A2 Business StudiesObjectives and Strategy –Unit 6

Decision Trees

Decision trees

Quantitative decision-making model

Applied to problems for which the probability of different consequences is known and the financial outcome of the decision can be estimated

It maps out different options and allows the best to be chosen

The Process

There is also the option to do nothing and maintain the current status quo! This would have an outcome of £0.

The probability of each outcome is drawn on the tree

Expand by opening new outlet

Maintain current status

Economic growth rises

Economic growth declines

0.7

0.3

Expected outcome£300,000

Expected outcome-£500,000

£0

A simple decision tree

A square denotes the point where a decision is made.

A business is contemplating opening a new outlet. The uncertainty is the state of the economy – Economic growth is estimated to yield profits of

£300,000.

If economy fails to grow as expected, the potential loss is estimated at £500,000.

The circle denotes the point where different outcomes could occur. The estimates of the probability and expected outcome allow a calculation of

the likely return. In this example it is:

Economic growth rises: 0.7 x £300,000 = £210,000

Economic growth declines: 0.3 x £500,000 = -£150,000

The calculation would suggest it is wise to go ahead with the decision

(an ‘expected value’ of +£60,000)

The Process

0.5

0.5

Expand by opening new outlet

Maintain current status

Economic growth declines

Economic growth rises Expected outcome£300,000

Expected outcome-£500,000

£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 expected value is -£100,000

The decision looks less favourable!

Evaluating the decision tree

To calculate the expected value:New outlet: 0.7 x £300,000 = £210,000

: 0.3 x -£500,000 = -£150,000

= £ 60,000

= £ 60,000 - £20,000 = £40,000

£300,000

Expand by opening new outlet

Do nothing £0

Economic growth rises

Economic growth declines -£500,000

0.7

0.3

-£20,000

Net = +£40,000

//Cross through any rejected decisions

Remember to subtract the initial cost of the project to get the final expected value (or ‘net benefit’)

Once the value of each option has been calculated it is added to the

decision tree

If more than one activity

Most decision trees will have more than one optionThe tree above shows the choice a company will face between choosing to produce product A or BTo choose between them work out the expected value for both and choose the most beneficial Which option should be chosen?

Product A

Do nothing

High demand

Low demand

£16m

£6m

£0

£12m

£4mLow demand

High demandProduct B

0.7

0.3

0.6

0.4

-£7m

-£2m

Answer

Product A:0.7 x £16m = £11.2m0.3 x £6m = £1.8mExpected value = £11.2m + £1.8m = £13m - £7m = £6m

Product B:0.6 x £12m = £7.2m0.4 x £4m = £1.6mExpected value = £7.2m + £1.6m = £8.8m - £2m = £6.8m

B should be chosen, but the difference is narrow so qualitative factors will be important

Student Activities

AQA A2 Business StudiesP.492 exercise 2 (10 minutes)P.492 exercise 3 (20 minutes)P.493 exercise 4 (25minutes)

launch

Do nothing

New competitor

No competitor

£1.5m

£2.5m

-(£0.4m)

£0.6m

New competitor

No competitor

0.7

0.3

0.4

0.6Expected value (Launch):

0.7 x 1.5 = £1.05m

0.3 x 2.5 = £0.75m

1.05 - 0.75 = £1.8m - £1.2m = £0.6m

Expected value (Do nothing):

0.4 x –£0.4m = -£0.16m

0.6 x £0.6m = £0.36m

0.16 + 0.36 = £0.2m - £0 = £0.2m

AQA P.492 PE 2

//

EV = £0.6m

EV = £0.2m

-£1.2m

The large promotional campaign is most desirable on financial grounds.

P492 Ex3

On financial grounds alone, the move to cheaper premises is more desirable

Ex4 p.493

Decision Trees

Lesson 2

Advantages of decision trees

Encourage a careful consideration of all alternatives

Set out problems clearly and give a logical approach

A quantitative (numerical) consideration of chance is adopted

Risk is taken into account

Discourages hunch decisions

Disadvantages

Reliant on the accuracy of the data used

Qualitative factors not considered – human resources, motivation, reaction, relations with suppliers and other stakeholders

Difficult to get accurate probabilities as estimated. What market research has been done?

Requires qualitative input to give complete picture

Qualitative issues must not be ignored just because the expected value looks convincing

Competitor actions, future recession?

Student Activities

Complete A-Z questions worksheet (25 minutes)

Electric

Gas

Max contribution

Medium

Disappointment

£500,000

£200,000

£80,000

£150,000

£80,000

A-Z Activity decision tree

Further Questions

1. What is a decision tree?

2. Explain 2 advantages of using it

3. Explain 2 disadvantages of using it

4. Why might it be less useful concerning new situations?

5. Explain 3 qualitative factors that might be important.

6. If the probability of success is o.6, what is the probability of failure?