A2 Business Studies Objectives and Strategy –Unit 6 Decision Trees

Decision trees Quantitative decision-making model Applied to problems for which the probability of different consequences is known and the financial outcome of the decision can be estimated It maps out different options and allows the best to be chosen

The Process There is also the option to do nothing and maintain the current status quo! This would have an outcome of £0. The probability of each outcome is drawn on the tree Expand by opening new outlet Maintain current status Economic growth rises Economic growth declines Expected outcome £300,000 Expected outcome -£500,000 £0 A simple decision tree A square denotes the point where a decision is made. A business is contemplating opening a new outlet. The uncertainty is the state of the economy – Economic growth is estimated to yield profits of £300,000. If economy fails to grow as expected, the potential loss is estimated at £500,000. The circle denotes the point where different outcomes could occur. The estimates of the probability and expected outcome allow a calculation of the likely return. In this example it is: Economic growth rises: 0.7 x £300,000 = £210,000 Economic growth declines: 0.3 x £500,000 = -£150,000 The calculation would suggest it is wise to go ahead with the decision (an ‘expected value’ of +£60,000)

The Process 0.5 Expand by opening new outlet Maintain current status Economic growth declines Economic growth rises Expected outcome £300,000 Expected outcome -£500,000 £0 Look what happens however if the probabilities change. If the firm is unsure of the potential for growth, it might estimate it at 50:50. In this case the outcomes will be: Economic growth rises: 0.5 x £300,000 = £150,000 Economic growth declines: 0.5 x -£500,000 = -£250,000 In this instance, the expected value is -£100,000 The decision looks less favourable!

Evaluating the decision tree To calculate the expected value: New outlet: 0.7 x £300,000 = £210,000 : 0.3 x -£500,000 = -£150,000 = £ 60,000 = £ 60,000 - £20,000 = £40,000 £300,000 Expand by opening new outlet Do nothing £0 Economic growth rises Economic growth declines -£500, £20,000 Net = +£40,000 // Cross through any rejected decisions Remember to subtract the initial cost of the project to get the final expected value (or ‘net benefit’) Once the value of each option has been calculated it is added to the decision tree

If more than one activity Most decision trees will have more than one option The tree above shows the choice a company will face between choosing to produce product A or B To choose between them work out the expected value for both and choose the most beneficial Which option should be chosen? Product A Do nothing High demand Low demand £16m £6m £0 £12m £4m Low demand High demand Product B £7m -£2m

Answer Product A: 0.7 x £16m = £11.2m 0.3 x £6m = £1.8m Expected value = £11.2m + £1.8m = £13m - £7m = £6m Product B: 0.6 x £12m = £7.2m 0.4 x £4m = £1.6m Expected value = £7.2m + £1.6m = £8.8m - £2m = £6.8m B should be chosen, but the difference is narrow so qualitative factors will be important

Student Activities AQA A2 Business Studies P.492 exercise 2 (10 minutes) P.492 exercise 3 (20 minutes) P.493 exercise 4 (25minutes)

launch Do nothing New competitor No competitor £1.5m £2.5m -(£0.4m) £0.6m New competitor No competitor Expected value (Launch): 0.7 x 1.5 = £1.05m 0.3 x 2.5 = £0.75m = £1.8m - £1.2m = £0.6m Expected value (Do nothing): 0.4 x –£0.4m = -£0.16m 0.6 x £0.6m = £0.36m = £0.2m - £0 = £0.2m AQA P.492 PE 2 // EV = £0.6m EV = £0.2m -£1.2m

The large promotional campaign is most desirable on financial grounds. P492 Ex3

On financial grounds alone, the move to cheaper premises is more desirable Ex4 p.493

Decision Trees Lesson 2

Advantages of decision trees Encourage a careful consideration of all alternatives Set out problems clearly and give a logical approach A quantitative (numerical) consideration of chance is adopted Risk is taken into account Discourages hunch decisions

Disadvantages Reliant on the accuracy of the data used Qualitative factors not considered – human resources, motivation, reaction, relations with suppliers and other stakeholders Difficult to get accurate probabilities as estimated. What market research has been done? Requires qualitative input to give complete picture Qualitative issues must not be ignored just because the expected value looks convincing Competitor actions, future recession?

Student Activities Complete A-Z questions worksheet (25 minutes)

Electric Gas Max contribution Medium Disappointment £500,000 £200,000 £80,000 £150,000 £80,000 A-Z Activity decision tree

Further Questions 1. What is a decision tree? 2. Explain 2 advantages of using it 3. Explain 2 disadvantages of using it 4. Why might it be less useful concerning new situations? 5. Explain 3 qualitative factors that might be important. 6. If the probability of success is o.6, what is the probability of failure?