Decision Making Tools: Decision Tree Analysis and EMV
Decision Makers' Toolkit
“Decision-making is the cognitive process of selecting a course of
action from among multiple alternatives. Every decision-making process
produces a final choice.” That’s what Wikipedia says anyway. What
it doesn’t say is that some decisions must be made for outcomes that
will occur in the future. However, there are a couple of tools that can
be put to use in helping make complex decisions, namely, Expected
Monetary Value and Decision Tree Analysis.
Expected Monetary Value (EMV)
EMV is a balance of probability and its impact over the range of
possible scenarios. If you have to make a decision between two
scenarios, which one will provide the greater potential payoff?
|Best case provides a 20% probability of making $180,000||BC = 20%||X $180,000= $36,000|
|Worst case provides a 15% probability of loosing [-$20,000]||WC = 15%||X(-$20,000) =(-$3,000)|
|Most likely case provides a 65% probability of making $ 75,000||MLC = 65%||X $75,000 = $48,750|
|Best case provides a 15% probability of making $200,000||BC=15%||X $200,000 =$30,000|
|Worst case provides a 25% probability of making $15,000||WC= 25%||X $ 15,000 = $ 3,750|
|Most likely case provides a 60% probability of making $45,000||MLC=60%||X $45,000 = $27,000|
Which scenario do you choose? Number one, because it has the highest EMV, or $81,750
Decision Tree Analysis
In decision tree analysis, a problem is
depicted as a diagram which displays all possible acts, events, and
payoffs (outcomes) needed to make choices at different points over a
period of time.
Example of Decision Tree Analysis: A Manufacturing ProposalYour corporation has been presented with a new product development proposal. The cost of the development project is $500,000. The probability of successful development is projected to be 70%. If the development is unsuccessful, the project will be terminated. If it is successful, the manufacturer must then decide whether to begin manufacturing the product on a new production line or a modified production line. If the demand for the new product is high, the incremental revenue for a new production line is $1,200,000, and the incremental revenue for the modified production line is $850,000. If the demand is low, the incremental revenue for the new production line is $700,000, and the incremental revenue for the modified production line is $150,000. All of these incremental revenue values are gross figures, i.e., before subtracting the $500,000 development cost, $300,000 for the new production line and $100,000 for the modified production line. The probability of high demand is estimated as 40%, and of low demand as 60%.
The development of a decision tree is a multi step process. The first step is to structure the problem using a method called decomposition, similar to the method used in the development of a work breakdown structure. This step enables the decision-maker to break a complex problem down into a series of simpler, more individually manageable problems, graphically displayed in a type of flow diagram called a decision tree. These are the symbols commonly used:
The second step requires the payoff values to be developed for each end-position on the decision tree. These values will be in terms of the net gain or loss for each unique branch of the diagram. The net gain/loss will be revenue less expenditure. If the decision to not develop is made, the payoff is $0. If the product development is unsuccessful, the payoff is - $500,000. If the development is successful, the decision is to build a new production line (NPL) or modify an existing production line (MPL). The payoff for the NPL high demand is ($ 1,200,000 - $500,000 development cost -$300,000 build cost) or $400,000. For a low demand, the payoff is ($700,000 - $500,000 development cost -$300,000 build cost) or -$100,000. The payoff for the MPL high demand is ($850,000 -$500,000 development cost - $100,000 build cost) or $250,000. For a low demand, the payoff is ($720,000- $500,000 development cost - $100,000 build cost) or $120,000.
The third step is to assess the probability of occurrence for each outcome:
Development Successful = 70% NPL High Demand = 40% MPL High Demand = 40%
Development Unsuccessful = 30% NPL Low Demand = 60% MPL Low Demand = 60%
Probability Totals* 100% 100% 100%
*Probabilities must always equal 100%, of course.
The fourth step is referred to as the roll-back and it involves
calculating expected monetary values (EMV) for each alternative course
of action payoff. The calculation is (probability X payoff) = EMV This
is accomplished by working from the end points (right hand side) of the
decision tree and folding it back towards the start (left hand side)
choosing at each decision point the course of action with the highest
expected monetary value (EMV).
New Production Line vs. Modified Production Line
high demand + low demand = EMV high demand + low demand = EMV
(4 0% X $400,000) + (60%X -$100,000) (40% X $250,000)+(60% X $120,000)
Decision Point 2 Decision: Modified Production Line with an EMV of $172,000
Decision 1: Develop or Do Not Develop
Development Successful + Development Unsuccessful
(70% X $172,000) (30% x (- $500,000))
$120,400 + (-$150,000)
Decision Point 1 EMV=(-$29,600)
Decision: DO NOT DEVELOP the product because the expected value is a negative number.
When doing a decision tree analysis, any amount greater than zero signifies a positive decision. This tool is also very useful when there are multiple cases that need to be compared. The one with the highest payoff should be picked.
How to Learn More about This Topic
Decision-making tools are an important part of any good course on project management. Eogogics offers a couple of project management courses, both based on the Project Management Institute (PMI ®) curriculum.
Those who want a quick but intensive overview of the entire range of project management issues should consider our two-day Project Management Workshop.
Those who need to prepare themselves for the PMI Professional
(PMP®) certification should take our four-day Project
and Team Management Workshop which has been specifically designed
to satisfy the preparation and training requirements of the PMP
Risk and Decision Analysis in Projects by John Schuyler. Project Management Institute, 2001.
Project Risk Management by Bruce T. Barkley. McGraw-Hill, 2004.
Identifying and Managing Project Risk: Essential Tools for Failure-Proofing Your Project by Tom Kendrick. AMACOM, 2003.
Proactive Risk Management: Controlling Uncertainty in Product Development by Guy M. Merritt and Preston G. Smith. Productivity Press, 2002.
http://en.wikipedia.org/wiki/Decision_tree: A good article on decision tress that also lists some of the software tools used in decision tree analysis.
www.managementhelp.org Free Management Library is one of the world's largest collections of resources on management topics.
www.pmi.org PMI develops project management standards as well as certifies project management professionals worldwide. Its Guide to the Project Management Body of Knowledge (PMBOK® Guide), an ANSI (American National Standards Institute) standard, is used worldwide as a reference on how to manage projects.