)
• path to terminal node 15, we conduct the three-day test
(cost £0.75m + £0.25m), find we have an enhanced
chance of significant metal deposits, purchase and
explore (cost £4m) and find silver (revenue £150m), total
profit 145 (£m)
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• path to terminal node 16, we conduct the three-day test
(cost £0.75m + £0.25m), find we have an enhanced
chance of significant metal deposits, purchase and
explore (cost £4m) and find nothing, total profit -5 (£m)
• path to terminal node 17, we conduct the three-day test
(cost £0.75m + £0.25m), find we have an enhanced
chance of significant metal deposits, decide to abandon,
total profit -1 (£m)
• path to terminal node 18, we conduct the three-day test
(cost £0.75m + £0.25m), find we have an reduced
chance of significant metal deposits, purchase and
explore (cost £4m) and find manganese (revenue £30m),
total profit 25 (£m)

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• path to terminal node 19, we conduct the three-day test
(cost £0.75m + £0.25m), find we have an reduced
chance of significant metal deposits, purchase and
explore (cost £4m) and find gold (revenue £250m), total
profit 245 (£m)
• path to terminal node 20, we conduct the three-day test
(cost £0.75m + £0.25m), find we have an reduced
chance of significant metal deposits, purchase and
explore (cost £4m) and find silver (revenue £150m), total
profit 145 (£m)
• path to terminal node 21, we conduct the three-day test
(cost £0.75m + £0.25m), find we have an reduced
chance of significant metal deposits, purchase and
explore (cost £4m) and find nothing, total profit -5 (£m)
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• path to terminal node 22, we conduct the
three-day test (cost £0.75m + £0.25m),
find we have an reduced chance of
significant metal deposits, decide to
abandon, total profit -1 (£m)
• Hence we can arrive at the table below
indicating for each branch the total profit
involved in that branch from the initial
node to the terminal node.

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• Terminal node Total profit £
• 8 0
• 9 26
• 10 246
• 11 146
• 12 -4
• 13 25
• 14 245
• 15 145
• 16 -5
• 17 -1
• 18 25
• 19 245
• 20 145
• 21 -5
• 22 -1 AEPM L11 27
• We can now carry out the second step of the decision
tree solution procedure where we work from the right-
hand side of the diagram back to the left-hand side.
• Step 2
• Consider chance node 7 with branches to terminal nodes
15-21 emanating from it. The expected monetary value
for this chance node is given by
• 0.0075(25) + 0.0004(245) + 0.00175(145) + 0.99035(-5)
= -4.4125
• Hence the best decision at decision node 5 is to
abandon (EMV=-1).
• The EMV for chance node 6 is given by 0.03(25) +
0.02(245) + 0.01(145) + 0.94(-5) = 2.4

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• Hence the best decision at decision node 4 is to
purchase (EMV=2.4).
• The EMV for chance node 3 is given by 0.5(2.4) + 0.5(-1)
= 0.7
• The EMV for chance node 2 is given by 0.01(26) +
0.0005(246) + 0.002(146) + 0.9875(-4) = -3.275
• Hence at decision node 1 have three alternatives:
• abandon EMV=0
• purchase and explore EMV=-3.275
• 3-day test EMV=0.7
• Hence the best decision is the 3-day test as it has the
highest expected monetary value of 0.7 (£m).

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• Sharing the costs and revenues on a
50:50 basis merely halves all the monetary
figures in the above calculations and so
the optimal EMV decision is exactly as
before. However in a wider context by
accepting to share costs and revenues the
company is spreading its risk and from
that point of view may well be a wise offer
to accept.
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STOCHASTIC DECISION TREES
• Example 4
• Based upon the recommendations of their
strategic planning group, Droflas
Associates has decided to expand their
present organisation. Having considered
several alternatives, the following
strategies were considered to be viable
options:
• Strategy A: Build a large office with an
estimated cost of £2M.
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• This alternative can face two states of nature
(market conditions), high demand for
surveying services with a probability of 0.7 or
low demand with a probability of 0.3. If the
demand is high, the company can expect to
receive an annual cash flow of £500000 for 7
years.
• If the demand is low, the annual cash flow
would be only £100000 because of the large
fixed costs and inefficiencies caused by the
small work load.
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• Strategy B: Build a small office with an
estimated cost of £1M.
• This alternative also faces two states of nature,
high demand with a probability of 0.7 and low
demand with a probability of 0.3. The company
expects to receive an annual cash flow of
£300000 or £150000 if demand is high or low
respectively. If the demand is low and remains
low for 2 years the office will certainly not be
expanded.

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• However, if initial demand is high and remains
high for 2 years they will face another decision of
whether or not to expand the office. It is
assumed that the cost of expanding the office at
that time will be £1.5M. Further, it is assumed
that after this second decision, the probabilities
of high and low demand will remain the same.

• If the decision to expand is made, the company

then expects to receive an annual cash flow of
£600000 or £100000 if the demand is high or
low respectively.

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 Which is the optimal strategy?
• Elements needed to construct a decision
tree:
• All decision and chance nodes;
• Branches that connect various decision and
chance nodes;
• Payoff (reward or cost), if any, associated
with branches emanating from decision
nodes;
• Probability value associated with branches
emanating from chance nodes;
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• Payoffs associated with each chance
node;
• Payoffs associated with each terminal
branch at the conclusion of each path that
can be traced through various
combinations that form the tree;
• Position values of chance and decision
nodes;
• The process of rollback.

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• Some possible refinements:

• The sequence of decisions can involve a

larger number of decisions;
• At each decision node, consider a larger
number of strategies;
• At each chance node, consider a larger
number of chance branches, or assume a
continuous probability distribution at each
chance node;

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• More sophisticated and more detailed
projections of cash flows can be
introduced;
• Discounted cash flows can be introduced;
• The quality of risk can be explicated by
estimating the range or standard deviation
of the payoff distribution for each path;
• Sensitivity testing and sensitivity analysis
can be introduced.

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 A1
2.66m
HD .7, cash .5m
CN#1

Large LD .3 cash .1m

office A2
2m 2 YEARS 5 YEARS

HD .7,
DN#1 2.25
cash .6 B1

CN#3
Expand
1.5m LD .3 ,
Small HD .7 , 0.1
1.275 B2
office, cash 0.3
1m DN#2 HD .7,
Not 1.275 cash .3 B3
1.402
expand
CN#4
CN#2
LD .3 ,
LD .3 , 0.15 m 0.15 B4
AEPM L11 B5 39
• Large office
• EMV1=-2+0.7x.5x7+ 0.3x0.1x7 = 0.66m(best strategy)

• Small office expand after 2y

• DN #2 =.7x.3x5 + .3x.15x5=1.275m

• Small office Not Expand

• EMV2 =-1+ 1.275x.7 + .7x.3x2 + .3x .15x 2=0.402m

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