DecisionTrees

Exercise

InthisExercise
ExpectedValue
Selectingbestpath

Duration:60minutes

AsimpledecisionScenario
FavoMediisoneofthebiggestsuppliersofmedicalequipmentforhospitals.FavoMediisconsidering
whether it should tender for 2 contracts on offer from a hospital in Thessaloniki for the supply of
certainequipment.The2contactshavethecodenameCONACONBrespectively.Thecompanyhas
threeoptionsaboutthosecontacts,totenderonlyforCONA,totenderonlyforCONBortotender
forboth.
There is a risk in submitting the tenders, as tendering a contract costs. If the company wins the
tendersthenthesubmissioncostwillberecoupedentirelybutifatenderisunsuccessfulthenthe
companywilllose.Thecostsfortenderingthecontactsandsupplyingtheequipmentareshownin
Table1.
Option

Tendercost

Supplycost

CONA

60,000

19,000

CONB

25,000

14,000

CONAandCONB

66,000

28,000

Table1

Bearing in mind earlier bids for hospital supplies, the company made some assessment of the
probabilityofgettingthecontractwithaparticulartenderpriceasshowninthetablebelow:

Option

Tenderprices

Probabilityof
positive
outcome

CONA

105.000

15%

95.000

60%

90.000

80%

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CONB

55,000

10%

50.000

95%

CONAandCONB

170.000

25%

150.000

80%

Table2

Whichofthethreeoptions(CONA,CONB,CONA&CONB)thecompanyshouldtake?

Solution
Doingallthecalculations

Step1
As we have seen already in prior exercises the first step in solving the problem is to construct the
decisiontreeasshowninFigure1.Wearenotgoingtodiscussthistimehowtoconstructthistree.
Step2
Step2ofthedecisiontreesolutionprocedure,involvesworkingoutthetotalprofitforeachofthe
pathsfromtheinitialnodetotheterminalnode.Allthecalculationsareshownbelow:

path to terminal node Win 1, we tender for CANA only which costs 60.000, at a price of
105.000, and win the contract, so incurring equipment supply costs of 19.000, the total
profitis:105.00060.00019.000=26.000.

path to terminal node Lose 1, we tender for CANA only which costs 60.000, at a price of
105.000,andlosethecontract,thetotalprofitis:105.00060.000105.000=60.000.

path to terminal node Win 2, we tender for CANA only which costs 60.000, at a price of
95.000,andwinthecontract,soincurringequipmentsupplycostsof19.000,thetotalprofit
is:95.00060.00019.000=16.000.

path to terminal node Lose 2, we tender for CANA only which costs 60.000, at a price of
95.000,andlosethecontract,thetotalprofitis:95.00060.00095.000=60.000.

path to terminal node Win 3, we tender for CANA only which costs 60.000, at a price of
90.000,andwinthecontract,soincurringequipmentsupplycostsof19.000,thetotalprofit
is:90.00060.00019.000=11.000.

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Figure1

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path to terminal node Lose 3, we tender for CANA only which costs 60.000, at a price of
90.000,andlosethecontract,thetotalprofitis:90.00060.00090.000=60.000.

path to terminal node Win 4, we tender for CONB only which costs 25.000, at a price of
55.000,andwinthecontract,soincurringequipmentsupplycostsof14.000,thetotalprofit
is:55.00025.00014.000=16.000.

path to terminal node Lose 4, we tender for CONB only which costs 25.000, at a price of
55.000,andlosethecontract,thetotalprofitis:55.00025.00055.000=25.000.

path to terminal node Win 5, we tender for CONB only which costs 25.000, at a price of
50.000,andwinthecontract,soincurringequipmentsupplycostsof14.000,thetotalprofit
is:50.00025.00014.000=11.000.

path to terminal node Lose 5, we tender for CONB only which costs 25.000, at a price of
50.000,andlosethecontract,thetotalprofitis:50.00025.00050.000=25.000.

pathtoterminalnodeWin6,wetenderforbothCONAandCONBwhichcosts66.000,ata
priceof170.000,andwinthecontract,soincurringequipmentsupplycostsof28.000,the
totalprofitis:170.00066.00028.000=76.000.

pathtoterminalnodeLose6,wetenderforbothCONAandCONBwhichcosts66.000,ata
price of 170.000, and lose the contract, the total profit is : 170.00066.000170.000 =
66.000.

pathtoterminalnodeWin7,wetenderforbothCONAandCONBwhichcosts66.000,ata
priceof150.000,andwinthecontract,soincurringequipmentsupplycostsof28.000,the
totalprofitis:150.00066.00028.000=56.000.

pathtoterminalnodeLose7,wetenderforbothCONAandCONBwhichcosts66.000,ata
price of 150.000, and lose the contract, the total profit is : 150.00066.000150.000 =
66.000.

Wecanorganizetheaboveinformationinatableliketheonebelowforquickreview.
TerminalNodes

Win1

Lose1

Win2

Lose2

Win3

Lose3

Win4

TotalProfitinEuros

26.000

60.000

16.000

60.000

11.000

60.000

16.000

TerminalNodes

Lose4

Win5

Lose5

Win6

Lose6

Win7

Lose7

TotalProfitinEuros

25.000

11.000

25.000

76.000

66.000

56.000

66.000

Table3

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Step3
Inthesecondstepofthedecisiontreesolutionprocedureweworkfromtherighthandsideofthe
diagrambacktothelefthandside.

ForchancenodePrice1theEMVis0.15(26.000)+0.85(60.000)=47.100

ForchancenodePrice2theEMVis0.60(16.000)+0.40(60.000)=14.400

ForchancenodePrice3theEMVis0.80(11.000)+0.20(60.000)=3.200

HencethebestdecisionatdecisionnodeCONAistotenderatapriceof95.000(EMV=14.400).

ForchancenodePrice4theEMVis0.10(16.000)+0.90(25.000)=20.900

ForchancenodePrice5theEMVis0.95(11.000)+0.05(25.000)=9.200

HencethebestdecisionatdecisionnodeCONBistotenderatapriceof50.000(EMV=9.200).

ForchancenodePrice6theEMVis0.25(76.000)+0.75(66.000)=30.600

ForchancenodePrice7theEMVis0.80(56.000)+0.20(66.000)=31.600

HencethebestdecisionatdecisionnodeCONABistotenderatapriceof150.000(EMV=31.600).
HenceatrootdecisionnodeDecisiontherearethreealternatives:

tenderforCONAonlyEMV=3.200

tenderforCONBonlyEMV=9.200

tenderforbothCONAandCONBEMV=31.600

Hence the best decision is to tender for both CONA and CONB at a price of 150.000 as it has the
highest expected monetary value of 31.600. The downside is a loss of 66.000 and the upside is a
profitof56.000.ThecompleteDecisionTreewiththebestpathtoterminalnodeisshowninFigure
2.

Exercise
BuildtheabovetreemodelwithDETRETUandsolveit.

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Figure2

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