How can decision trees improve your budget performance?

1 Clarify your objectives and criteria

Before you start building a decision tree, you need to have a clear idea of what you want to achieve with your budget and what criteria you will use to measure your success. For example, your objective might be to maximize your net income, minimize your expenses, or achieve a certain return on investment. Your criteria might include factors such as cash flow, profitability, liquidity, or risk. You should also define the time horizon and the scope of your budget, as well as any constraints or assumptions that might affect your decisions.

2 Identify and evaluate your options

Next, you need to identify and evaluate the different options that you have for allocating your resources and achieving your objectives. For each option, you need to consider the possible events or scenarios that might occur and how they would affect your outcomes. For example, you might have to choose between investing in a new project, expanding an existing one, or maintaining the status quo. For each option, you might have to consider the market demand, the competition, the costs, the revenues, and the risks. You can use historical data, forecasts, surveys, or expert opinions to estimate the probabilities and values of each scenario.

3 Quantify and compare the expected values and risks

Once you have identified and evaluated your options and scenarios, you can use a decision tree to quantify and compare the expected values and risks of each option. A decision tree consists of nodes and branches that represent your choices and their outcomes. A decision node is a point where you have to make a choice, and it is usually represented by a square. A chance node is a point where an uncertain event or scenario occurs, and it is usually represented by a circle. A branch is a line that connects a node to another node or to an end point, and it shows the probability and value of each outcome. An end point is a final outcome that has no further consequences, and it is usually represented by a triangle. To calculate the expected value of each option, you need to multiply the value of each outcome by its probability and then sum up the results along each branch. To compare the expected values and risks of each option, you can use criteria such as the expected value, the standard deviation, the coefficient of variation, or the expected utility.

4 Make informed and rational decisions

After you have quantified and compared the expected values and risks of each option, you can use the decision tree to make informed and rational decisions that align with your objectives and criteria. You can choose the option that has the highest expected value, the lowest risk, or the best trade-off between the two, depending on your preferences and goals. You can also use the decision tree to identify the critical factors that influence your outcomes and the sensitivity of your results to changes in probabilities or values. You can use this information to adjust your budget accordingly or to perform a scenario analysis or a what-if analysis to test the robustness of your decisions.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?