Decision Trees FDA B&M Level C 2012/13 Week 3 matthewsp@bpc.ac.uk

Decision TreesFDA B&M Level C 2012/13Week 3matthewsp@bpc.ac.uk

Decision Trees

Planning Tool

Decision Trees • 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 • 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

Process

Advantages

Disadvantages

You have recently approached by the managing director of a gadget factory based in Poole. The factory has been quite successful the past three years and she is wondering whether or not it would be a good idea to expand the factory later this year. The cost to expand the factory is estimated at £1.5M. If the factory remained as it is, the economy continues to recover from the recent recession and people continue to buy lots of gadgets it expects £3M in revenue; while only £1M if the economy is bad. If the expands the factory, he expects to receive £6M if economy is good and £2M economy is bad. She also assumes that there is a 40% chance of a good economy and a 60% chance of a bad economy. Typical Question (last yr exam)

Where do we start • Decision tree's are about making decisions we use a square to denote a decision & draw decisions lines from it Do Something Label what your decisions are Do not do it

You may have multiple options • Decision tree's are about making decisions we use a square to denote a decision & draw decisions lines from it Do Something Could do this Do not do it

If there is a cost to the decision • If there is a cost associated with the decision i.e. capital expenditure, purchasing something etc. note it (as it is a cost make sure it is a negative) Expand Factory “The cost to expand the factory is estimated at £1.5M. “ -1.5m Do not expand 0

These show an alternative line that is subject to uncertainty. These are circles Event fork Expand Factory Success / Good -1.5m Label the lines Do not do it Failure / Bad

Event fork Uncertainty is an estimated chance, put this on either a % or it eqv number Expand Factory Success / Good -1.5m 40% Do not do it Failure / Bad 0.6

Expected Outcome Either income or profit from the event £6m £6m Success / Good 40% Expand Factory -1.5m Failure / Bad 0.6 £2m Do not do it

£6m Success / Good 40% Expand Factory Failure / Bad -1.5m £2m 0.6 £3m Do not do it Success / Good 40% Failure / Bad 0.6 £1m

We start at the right hand side and work back to the left Finally put in the Expected value (EV)

Finally put in the Expected value (EV) • This is the financial outcome of the decision it is based on the Profit or Loss of an outcome and the probability of that outcome occuring

Finally put in the Expected value (EV) £6m x 40% = £2.4m £2m x 60% = £1.2m + -------- £3.6m -£1.5m -------- £2.1m

Decision Trees FDA B&M Level C 2012/13 Week 3 matthewsp@bpc.ac.uk