Decision Tree and Decision Tables

A decision tree represents complex decisions in the form of a tree. Though visually it is
appealing, it can soon get out of hand when the number and complexity of decisions
increase. An example is given below.
First the textual statement is given and then the corresponding decision tree is given:

Rules for electricity billing are as below:

If the meter reading is "OK", calculate on consumption basis(i.e. meter

reading)
If the meter reading appears "LOW", then check if the house is occupied
If the house is occupied, calculate on seasonal consumption basis
otherwise calculate on consumption basis
If the meter is damaged, calculate based on maximum possible
electricity usage

ELECTRICITY BILL CALCULATION BASED ON CUSTOMER CLASS

If a customer uses electricity for domestic purposes and if the

consumption is less than 300 units per month then bill with minimum
monthly charges.

Domestic customers with a consumption of 300 units or more per month are
billed at special rate.

Non-domestic users are charged double that of domestic users (minimum and
special rates are double).

BINARY-VALUED DECISION TABLE

Domestic Customer Y Y N N

Consumption < 300 units per month Y N Y N

Minimum rate Y N N N

Special rate N Y N N

Double minimum rate N N Y N

Double special rate N N N Y

Decision tables can grow large if the number of rules increase. In the
above example, if we add a new class of customers, called Academic,
with the rules:
If the consumption is less than 300 units per month then bill with concessional rates.
Otherwise bill with twice the concessional rates. then new tables will look like the
following:

BINARY-VALUED DECISION TABLE (three rows and two columns

are added to deal with the extra class of customers)

Academic N N N N Y Y

Domestic customer Y Y N N N N

Consumption < 300 units/month Y N Y N Y N

Minimum rate Y N N N N N

Special rate N Y N N N N

Twice minimum rate N N Y N N N

Twice special rate N N N Y N N

Concessional rate N N N N Y N

Twice concessional rate N N N N N Y

Decision trees examples

Your company is considering whether it should tender for two contracts (MS1 and MS2)
on offer from a government department for the supply of certain components. The
company has three options:

● tender for MS1 only; or

● tender for MS2 only; or
● tender for both MS1 and MS2.

If tenders are to be submitted the company will incur additional costs. These costs will
have to be entirely recouped from the contract price. The risk, of course, is that if a tender
is unsuccessful the company will have made a loss.

The cost of tendering for contract MS1 only is £50,000. The component supply cost if the
tender is successful would be £18,000.

The cost of tendering for contract MS2 only is £14,000. The component supply cost if the
tender is successful would be £12,000.
The cost of tendering for both contract MS1 and contract MS2 is £55,000. The
component supply cost if the tender is successful would be £24,000.

For each contract, possible tender prices have been determined. In addition, subjective
assessments have been made of the probability of getting the contract with a particular
tender price as shown below. Note here that the company can only submit one tender and
cannot, for example, submit two tenders (at different prices) for the same contract.

Option Possible Probability

tender of getting
prices (£) contract
MS1 only 130,000 0.20
115,000 0.85
MS2 only 70,000 0.15
65,000 0.80
60,000 0.95
MS1 and MS2 190,000 0.05
140,000 0.65

In the event that the company tenders for both MS1 and MS2 it will either win both
contracts (at the price shown above) or no contract at all.

● What do you suggest the company should do and why?

● What are the downside and the upside of your suggested course of action?
● A consultant has approached your company with an offer that in return for
£20,000 in cash she will ensure that if you tender £60,000 for contract MS2 only your
tender is guaranteed to be successful. Should you accept her offer or not and why?

Solution

The decision tree for the problem is shown below.

Below we carry out step 1 of the decision tree solution procedure which (for this
example) involves working out the total profit for each of the paths from the initial node
to the terminal node (all figures in £'000).

