Decision Tree Analysis is used to evaluate the best option from a number of mutually exclusive options when an organization is faced with an investment decision. The finance team can use this tool while evaluating a number of potential options, such as which product or plant to invest in, or whether or not to invest in a new initiative.
The Decision Tree schematic is tree-shaped diagram which is used to understand a statistical probability or a course of action. Each branch of the decision tree signifies a possibility or occurrence. The structure of the tree depicts how one choice leads to another.
Advantages of Decision Tree Analysis
- This tool allows the team to clearly lay out and consider all available options, including a “Do Nothing” option, which is often ignored although it may sometimes be the best option.
- It is relatively easy to visualize the costs, benefits, and probabilities linked to all options to help facilitate focused decision making.
- Additional options can be added without impacting the evaluation of the other branches throughout the tree.
Disadvantages of Decision Tree Analysis
- In situations where there are many options to consider and each option has multiple possible outcomes, creating decision trees becomes a complex process and may require the use of software, rendering it a less-than-useful tool for strategic discussions.
- In some trees, even a small variation in an expected outcome or probability can completely change the results of the analysis. Therefore, obtaining accurate information is critical to the usefulness of this tool.
- This tool sometimes requires complex preparation, as well as extra time and effort to determine the various possible outcomes for each option, and to explicitly delineate each decision node and possible outcomes and options from those nodes.