Decision Analysis

Decision analysis helps you make better business decisions when you're uncertain about the future - like choosing between different strategies by comparing their likely outcomes and risks.

Business Foundation

Expected Value Decision Making

Choose alternatives based on weighted average outcomes:

Process:

1. Identify Alternatives: List all possible decision options
2. Define States: Identify possible future scenarios
3. Assign Probabilities: Estimate likelihood of each scenario
4. Calculate Payoffs: Determine outcomes for each alternative-scenario combination
5. Compute Expected Value: Probability-weighted average of all outcomes
6. Select Optimal: Choose alternative with highest expected value

Business Applications:

• Product launch decisions under market uncertainty
• Investment portfolio allocation across economic scenarios
• Supply chain capacity planning with demand variability
• Strategic acquisitions with regulatory approval risks

Decision Rule: Select the alternative with the highest expected value

Decision Trees

Visual framework for sequential decisions:

Components:

• Decision Nodes: Points where managers choose between alternatives
• Chance Nodes: Points where external events determine outcomes
• Branches: Paths representing decisions or events
• Payoffs: Final outcomes at the end of each path

Analysis Process:

1. Map out all decision sequences and uncertain events
2. Assign probabilities to uncertain events
3. Calculate expected values working backwards from outcomes
4. Identify optimal path through the decision tree

Utility Theory

Expected Utility Maximization

Accounts for risk preferences in decision making:

Concept: Organizations and individuals have different risk tolerances that affect their optimal decisions. Expected utility combines potential outcomes with risk preferences to identify the best choice.

Business Implementation:

• Survey stakeholders to understand risk tolerance
• Define utility functions that reflect organizational risk preferences
• Weight outcomes by both probability and utility impact
• Select alternatives that maximize expected utility rather than raw expected value

Risk Attitudes

Different organizations exhibit distinct risk preferences:

Risk Averse Organizations:

• Prefer certain outcomes over uncertain ones with same expected value
• Examples: Insurance companies, regulated utilities, pension funds
• Decision bias: Choose lower expected returns for reduced uncertainty

Risk Neutral Organizations:

• Focus purely on expected monetary value
• Examples: Large corporations with diversified portfolios
• Decision approach: Select highest expected value regardless of variability

Risk Seeking Organizations:

• Prefer uncertain outcomes over certain ones with same expected value
• Examples: Venture capital firms, startups, speculative investments
• Decision bias: Accept lower expected returns for potential upside

Financial Services Example: Life Insurance Investment Strategy

Business Context: A life insurance company must decide how to invest 2B in premium reserves across different asset classes while meeting regulatory requirements and managing risk.

Decision Variables:

• = Conservative strategy (80% bonds, 20% stocks)
• = Balanced strategy (60% bonds, 40% stocks)
• = Growth strategy (40% bonds, 60% stocks)

Economic States:

• = Recession (Probability = 0.2)
• = Stable growth (Probability = 0.6)
• = Economic boom (Probability = 0.2)

Payoff Matrix (5-year returns in billions):

Expected Value Analysis:

Conservative Strategy Expected Value:

• (0.2 × 2.4B) + (0.2 × 2.36B

Balanced Strategy Expected Value:

Considering Risk in Decisions

Risk-Averse vs Risk-Taking

Not all businesses should make the same decision, even with identical expected values:

Risk-Averse Business (steady, established company):

• Prefers certain outcomes over uncertain ones
• Example: Choose guaranteed $100K profit over 50% chance of $250K (expected $125K)
• Focus: Avoid losses, maintain stability

Risk-Taking Business (startup, growth company):

• Willing to accept higher uncertainty for higher potential returns
• Example: Choose 50% chance of $250K over guaranteed $100K
• Focus: Maximize growth potential, willing to accept losses

Decision Adjustment: Consider your company's risk tolerance when choosing between options

Simple Tools You Can Use

Spreadsheet Analysis

• Create simple tables with scenarios and outcomes
• Use probability × outcome calculations
• Good for: Most business decisions, easy to explain

Decision Trees

• Draw branching diagrams showing choices and outcomes
• Many online tools available (Lucidchart, Draw.io)
• Good for: Complex sequential decisions, visual communication

Scenario Planning

• Create "what if" scenarios (best case, worst case, most likely)
• Test how robust each option is across scenarios
• Good for: Strategic planning, long-term decisions

Common Business Applications

Product Development

Decision: Which features to include in new product Uncertainty: Customer demand for each feature Analysis: Compare development costs vs. expected revenue increase

Market Entry

Decision: Enter new geographic or customer market Uncertainty: Market size, competitive response, regulatory changes Analysis: Expected profits vs. investment required and risk of losses

Capacity Planning

Decision: How much production or service capacity to build Uncertainty: Future demand levels Analysis: Cost of excess capacity vs. cost of lost sales from insufficient capacity

Pricing Strategy

Decision: Set product or service prices Uncertainty: Customer price sensitivity, competitive reactions Analysis: Expected revenue at different price points considering demand changes

Making Better Decisions

Gather Better Information

• Research historical data for similar situations
• Survey customers about their preferences
• Analyze competitor actions and results
• Consider expert opinions and industry reports

Test When Possible

• Run small pilots before full implementation
• Use A/B testing for marketing and pricing decisions
• Start with limited geographic or customer segments
• Learn from results before making larger commitments

Plan for Multiple Scenarios

• Don't assume only one future will happen
• Prepare contingency plans for different outcomes
• Build flexibility into your decisions when possible
• Monitor early indicators to detect which scenario is unfolding

Quick Decision Guide

For Major Investments: Use formal decision analysis with expected value calculations For Strategic Decisions: Consider multiple scenarios and your company's risk tolerance For Product Decisions: Test with small segments before full launch For Operational Decisions: Focus on most likely scenarios with backup plans For Pricing Decisions: Test different price points and measure customer response

Decision analysis helps you make smarter choices by systematically considering uncertainty and risk, leading to better business outcomes over time.