What Is Decision Tree Analysis?

A decision tree analysis is a method used by businesses for making decisions by utilizing a chart that shows all of the possible outcomes that can arise from one original decision. As the original decision leads to other decisions, the chart adds branches for all of the new possibilities. Estimates are made of the hypothetical values of each outcome, and the possibility is that each outcome will actually occur. Through this process, a decision tree analysis doesn't omit any possible outcome and can show what the best path is to take based on probabilities.

In the business world, decisions have to be made practically every day by managers and executive officers. Some of these decisions may not seem like big deals, but others can have significant impact on whether or not the business will be successful. This is especially true for those decisions that require a large commitment of capital. For such decisions, it is a good idea for those making the decision 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 drawing a box with two lines emanating from it. These two lines represent the choices between which the business 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 this box. This process continues until the choices lead to some sort of outcome.

Outcomes are represented in a decision tree analysis by circles. The circles represent all of the possible outcomes from a choice. For example, a choice might turn out well, it might turn out poorly, or it might turn out mediocre. Those doing the analysis must determine both the chances that these outcomes might occur and the monetary value that an outcome is worth. For example, a choice to do something might have a 30 percent chance of turning out very well, which would be worth $500,000 US Dollars (USD) to the company.

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