Steps in Decision Tree Analysis

In a decision tree analysis, the decision-maker has usually to proceed through the following six steps:

1.    Define the problem in structured terms.

First of all, the factors relevant to the solution should be determined. Then probability distributions that are appropriate conditional future behavior of those factors are estimated. The financial data concerning conditional outcomes is collected.

2.    Model the decision process.

A decision tree that illustrated all the alternatives in the problem is constructed. The entire decision process is presented schematically and in an organized step-by-step fashion.

3.    Apply the appropriate probability values and financial data.

To each of the braches and sub-branches of the decision tree the appropriate probability values and financial data are applied. This would enable to distinguish between the probability value and conditional monetary value associated with each outcome.

4.    “Solve” the decision tree.

Using the methodology mentioned above proceed to locate that particular branch of the tree that has the largest expected value or that maximizes the decision criteria.

5.    Perform sensitivity analysis.

Determine how the solution reacts to changes in inputs. Changing probability value and conditional financial values, allow the decision maker to text both the magnitude and the direction of the reaction.

6.    List the underlying assumptions.

The accounting, cost finding and other assumptions used to arrive at a function should be explained. This would also enable other to know what risks they are taking when they use the results of decision tree analysis. The limits under which the results obtained will be valid should be clearly specified.

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