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Decision Tree Analysis

A decision tree is a useful construct for visualizing a firm’s business decision and setting out all logical possibilities associated with it. A decision tree presents in an ordered form the decisions faced by a company in a given situation by tracking the options available to the decision maker and the expected payoffs and probabilities associated with the potential outcome of each decision.

decision tree



  1. Gather and group data. All critical decisions in the planning period for a specific issue must be included—the data should be exhaustive. Apply probabilities and values to alternatives. Group related issues.
  2. Sequence decisions. The main issue is the first node, with each branch stemming from the node. The process is applied sequentially from left to right, until all of the possible final outcomes and related pay-offs are reached. Probabilities assigned to branches stemming from one node must add up to 1 (and alternatives must be exhaustive).
  3. Interpret. For every outcome node compute the expected pay-offs as the product of the expected value and probability. For every decision node choose the outcome node with the highest expected pay-off. Determine the route with the highest pay-off.
  4. Sensitivity Analysis. Study the variability of the judgments made along the tree. Re-examine the most subjective components. Alter the various pay-offs and probabilities to determine the point at which a different alternative would be chosen.