Decision Trees

• Decision trees are a visual tool in decision making, used to identify the best choice among different options or strategies.

• This technique involves mapping out in a tree format each possible outcome and its associated probabilities, hence the name ‘decision tree.’

• Every decision tree has two types of nodes: decision nodes, represented by squares, and chance nodes, represented by circles. The decision nodes are where a choice can be made, while chance nodes show the possible outcome of a previous decision.

• The branches connecting these nodes represent the decisions, outcomes or events, while the path from the beginning to the end of the tree shows a ‘scenario’ which is a sequence of events.

• Decision trees enable businesses to evaluate potential costs and benefits of different decisions, allowing them to strategize effectively.

• These trees also facilitate the calculation of expected payoffs or values for different scenarios, which are important in determining the best decision to take.

• Decision trees incorporate aspects of uncertainty and risk through the use of probabilities at the chance nodes. These probabilities are usually based on past data, market research, or subjective judgement.

• Another key aspect of decision trees is that they take into account the time value of money. Payoffs down the line are often discounted to account for the preference for receiving money sooner rather than later.

• As part of this decision-making tool, sensitivity analysis can also be performed. This allows the impact of changes in variables (such as costs or probabilities) on the final decision to be analysed.

• While decision trees are a useful tool, there are limitations. The accuracy of the decision tree largely depends on the accuracy of the probabilities and predictions made. Additionally, not all influences on a decision, especially intangible ones like employee morale, can be easily quantified.

• Lastly, decision trees can also become very complex when dealing with complex decisions or numerous options, which could limit their practicality. Nonetheless, they remain a popular tool in business decision making due to their ability to visualise and quantify different decision paths.