A decision tree analysis is a method used by companies to make decisions, showing all possible outcomes and their hypothetical values. It helps track contingencies and determine the best way forward based on probabilities.
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 chart adds branches for all the new possibilities. Estimates are made of 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 you the best way forward based on probabilities.
In the business world, decisions must be made virtually every day by managers and executives. Some of these decisions may not seem like big deals, 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 these decisions, it’s a good idea for the decision maker to keep track of all the different contingencies that might 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 between which the company must choose. If one option leads to another, 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.
The results are represented in a decision tree analysis by circles. The circles represent all possible outcomes of a choice. For example, a choice can go right, it can go wrong, or it can be mediocre. Those doing the analysis must determine the chances of these outcomes occurring and the monetary value they are worth. For example, a do something option might have a 30% chance of success, which would be worth $500,000 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 attached to each specific option must be subtracted from the corresponding values. Tracing the tree back through the results will produce approximate values for each of the two original options, revealing which is likely to return the most value to the company.
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