What is decision tree analysis?

In the business world, decisions must be made virtually every day by managers and executives.

A decision tree analysis is a method used by companies to make decisions, using a graph that shows all the possible outcomes that can arise from an original decision. As the original decision leads to other decisions, the graph adds ramifications for all new possibilities. Estimates are made from the hypothetical values ​​of each outcome, and the possibility is that each outcome actually occurs. Through this process, a decision tree analysis does not omit any possible outcomes and can show which is the best way forward based on the probabilities.

In the business world, decisions must be made virtually every day by managers and executives. Some of these decisions may not seem like a big deal, but others can have a significant impact on whether or not the business succeeds. This is especially true for decisions that require a large capital commitment. For such decisions, it is a good idea for decision makers to keep track of all the different contingencies that may arise from the original decision. A decision tree analysis is a good way to do this.

The first step in creating a decision tree analysis is to draw a box with two lines emanating from it. These two lines represent the options that the company must choose. If one choice leads to another choice, another box is drawn at the end of the line and more lines can emerge from that box. This process continues until the choices lead to some sort of outcome.

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The results are represented in a circle analysis of the decision tree. The circles represent all possible outcomes of a choice. For example, a choice might work out well, it might be bad, or it might be mediocre. Those doing the analysis must determine the odds that these outcomes will occur and the monetary value of an outcome. For example, the choice to do something might have a 30 percent chance of succeeding, which would be worth $500,000 US dollars (USD) to the company.

By doing some simple math, the company can use decision tree analysis to figure out which of the two original options is better. The costs that would be assigned to each particular choice must be subtracted from the corresponding values. Following the tree back through the results will yield approximate values ​​for each of the two original choices, revealing which one is likely to return the most value to the company.

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