PROJECT MANAGEMENT

DECISION TREE
Planning Tool
 Using Decision Trees
• A decision tree is a schematic
tree-shaped diagram which sets out the
options available to managers when
making a decision.
• Can be used as visual aids to structure
and solve sequential decision problems
• Especially beneficial when the complexity
of the problem grows
 DECISION TREE
• Enable a business to quantify decision making
• Useful when the outcomes are uncertain
• Places a numerical value on likely or potential
outcomes
• Allows comparison of different possible
decisions to be made
 Decision Trees
• Three types of “nodes”
– Decision nodes - represented by squares (□)
– Chance nodes - represented by circles (Ο)
– Terminal nodes - represented by triangles (optional)
• Solving the tree involves pruning all but the best
decisions at decision nodes, and finding expected values
of all possible states of nature at chance nodes
• Create the tree from left to right
• Solve the tree from right to left
 HOW DECISION TREES ARE CONSTRUCTED

• It is constructed from left to right

• Each branch of the tree represents an option
together with a range of consequences or
outcomes and the chances of these occurring
• Decision points are denoted by a square called
decision nodes
• A circle shows that a range of outcomes may
occur called chance nodes
• Probabilities are shown alongside each of
these possible outcomes. These probabilities
are the numerical values of an event occurring
• The pay-offs are the expected financial gains
or losses of a particular outcome.
 Analysis of decision tree
• 1. In the calculations, start on the right and
work backwards.
• 2. To get the expected values multiply
outcomes by probabilities.
• 3. Add the expected values at each node.
• 4. Deduct any cost incurred.
• 5. The course of action which provides the
highest expected returns for the firm is
selected.
• 6. Use parallel lines to show the branches not
taken ( \\ ).
 The Process
Economic growth rises Expected outcome
0.7 £300,000

Expand by opening new outlet

Economic growth declines Expected outcome
-£500,000
0.3

Maintain current status

£0

The circle denotes the point where different outcomes could occur. The estimates of the probability and the
knowledge of the expected outcome allow the firm to make a calculation of the likely return. In this example
it is: A square denotes the point where a decision is made, In this example, a business is contemplating
There is also
opening the outlet.
a new option The
to douncertainty
nothing andis maintain
the state the current
of the status– quo!
economy if theThis wouldcontinues
economy have an outcome
to grow of
Economic
£0. growth rises: 0.7 x £300,000 = £210,000
healthily the option is estimated to yield profits of £300,000. However, if the economy fails to grow as
expected,
Economic growththe declines:
potential 0.3
lossxis£500,000
estimated= at £500,000.
-£150,000
The calculation would suggest it is wise to go ahead with the decision ( a net ‘benefit’ figure of +£60,000)
 The Process
Economic growth rises Expected outcome
0.5 £300,000

Expand by opening new outlet

Economic growth declines Expected outcome
-£500,000
0.5

Maintain current status

£0

Look what happens however if the probabilities change. If the firm is unsure of the potential for growth, it might
estimate it at 50:50. In this case the outcomes will be:
Economic growth rises: 0.5 x £300,000 = £150,000
Economic growth declines: 0.5 x -£500,000 = -£250,000
In this instance, the net benefit is -£100,000 – the decision looks less favourable!
 Problem: Jenny Lind
(Text Problems 8-16)

Jenny Lind is a writer of romance novels. A movie

company and a TV network both want exclusive
rights to one of her more popular works. If she signs
with the network, she will receive a single lump sum,
but if she signs with the movie company, the amount
she will receive depends on the market response to
her movie. What should she do?
 Payouts and Probabilities

• Movie company Payouts

– Small box office - $200,000
– Medium box office - $1,000,000
– Large box office - $3,000,000
• TV Network Payout
– Flat rate - $900,000
• Probabilities
– P(Small Box Office) = 0.3
– P(Medium Box Office) = 0.6
– P(Large Box Office) = 0.1
 Jenny Lind - Payoff Table
States of Nature

Small Box Medium Box Large Box

Decisions Office Office Office

Sign with Movie

$200,000 $1,000,000 $3,000,000
Company

Sign with TV
$900,000 $900,000 $900,000
Network
Prior
0.3 0.6 0.1
Probabilities
 Example Decision Tree

Chance
Event 1
node
Decision Event 2
s i on1
node Deci
Event 3
Dec
isio
n2
Jenny Lind Decision Tree

Small Box Office

$200,000

Sign with Movie Co. Medium Box Office

$1,000,000

Large Box Office

$3,000,000

Small Box Office

$900,000

Sign with TV Network Medium Box Office

$900,000

Large Box Office

$900,000
 Jenny Lind Decision Tree - Solved

Small Box Office

ER .3 $200,000
960,000
Sign with Movie Co. .6 Medium Box Office
$1,000,000
ER .1
960,000 Large Box Office
$3,000,000

Small Box Office

ER .3 $900,000
900,000
Sign with TV Network .6 Medium Box Office
$900,000
.1
Large Box Office
$900,000
Advantages
Disadvantages
 Decision Trees

• Limitations:
– How accurate is the data used
in the construction of the tree?
– How reliable are the estimates
of the probabilities?
– Data may be historical – does this data relate to real
time?
– Necessity of factoring in the qualitative factors –
human resources, motivation, reaction, relations with
suppliers and other stakeholders
 Class Exercise: A Glass Factory
A glass factory specializing in crystal is experiencing a substantial
backlog, and the firm's management is considering three courses of
action:
A) Arrange for subcontracting
B) Construct new facilities
C) Do nothing (no change)

The correct choice depends largely upon demand, which may be

low, medium, or high. By consensus, management estimates the
respective demand probabilities as 0.1, 0.5, and 0.4.

Given the payoffs on the next page, manually create and solve this
problem using a decision tree.
 A Glass Factory: The Payoff Table
The management estimates the profits when choosing
from the three alternatives (A, B, and C) under the
differing probable levels of demand. These profits, in
thousands of dollars are presented in the table below: