InternationalHellenicUniversity

ParaskevopoulosKonstantinos
1

E x e r c i s e
DecisionTrees
1
InthisExercise
BuildaDecisionTree
Decisionnodes
Eventnodes
Endnodes
Calculateexpectedvalues
Duration:80minutes

DecisionScenario
NiceCeramics A.E. is the biggest ceramic tile producer in Greece and one of the greatest in Europe.
Themainfactoryofthecompany,locatedinThessaloniki,isproducingannually5.500.000moftiles,
whereas45%ofitsproductionisbeingexportedto34countriesallaroundtheworld.
The Vice President of the company Grigoris Keramidas expressed his wish for your opinion on a
decisionthecompanymustmakeduringthenextdays,soherecruitedyouasaconsultanttomakea
recommendation.
During a meeting, Keramidas expressed his worry to you, for a new competitor company
MoreniceCeramics. This new competitor has entered the Greek market during the last year and is
now openly threatening the primacy of NiceCeramics in sales in Greece. The headache for
NiceCeramicsstartedwhenMoreniceCeramicshavelaunchedaverysuccessfulseriesoffloortilesfor
internal and external use, which are cheaper and better quality than existing tile series of
NiceCeramics. Keramidas explains to you that NiceCeramics needs to develop a new product and
face the threat. The design department of the company has come up with two product ideas, and
gavethemthecodenamesSupertileandSaviortile.Theproductionofthenewproducthastostartas
soonaspossible,soNiceCeramicshasresourcesandtimetodeveloponlyoneofthetwoproductsor
noneofthem.TheBusinessAnalysisdepartmentofNiceCeramicssaysthatSupertileproductwillcost
90.000todevelop,andifitsucceeditwillgeneratearevenueof900.000.Ontheotherhand,the
analystsoftheBusinessAnalysisdepartmentbelievethatSaviortile product willcostonly9.000to
developwithageneratedrevenueof250.000ifitwillsucceed.
YourtaskistohelpMr.Keramidastodecidewhichproduct,ifeither,todevelop.Youhavetousea
decision tree to describe and then to evaluate the decision alternatives, given all the uncertainties
involved,inameasurableway.Ifyousucceedapromotioniswaitingforyou!

DecisionTrees
SolutionusingDETRETUsoftware
Adecisiontreeisawaytodescribeanalgorithmthathelpsidentifyastrategymostlikelytoreacha
goal.Itusesdiagramsofnodesandconnectingbranches.Thesediagramscontainnodesthatindicate
decision points, chance events or branch terminals and are read from left to right. Branches
correspondtoeachdecisionalternativeoreventoutcomeemergingfromanode.

Thefirstdecisionnode(rootnode)
YoucanstartbuildingyourfirstdecisiontreeinDETRETU,byfollowingthenextsteps:
1. Select File > Create new Decision Tree. A new node will be inserted in the canvas area of the
applicationwindowasshowninFigure1.Thisnodewillbetherootnodeofyourdecisiontree.
The root node will play the role of a decision node and will represent the first set of decision
alternatives.Whileexecutingthefollowingsteps,yourtreewillstartexpandingtotheright.

Figure1

2. Foreachdecisionalternativeaddabranch,extendingtotherightfromtherootnode.Todothat
clickonthetriangleshape ontherightsideoftherootnode.OnthedialogframeInsertNew
Branch (Figure 2) that will show on your screen select Decision Node and click OK. This action
willresultinaddingtwonewnodesattherightsideoftherootnode.Repeatthesamestepsto
add one more decision node in the root node. Your tree should look like Figure 3 now.

Figure2
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Figure3
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lookliketheoneisshowninFigure4
4. nodeSupertileinsertthenumber90000 eclickingonthelabelwiththenumber0.00
3. Rename the three new nodes by clicking on the name label of each one of them. Rename the
one on the top to Supertile, the one in the middle to Saviortile and the one at the bottom to
Neither.Yourtreenow should .

Figure4
In bydoubl
under the label with the name Supertile. This number is the associated investment cost to
develop Supertile. Note that this cost is a negative value since it represents loss of money. Do
thesamewiththenodeSaviortilebyinsertingthenumber9000,asthisistheinvestmentcost
to develop this product. Leave the node Neither intact, as there is no investment cost if the
companydecidetoinvestinnoneofthetwoproducts.Yourtreenowshouldlookliketheonein
Figure5.

Figure5
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DecisionTrees
Eventnodesandoutcomeprobability
Each product development effort in NiceCeramics decision scenario can have one out of two
outcomes. Eachplanfordevelopinganewproduct caneithersucceedorfail. Inthefollowingsteps
youwillinsertinthedecisionthreethoseperspectives.

1. Clickonthetriangleshape ontherightsideoftheSupertilenodetoopenthedialogframe
InsertNewBranchasshowninFigure2.
2. SelectthegraphicEventNodeandthenclickOKtoinserttwoeventnodesontherightside
of node Supertile. Those two new nodes depict the two possible outcomes of developing
Supertileproduct.Theoneatthetoprepresentssuccessandtheotherfailure.Labelthetwo
branchesaccordingly.TheresultshouldbesimilarastheoneshowninFigure6.

Figure6

Notethepercentagenumbersinfrontofeachoneofthetwonewnodes.Thosepercentages
arethechancesthateacheventnodehastohappen.Theprogrambydefaultsetseachone
ofthosepercentagesin50%.
3. Repeat step two to insert two new nodes at the right side of Saviortile node. Your tree
shouldnowlookliketheoneshowninFigure7.
4. You can now incorporate the relative outcome probability, or uncertainty, associated with
each chance event. The Business Analysis department of NiceCeramics gave you the
information that the Supertile has a 50% chance of success and 50% chance of failure. The
Saviortile has 70% chance of success, and therefore 30% chance of failure. Insert those
values by double clicking on the percentage field of each event node. Your decision tree
shouldlookliketheoneshowninFigure8.

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Figure7

Figure8

Endnodes
Now its time to insert at the end nodes the values that represent the cash flow for each one of
them. The logic is similar as before, when you entered the nodes Supertile and Saviortile. Then you
had to depict the investment cost for both products, by typing the investment values as negative
numbers in both nodes. Now you will have to do the same with the ending nodes. According to
NiceCeramics scenario if Supertile product succeeds then the generated revenue for the company
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DecisionTrees
will be 900.000. On the other hand if Saviortile product succeeds then the generated revenue for
thecompanywillbe250.000.Todepictthoserevenuesinyourdecisiontree,dothefollowingsteps:
1. Double click the label with the number 0.00 in the Supertile Success node and type the
number900000,asthisistheexpectedgeneratedrevenueincaseofsuccessininvestingin
Supertileproduct.
2. Do the same with the Saviortile Success node and type the number 250000, as this is the
expectedrevenueincaseofsuccessfulinvestmentinproductSaviortile.
Note that you should leave both Failure nodes with zero values as in case of a failure in
investmentthereisnorevenueorextraloseotherthantheamountofmoneydepictedwith
thenegativevaluesinthenodesSaviotileandSupertile.
YourdecisiontreenowshouldlookliketheoneinFigure9.

Figure9

Congratulations!Youjustfinishedbuildingyourfirstdecisiontree.Inthenextstepyouaregoingto
findoutwhichone(orneither)ofthetwoalternativeproductsSupertileorSaviortiletoproduce.

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Finalanswer
In this step you are going to evaluate the relative merits of each decision alternative. The way to
combinepayoffsandprobabilitiesforeachnodeiscalledExpectedmonetaryvalue(EMV).Thehigher
the EMV, the better a particular decision alternative on average, when compared to the other
alternativesinthedecisiontree.
Thecalculationsneededtofindthebestpath,inotherwordsthemostprofitableproducttodevelop
inthedecisiontreecanbemadeautomaticallyfromDETETRU,byclickingthemenuTree>Solve.In
Figure10youcanseetheresultofsuchanaction.Thebestpathiscoloredblackwhereastheother
pathsarecoloredlightgraycolor.

Figure10

Lets see now how DETRETU came up with the conclusion that the Supertile project is the best to
follow.LetsseehowyouwouldmakeallthecalculationsbyhandifyoudidnthaveDETRETU.
FirstyouwouldneedtocalculatetheEMVinendnodes.YoucancalculatetheEMVinendnodesby
finding the total profit or lose in each one of the paths. For example the EMV in the first node
Success (child node of Supertile) is 810.000 as the total profit of this path is 900.000 90.000.
Using the same logic the EMV of node Failure (the child node of Supertile) is 90.000. Do the same
calculationsfortheotherendnodestofindalltheEMVs.
SecondyouwouldneedtocalculatetheEMVsforanyeventnodebysummingtogetheralltheEMVs
for each branch that is connected to the node. The general formula for calculating EMV at any
chancenodesisgivenas:
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DecisionTrees
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EHI
ccnt nodc
= EHI
bunch 1
+EHI
bunch 2
+ + EHI
bunchN

InNiceCeramicsscenario,iftheSupertileproductissuccessful,theEMVistheprofitmultipliedbyits
probability,thus810.000 Su%=405.000.OntheotherhandiftheSupertileproductfails,theEMV
is-9u.uuu Su%=45.000.TheEMVforthedecisiontodeveloptheSupertileproduct,incorporating
bothsuccess ailureis ofEM theev andf thesum Vforall entualities.
EHI
SupctIc
= EHI
Succcss
+ EHI
PuIuc
= 4uS.uuu - 4S.uuu=360.000
Similarly, the EMV for the decision to develop the Saviortile is given by 241.uuu - 7u% +
(-9uuu - Su%) = 168.7uu -2.7uu = 166.uuu.
Third in row, you would have to calculate the EMVs for the root decision node. The EMV for this
node is calculated by calculating the maximum EMV from the children nodes. As you can see in
FigurethemaximumEMVfromthethreenodesSupertile,SaviortileandNeitheristheEMV360.000
fromnodeSupertile.Nowyoucanreporttheanalysiswiththesesummarizedpresentationpoints:
The Supertile is a better product to develop, despite the great risk. The significantly larger
anticipatedprofitsmaketheriskmoreacceptablethantheSaviortileproduct.
The Saviortile product is less risky to develop, but also significantly less profitable. The
projectdoesnotovercometheexpectedvalueofitsrivalproject,bearinginmindthegiven
profitexpectations.