Decision making
The search for alternative options is normally conducted with limited time and money. Therefore
information gathered is always incomplete or imperfect.
The cost of trying to improve your information does not rise in linear proportion, but exponentially.
Remember:
information costs
Perfect information costs too much
“The best is the enemy of the good”
often quoted by Sir John Harvey Jones (former chairman of ICI plc and
presenter of BBC tv’s “Troubleshooter” programmes. He borrowed this
saying from Voltaire.
“The art of management is to do a good job when you only have half the information and half of
that is wrong”
(R. Jones)
Decision Tree Analysis
(Reading:-
Moore, P.G. & Thomas H. (1988)
The Anatomy of Decisions
Penguin)
The decision analysis process is structured into 5 steps:1
Draw the tree with all possible alternative decisions and outcomes.
2
Insert a payoff at the end of each branch – the monetary
consequences (sales revenues).
3
Insert a probability (uncertainty) at each branch of a chance node.
4
Roll back (combine the first three steps by simple arithmetic) in
order to calculate EMVs (expected monetary values)
5
Summarise the optimal path and draw the risk profile (determine the
best alternative and then consider the non-monetary aspects of the
problem).
raj/aibs/mba/Managerial Decision Making/Lecture 5/Quantitative Methods 1/mar2003
Step 1 – draw the tree
= decision point
Outcome (result)
Increase
Outcome
Decision
= chance outcome
No change
Decrease
Increase
No change
Decrease
Increase
No change
Decrease
So draw the complete picture first. Then insert your figures
starting at the right hand side and work back to the left hand side.
Outcome
Decision
Step 2 – insert payoffs
Outcome (result)
Increase
Payoff
£
No change
Decrease
Increase
No change
Decrease
Increase
No change
Decrease
£
£
£
£
£
£
£
£
raj/aibs/mba/Managerial Decision Making/Lecture 5/Quantitative Methods 1/mar2003
.1 .4 .5
.3 .2 .5
Outcome
Decision
.2 .5
.3
Step 3 – insert probabilities
Outcome (result)
Increase
Payoff
£
No change
Decrease
Increase
No change
Decrease
Increase
No change
Decrease
£
£
£
£
£
£
£
£
Outcome (result)
Increase
Payoff
£
No change
Decrease
Increase
No change
Decrease
Increase
No change
Decrease
£
£
£
£
£
£
£
£
Step 4 – Roll back to EMVs
.5
.3
EMV
EMV
.1 .4 .5
.3
.2 .5
Outcome
Decision
.2
EMV
raj/aibs/mba/Managerial Decision Making/Lecture 5/Quantitative Methods 1/mar2003
Decision Tree Analysis
Example:Company X has developed a new product and wishes to launch it in the market. The cost of
launching the new product is estimated to be £750,000.
There are 3 options:1
Go ahead with a full launch of the product.
2
Carry out a test marketing to obtain extra information.
3
Abandon the product and cut the losses.
The company’s marketing department says that it can devise a simple test in a limited market which
will give an indication of favourable or unfavourable demand.
Cost of test marketing
= £100000
Probability (favourable test result)
= 60%
Probability (unfavourable test result) = 40%
Financial and probability data are presented in the table below. If the product is launched fully,
market research has shown that market demand can be categorised as being strong, weak or nonexistent and that the probabilities of each level of demand are 50%, 20% and 30% respectively.
Test
New product launch data:Market
Demand
Product
launch cost
£000
Payoff
(sales)
£ 000
Probabilities %
Probabilities %
of success
No test
of success
test = favourable
Probabilities %
of success
test = unfavourable
Strong
Weak
Nonexistent
750
750
750
1750
1000
0
50%
20%
30%
70%
20%
10%
20%
20%
60%
Test marketing results provide extra information which is likely to change the estimates of
probabilities of different demand levels. A favourable test result would make it more likely that the
demand for the product is strong.
The accounting department has calculated the financial implications of different levels of demand
(sales), strong, weak and non-existent.
Remember that obtaining information (e.g. market research, test marketing) costs money.
The risk profile reveals whether the EMV is concealing any large (especially negative) outcomes
which have small probabilities. Such outcomes, even if unlikely, could be catastrophic.
Do not follow EMV slavishly. It may be better to choose an option with an inferior EMV but which
has a smaller downside.
raj/aibs/mba/Managerial Decision Making/Lecture 5/Quantitative Methods 1/mar2003