Decision Tree

Topics: Cash flow, Decision making, Net present value Pages: 10 (3831 words) Published: February 16, 2013
Decision Trees for Decision Making

The management of a company that I shall call Stygian Chemical Industries, Ltd., must decide whether to build a small plant or a large one to manufacture a new product with an expected market life of ten years. The decision hinges on what size the market for the product will be. Possibly demand will be high during the initial two years but, if many initial users find the product unsatisfactory, will fall to a low level thereafter. Or high initial demand might indicate the possibility of a sustained high-volume market. If demand is high and the company does not expand within the first two years, competitive products will surely be introduced. If the company builds a big plant, it must live with it whatever the size of market demand. If it builds a small plant, management has the option of expanding the plant in two years in the event that demand is high during the introductory period; while in the event that demand is low during the introductory period, the company will maintain operations in the small plant and make a tidy profit on the low volume. Management is uncertain what to do. The company grew rapidly during the 1950’s; it kept pace with the chemical industry generally. The new product, if the market turns out to be large, offers the present management a chance to push the company into a new period of profitable growth. The development department, particularly the development project engineer, is pushing to build the large-scale plant to exploit the first major product development the department has produced in some years. The chairman, a principal stockholder, is wary of the possibility of large unneeded plant capacity. He favors a smaller plant commitment, but recognizes that later expansion to meet high-volume demand would require more investment and be less efficient to operate. The chairman also recognizes that unless the company moves promptly to fill the demand which develops, competitors will be tempted to move in with equivalent products. The Stygian Chemical problem, oversimplified as it is, illustrates the uncertainties and issues that business management must resolve in making investment decisions. (I use the term “investment” in a broad sense, referring to outlays not only for new plants and equipment but also for large, risky orders, special marketing facilities, research programs, and other purposes.) These decisions are growing more important at the same time that they are increasing in complexity. Countless executives want to make them better—but how? In this article I shall present one recently developed concept called the “decision tree,” which has tremendous potential as a decision-making tool. The decision tree can clarify for management, as can no other analytical tool that I know of, the choices, risks, objectives, monetary gains, and information needs involved in an investment problem. We shall be hearing a great deal about decision trees in the years ahead. Although a novelty to most businessmen today, they will surely be in common management parlance before many more years have passed. Later in this article we shall return to the problem facing Stygian Chemical and see how management can proceed to solve it by using decision trees. First, however, a simpler example will illustrate some characteristics of the decision-tree approach. Displaying Alternatives

Let us suppose it is a rather overcast Saturday morning, and you have 75 people coming for cocktails in the afternoon. You have a pleasant garden and your house is not too large; so if the weather permits, you would like to set up the refreshments in the garden and have the party there. It would be more pleasant, and your guests would be more comfortable. On the other hand, if you set up the party for the garden and after all the guests are assembled it begins to rain, the refreshments will be ruined, your guests will get damp, and you will heartily wish you had decided to have the party in the house....
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