Decision Trees

Choosing by Projecting "Expected Outcomes"

A decision tree helps you decide

Evaluate all of your options.

© iStockphoto

Decision Trees are excellent tools for helping you to choose between several courses of action.

They provide a highly effective structure within which you can lay out options and investigate the possible outcomes of choosing those options. They also help you to form a balanced picture of the risks and rewards associated with each possible course of action.

Drawing a Decision Tree

You start a Decision Tree with a decision that you need to make. Draw a small square to represent this towards the left of a large piece of paper.

From this box draw out lines towards the right for each possible solution, and write that solution along the line. Keep the lines apart as far as possible so that you can expand your thoughts.

At the end of each line, consider the results. If the result of taking that decision is uncertain, draw a small circle. If the result is another decision that you need to make, draw another square. Squares represent decisions, and circles represent uncertain outcomes. Write the decision or factor above the square or circle. If you have completed the solution at the end of the line, just leave it blank.

Starting from the new decision squares on your diagram, draw out lines representing the options that you could select. From the circles draw lines representing possible outcomes. Again make a brief note on the line saying what it means. Keep on doing this until you have drawn out as many of the possible outcomes and decisions as you can see leading on from the original decisions.

An example of the sort of thing you will end up with is shown in Figure 1:

Example decision tree diagram: Step 1

Once you have done this, review your tree diagram. Challenge each square and circle to see if there are any solutions or outcomes you have not considered. If there are, draw them in. If necessary, redraft your tree if parts of it are too congested or untidy. You should now have a good understanding of the range of possible outcomes of your decisions.

Evaluating Your Decision Tree

Now you are ready to evaluate the decision tree. This is where you can work out which option has the greatest worth to you. Start by assigning a cash value or score to each possible outcome. Estimate how much you think it would be worth to you if that outcome came about.

Next look at each circle (representing an uncertainty point) and estimate the probability of each outcome. If you use percentages, the total must come to 100% at each circle. If you use fractions, these must add up to 1. If you have data on past events you may be able to make rigorous estimates of the probabilities. Otherwise write down your best guess.

This will give you a tree like the one shown in Figure 2:

Example decision tree: Step 2

Calculating Tree Values

Once you have worked out the value of the outcomes, and have assessed the probability of the outcomes of uncertainty, it is time to start calculating the values that will help you make your decision.

Start on the right hand side of the decision tree, and work back towards the left. As you complete a set of calculations on a node (decision square or uncertainty circle), all you need to do is to record the result. You can ignore all the calculations that lead to that result from then on.

Calculating The Value of Uncertain Outcome Nodes

Where you are calculating the value of uncertain outcomes (circles on the diagram), do this by multiplying the value of the outcomes by their probability. The total for that node of the tree is the total of these values.

In the example in Figure 2, the value for "new product, thorough development" is:

0.4 (probability good outcome) x $1,000,000 (value) =

$400,000
0.4 (probability moderate outcome) x $50,000 (value) = $20,000
0.2 (probability poor outcome) x $2,000 (value) = $400
TOTAL $420,400

Figure 3 shows the calculation of uncertain outcome nodes:

Example decision tree: Step 3

Note that the values calculated for each node are shown in the boxes.

Calculating the Value of Decision Nodes

When you are evaluating a decision node, write down the cost of each option along each decision line. Then subtract the cost from the outcome value that you have already calculated. This will give you a value that represents the benefit of that decision.

Note that amounts already spent do not count for this analysis – these are 'sunk costs' and (despite emotional counter-arguments) should not be factored into the decision.

When you have calculated these decision benefits, choose the option that has the largest benefit, and take that as the decision made. This is the value of that decision node.

Figure 4 shows this calculation of decision nodes in our example:

Example decision tree: Step 4

In this example, the benefit we previously calculated for 'new product, thorough development' was $420,400. We estimate the future cost of this approach as $150,000. This gives a net benefit of $270,400.

The net benefit of 'new product, rapid development' was $31,400. On this branch we therefore choose the most valuable option, 'new product, thorough development', and allocate this value to the decision node.

Result

By applying this technique we can see that the best option is to develop a new product. It is worth much more to us to take our time and get the product right, than to rush the product to market. It is better just to improve our existing products than to botch a new product, even though it costs us less.

Key Points

Decision trees provide an effective method of Decision Making because they:

  • Clearly lay out the problem so that all options can be challenged.
  • Allow us to analyze fully the possible consequences of a decision.
  • Provide a framework to quantify the values of outcomes and the probabilities of achieving them.
  • Help us to make the best decisions on the basis of existing information and best guesses.

As with all Decision Making methods, decision tree analysis should be used in conjunction with common sense – decision trees are just one important part of your Decision Making tool kit.

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Comments (7)
  • Charlotte wrote This month
    This is a really helpful article! Thanks. :)
  • Midgie wrote Over a month ago
    HI vrusso71,
    Welcome to the Club.

    I am not aware of any software which implements the decision tree methodology. However, I will send it to our techie people to see if they have seen anything like it. Perhaps there is an app for it which we could then review.

    Hope to see you around the Forums and if there is anything I can help you with, just let me know.

    Midgie
  • vrusso71 wrote Over a month ago
    Hello - I was interested to know if any of you is familiar with a software tool which implements the decision tree methodology.
    I used some macros done for excel, but I found them not optimal from the presentation standpoint

    many thanks
    V
  • Midgie wrote Over a month ago
    Hi Masterblackbelt,
    Welcome to the Club.

    I totally agree that the decision trees gives you the big picture perspective, and from that vantage point, you can make a sound decision taking into consideration all the factors and variables!

    For me, just having the spreadsheets and numbers doesn't grab my attention nor aid in my understanding!

    Hope to see you around with more great insights and thoughts!

    Midgie
  • masterblackbelt wrote Over a month ago
    The best use of that tool is its structured visualization - the big picture you get!
    All the information at place for a rapid decision making.

    My favourite figure is No. 3 where all facts are listed. (I may leave out the calculation formula but add the costs from figure 4 though.) Usually tons of data are listed in various Excel sheets or report. They are hard to read and unlinked.
  • James wrote Over a month ago
    This is a really useful technique for choosing between different, mutually-exclusive projects, and, as Midgie says, it's good for personal ones as well as business ones.

    The issue with it is over assessment of the probabilities of different courses of action. While it's quite easy to assess the costs of a course of action, it can be very difficult to accurately assess these probabilities. For example, is there a 45% probability of a new product being successful, or a 25% probability? Unless you have hard data to support your decision, this is very subjective, and these subjective estimates (often guesses) have a huge impact on the figures that lead to your decision.

    (With very big business decisions, there may be good past data that you can find to support your estimates. It's worth looking around to see if you can find it.)

    Do use this tool to map out your options and assess ways forward, but use it with common sense, and match it with other approaches to decision making as well.
  • Midgie wrote Over a month ago
    This is a very powerful tool as it helps see all the options for potential decisions, provides a framework to evaluate them which then results in an easy to make decision at the end of it.

    I actually see this tool working for personal decisions as well as business related ones ... and will be using it very soon to make an important decision (that I've been putting off for a while)!

    How have members used this kind of tool and what were the results?

    Midgie

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