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Decision Tree Analysis

Decision tree analysis is used to analyze decisions involving uncertainty by mapping out possible future outcomes and their probabilities. The document describes using a decision tree to evaluate whether to use permanent or temporary tooling for a new product. Permanent tooling has higher upfront costs but lower production costs, while temporary tooling has lower upfront costs but higher production costs. The decision tree calculates the expected returns of each option based on probabilities of the product succeeding, having slow sales, or failing. It determines that permanent tooling may have a higher expected return long-term despite lower short-term returns.

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Bakey Azene
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281 views

Decision Tree Analysis

Decision tree analysis is used to analyze decisions involving uncertainty by mapping out possible future outcomes and their probabilities. The document describes using a decision tree to evaluate whether to use permanent or temporary tooling for a new product. Permanent tooling has higher upfront costs but lower production costs, while temporary tooling has lower upfront costs but higher production costs. The decision tree calculates the expected returns of each option based on probabilities of the product succeeding, having slow sales, or failing. It determines that permanent tooling may have a higher expected return long-term despite lower short-term returns.

Uploaded by

Bakey Azene
Copyright
© Attribution Non-Commercial (BY-NC)
Available Formats
Download as DOC, PDF, TXT or read online on Scribd
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DECISION TREE ANALYSIS

• Every intelligent decision maker dealing with uncertainty likes to


know the size and nature of the risk he is taking in choosing a course
of action.

• This is one of the main deficiencies in. the traditional decision making
process.

• Virtually every decision is based on the interaction of a number of


critical variables, many of which have an element of uncertainty but a
fairly high degree of probability.

• Thus, the wiseness of undertaking the introduction of a new product


might depend upon critical variables like the expenses of introducing
a new product, cost of production. Capital investment required price
obtainable, total market for the product and share of the market that
could be obtained by the product.

• One of the best ways to analyze a decision, by seeking the possible


direction that actions might take from various decision points and the
decision points relating to it in the future is called Decision Tree
Analysis.

• A decision tree depicts the future decision points and possible chance
events, usually with a notation of the probabilities of the various
uncertain events happening.

• When a new products is being introduced into the market, one of the
common problems that occurs in business is to decide whether to
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introduce it in a major way (Permanent Tooling) so as to assure
production at the lowest possible cost or to undertake a cheaper
temporary tooling involving a higher manufacturing cost, but lower
capital losses if the product does not sell as well as estimated.

• The decision tree shows the manager in what direction his chance
events are and what their values in terms of profits and losses are for
each of the two tooling alternatives.

• But it is not enough to give him the visibility he would like to have in
order to decide between going for permanent tooling or temporary
tooling.

• What is needed is an assessment of the probabilities of each course of


possible events.

• If the probability that product sales will be as much as estimated is


60%, that they will be slow is 20% and that the product may fail to
sell is 20%, his decision can be greatly helped.

The following are the assumptions of the project.

1. The product life is assumed to be 5 years.

2. The cost of permanent tooling is Rs. 20,00,000

3. The estimated inflows of cash under permanent tooling are


a) If the product succeeds it is Rs. 10, 00,000 per year for 5 years.

b) If the product sales are slow Rs. 2, 00,000 per year for 5 years.
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c) If the product fails the loss is Rs, 20, 00,000.

4. The cost of temporary tooling is Rs. 1.00.000

a) If the product succeeds it is Rs. 3, 00,000 per year for 5 years.

b) If the product sales are slow Rs. 50,000 per year for 5 years.

c) If the product fails the loss is Rs, 1, 00,000.

• The chance events for each of the three is 600/0 that the product will
succeed, 20% that the product sales will be slow and 20% that the
product is likely to fail.
• Taking into account these probabilities the 20,00,000 investment has a
predicted worth of Rs. 6,00,000/(10,00,000x .6) per year for the 5 years
of product life assumed and Rs. 1,00,000 temporary tooling alternative
has a worth of Rs. 1,80,000 ( 3,00,000 x .6) per year for 5 years.

• On consideration of rate of return on investment only, the temporary


tooling approach would seem to be preferable.

• But, depending on the availability of capital, a 30% return on 20,


00,000 over 5 years would normally be regarded us greatly preferable to
a 180% return on 1, 00,000 for 5 years.
At the end of the figure

Rates of return on investment for permanent tooling


= 6, 00,000
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10, 00,000 x 0.6 = ---------------- x 100 = 30%
20, 00,000

1, 80,000
ROI for temporary tooling = 3, 00,000 + 0.6 =--------------x 100 = 180%
1, 00,000

• There is also the probability that if we drew a decision tree for a


longer period and took into account a further chance event that one or
more competitors would enter the market, thus putting squeeze on
prices and volume, the larger investment would look all the more
better.

• With the same basic probabilities mentioned and the further


probability that a vigorous competitor would enter the field, more far
sighted and complete decision tree can be drawn as follows.

• As can be seen, by calculating the value of each probability over a


five year assumed product life and disregarding the cost of interest
and discounting of future income, the total probability modified return
on permanent tooling would be Rs. 19,18,000 and on the temporary
tooling Rs. 3,90,000.

• On percentage rate of return on investment, the temporary tooling


approach still looks better.
19, 18,000.

ROI on Permanent tooling =----------------------- X 100 =


95.9%
20, 00,000
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3, 90,000
ROI on Temporary tooling = ------------------------------ X 100 = 390%
1, 00,000
• The higher total profits expected plus the possibility of a product life
exceeding 5 years and considerations of better meeting competition
might indicate that the permanent tooling programme would be more
preferable.
• Whether this course of action is taken or not would largely depend upon
the extent to which the decision maker might prefer to avoid the risk of
investing Rs. 20, 00,000 before a product proved itself in the market.
• It can be seen from the above that as chance events increase, the
decision tree becomes more complicated and the compounding of
various probabilities makes the solution much more difficult.

• In real life the tree would show various decision points in the future.

• For example the firm might have its options open by initially
investing in temporary and them go for permanent tooling (at a loss of
Rs. 1,00,000 on temporary tooling) if the product demand justified
doing so.

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