1. 1.3 ORGANIZATIONAL PLANNING & DECISION MAKING INTRODUCTION TO DECISION TREES (HIGHER LEVEL CONTENT)

2. DECISION TREES Often feature in HL Exams!! A decision tree is a diagram setting out the key features of a decision making problem Examiners really like decision trees. Setting a decision tree question is relatively easy and can be adapted to most papers and time frames. There are also two obvious follow-up questions. First, candidates may be asked to examine the advantages and disadvantages of using decision trees. Secondly a student may be required to examine non- numerate or additional information, other than that on a decision tree. This information can be used to support a decision.

4. Decision Trees Can Look Complicated! Students are sometimes worried by decision trees because they look complicated and contain plenty of information and lots of numbers. The thing to remember when learning to construct and interpret decision trees, is that they merely repeat the same process over and over again through the diagram. When you start with a basic process, the decision tree suddenly begins to look easier to manage.

5. CONSTRUCTING A DECISION TREE Decision trees are particularly helpful in situations supporting complex business decisions or problems, involving more than one decision. A decision is constructed from left to right with events laid out in the sequence which they occur, but the calculation of financial results is always from right to left

6. CONSTRUCTING A DECISION TREE Squares Squares represent decision points which are under the control of the business. The lines that come out of each square show all the available options that can be selected.

7. The Option of Doing Nothing Although doing nothing may not have an immediate direct cost, it certainly may have a negative outcome. A failing business left to carry on failing may end up with bankruptcy of the owner and liquidation of the business, unless some miracle happens.

8. CONSTRUCTING A DECISION TREE Circles Circles represent probability or chance nodes. These show various circumstances that have uncertain outcomes. The lines that come out of each circle denote possible outcomes of that uncontrollable circumstance.

9. How does a business establish the probability of an event happening? It is difficult to establish accurate probabilities of an event, especially if that event is beyond the control of the business itself. However, estimates of probability can be achieved through market research or experience. Nevertheless, the fact that probabilities may be little more than educated guesses is clearly a weakness of the decision tree process.

10. An Outcome or Financial Return with Decision Trees Each branch of the decision tree will have an outcome or financial return.  Success of product A will increase profit by $20 million.  Success of product B will increase profit by $30 million.  Failure of Product A will lead to a loss of $2 million.  Failure of Product B will only increase profits by $6 million.

11. Average Outcome Calculations with Decision Trees A calculation is required of the average outcome given the probabilities. This is a weighted average, because the outcome is multiplied by the probability of that result happening. In decision trees, these are referred to as expected values (EVs) and are shown at every probability node.

12. AN EXAMPLE OF A BASIC DECISION TREE

13. NODE 1: CALCULATION OF EV Step 1: Outcome x Probability $20 m x 0.8 = $16 million ($2 m) x 0.2 = ($0.4 million) Step 2: Weighted Average The EV (or weighted average) is shown by adding the two results together EV = $16 m + ($.04 million) = $15.6 million NODE 2: CALCULATION OF EV Step 1: Outcome x Probability Step 2: Weighted Averaged $30 million x 0.7 = $21 million $21 million + 1.8 million = $22.8 million $6 million x 0.3 = $1.8 million Calculations to Understand the Decision Tree

14. Which outcome / product is best? Product A To achieve an EV of $15.6 million, the business has had to spend $10 million. Therefore the, cost must be deducted from the EV to find the final profit. (net EV) $15.6 million - $10 million = $5.6 million (net EV) Product B To achieve an EV of $22.8 million, the business had to spend $15 million. Therefore the cost must be deducted from the EV to find the final profit. $22.8 million - $15 million = $7.8 million (net EV)

15. ($20 million) ($30 million) 0.4 $1 m 0.6 $40 m 0.3 0.7 $30 m $ 3 m ACTIVITY Using the information in this diagram, complete appropriate calculations to determine which product should be launched by the company. PRODUCT A Or PRODUCT B?? OUTCOME