Step 1

● path to terminal node 12, we tender for MS1 only (cost 50), at a price of 130, and
win the contract, so incurring component supply costs of 18, total profit 130-50-18 = 62
● path to terminal node 13, we tender for MS1 only (cost 50), at a price of 130, and
lose the contract, total profit -50
● path to terminal node 14, we tender for MS1 only (cost 50), at a price of 115, and
win the contract, so incurring component supply costs of 18, total profit 115-50-18 = 47
● path to terminal node 15, we tender for MS1 only (cost 50), at a price of 115, and
lose the contract, total profit -50
● path to terminal node 16, we tender for MS2 only (cost 14), at a price of 70, and
win the contract, so incurring component supply costs of 12, total profit 70-14-12 = 44
● path to terminal node 17, we tender for MS2 only (cost 14), at a price of 70, and
lose the contract, total profit -14
● path to terminal node 18, we tender for MS2 only (cost 14), at a price of 65, and
win the contract, so incurring component supply costs of 12, total profit 65-14-12 = 39
● path to terminal node 19, we tender for MS2 only (cost 14), at a price of 65, and
lose the contract, total profit -14
● path to terminal node 20, we tender for MS2 only (cost 14), at a price of 60, and
win the contract, so incurring component supply costs of 12, total profit 60-14-12 = 34
● path to terminal node 21, we tender for MS2 only (cost 14), at a price of 60, and
lose the contract, total profit -14
● path to terminal node 22, we tender for MS1 and MS2 (cost 55), at a price of 190,
and win the contract, so incurring component supply costs of 24, total profit 190-55-
24=111
● path to terminal node 23, we tender for MS1 and MS2 (cost 55), at a price of 190,
and lose the contract, total profit -55
● path to terminal node 24, we tender for MS1 and MS2 (cost 55), at a price of 140,
and win the contract, so incurring component supply costs of 24, total profit 140-55-
24=61
● path to terminal node 25, we tender for MS1 and MS2 (cost 55), at a price of 140,
and lose the contract, total profit -55

Hence we can arrive at the table below indicating for each branch the total profit involved
in that branch from the initial node to the terminal node.

Terminal node Total profit £'000

12 62
13 -50
14 47
15 -50
16 44
17 -14
18 39
19 -14
20 34
21 -14
22 111
23 -55
24 61
25 -55

We can now carry out the second step of the decision tree solution procedure where we
work from the right-hand side of the diagram back to the left-hand side.

Step 2

● For chance node 5 the EMV is 0.2(62) + 0.8(-50) = -27.6

● For chance node 6 the EMV is 0.85(47) + 0.15(-50) = 32.45

Hence the best decision at decision node 2 is to tender at a price of 115 (EMV=32.45).

● For chance node 7 the EMV is 0.15(44) + 0.85(-14) = -5.3

● For chance node 8 the EMV is 0.80(39) + 0.20(-14) = 28.4
● For chance node 9 the EMV is 0.95(34) + 0.05(-14) = 31.6

Hence the best decision at decision node 3 is to tender at a price of 60 (EMV=31.6).

● For chance node 10 the EMV is 0.05(111) + 0.95(-55) = -46.7

● For chance node 11 the EMV is 0.65(61) + 0.35(-55) = 20.4

Hence the best decision at decision node 4 is to tender at a price of 140 (EMV=20.4).

Hence at decision node 1 have three alternatives:

● tender for MS1 only EMV=32.45

● tender for MS2 only EMV=31.6
● tender for both MS1 and MS2 EMV = 20.4

Hence the best decision is to tender for MS1 only (at a price of 115) as it has the highest
expected monetary value of 32.45 (£'000).

The downside is a loss of 50 and the upside is a profit of 47.

With regard to the consultants offer then, ignoring ethical considerations, we could of
course, tender 60 for MS2 only without her help and if we were to do that we would have
a 0.95 probability of having our tender accepted. Hence there are essentially three
options:

● as before, tender for MS1 only at a price of 115: EMV 32.45, downside -50
(probability 0.15), upside 47 (probability 0.85)
● tender for MS2 only at a price of 60, unaided by the consultant: EMV 31.6,
downside -14 (probability 0.05), upside 34 (probability 0.95)
● tender for MS2 only at a price of 60, with the consultants help, then (assuming
she can fulfil her promise of guaranteeing we will be successful), we have a certain
outcome with a profit of 34 (terminal node 20) - 20 (cash paid to the consultant) = 14

On an EMV basis we would still support our original decision. Looking at the risks
(probabilities) of loosing money, and considering tendering for MS2 only at 60, we
would essentially be paying the consultant 20 to avoid a 0.05 chance of loosing 14, the
downside of tendering unaided.

Paying 20 to guarantee not incurring a loss of 14 which will occur with a probability of
0.05 (one in twenty) does not seem like an awfully good investment and so we should
reject her offer (or offer her a smaller sum of money in return for her guarantee!).