How Decision Trees Can Help Small Businesses Analyze and Solve Problems
Small business owners are often confronted with a multitude of challenges, from inventory management to marketing strategies, making it difficult to determine the best course of action. However, decision trees offer a simplified approach to decision-making by breaking down complex problems into smaller, more manageable parts. By utilizing decision trees, small business owners can better analyze a problem and choose the most suitable course of action, thus enabling them to navigate their challenges more effectively.
Let's consider a hypothetical scenario where you are the owner of a small clothing boutique. You are considering the possibility of investing in a new line of clothing and need to make a decision on whether or not it would be a wise choice for your business. With several options available, you want to evaluate each scenario and determine the best course of action that aligns with your business goals.
As a small business owner, it's important to understand that investing in a new line of clothing could bring in new customers and increase your revenue. However, it also involves a considerable amount of risk, such as making a large upfront investment, possible inventory excess, and potential financial losses.
To make a sound decision, you need to consider the various scenarios and their implications. You may need to analyze market trends, evaluate customer preferences and feedback, and consider the overall feasibility of the investment. Only after a thorough evaluation of all the available options can you determine the best course of action that suits your business needs and goals.
By using a decision tree, you can break down the problem into smaller parts and analyze each possible outcome. With this method, you can assign dollar values to each option and weigh the potential risks and benefits of each choice. By doing so, you can make an informed decision that maximizes the potential for growth and success. Below we will work through the approach to the problem step by step.
Step 1: Identify the problem
The problem is whether to invest in a new line of clothing. Investing in the new line of clothing would cost $50,000 upfront to purchase inventory and create marketing materials. If the new line of clothing is popular and sells well, it could generate an additional $150,000 in immediate revenue. If the line is unpopular you will not make any additional revenue. You also have the option of paying $10,000 up front for professional third party market research prior to making any decision.
Step 2: Identify the possible scenarios
There are several possible scenarios to consider, such as:
Conduct market research that says to make the investment because the new line of clothing will be popular and sell well
Conduct market research that says to avoid the investment because the new line of clothing will be unpopular and sales will be poor
Don’t conduct market research, make the investment and the new line of clothing is popular
Don’t conduct the market research, make the investment and the new line of clothing is unpopular
For our purposes, I will restrict the scenarios to the four listed above, but real world examples can become much more complex depending on the variables involved.
Step 3: Create a decision tree
Now that you've identified the problem and possible scenarios, you can create a decision tree. Your decision tree might look something like this:
Step 4: Analyze the options
Based on your decision tree, you have two essential decisions to consider:
Decision 1: Should I pay $10,000 up front for market research?
From the decision tree, you can see that there is a risk that the new line of clothing may not sell as well as expected. This risk is mitigated entirely if the market research is conducted, but saving the $10,000 up front presents the risk of the only net negative outcome. On the other hand, not spending the money on the market research up front results in better net financial result if the new clothing line turns out to be popular.
It should also be noted in this situation that doing nothing at all, neither the market research nor the investment opportunity, results in a positive net outcome financially.
Decision 2: Should I make the investment in the new clothing line?
If you paid for the market research, then this is very simple because you have complete certainty in the information (assuming the research was good) before you have had to make the investment decision. However, if you did not pay for the market research and make the decision to invest, you are essentially taking a coin flip on the result.
Step 5: Choose a course of action
Based on these dollar values, we can weigh the options and make an informed decision. Making the investment without the market research has the potential to generate the highest revenue and profit, but also carries the highest risk. Neither paying for the market research nor the new clothing line has no risk, but also no potential for a higher gain.
Performing the market research removes the risk from the investment decision by protecting the downside if the research shows the clothing line will be unpopular. At the same time, if the research shows that the line will be popular, you have sacrificed some of the potential gains for that certainty.
Conclusion
The actual course of action selected in this situation speaks to the risk tolerance of the individual involved and there is no ‘wrong answer’ per se. Objectively as a static scenario, the potential of the additional $20,000 upside is not worth risking a loss of $40,000 in making the decision to invest without the market research. However, that is where confounding factors come into play, such as the ability of the company to pay the $10,000 at the required time to the market research firm. Obviously the scenario above is not perfect and real life situations are much more complex and dynamic. However, by using a decision tree and assigning dollar values to each decision, small business owners break down complex scenarios into actionable steps to bring focus and at least some clarity to strategic decision making.
