By Eli Schragenheim and Alejandro Céspedes (Simple Solutions)
This is the second of our posts on the topic of biases and how TOC should treat them. Behavioral biases mean that many people make decisions that seem wrong from the outside. Such judgment is based on considering the cause-and-effects from the decision up to the expected results that seem lower than from a different decision. The troubling point for the TOC community, and several other approaches trying to change established paradigms, is to understand how come managers continue to make decisions that lead to undesired outcomes. We’ll focus this time on ‘mental accounting’ and ‘sunk cost’, and like the first post, we’ll eventually deal not just with the bias itself, but mainly how it affects managing organizations.
Suppose that you bought yourself a new car but it turned out to be very disappointing. How would you consider the idea to sell the new car, for just 75% of what you paid, and buy a new one?
The above example demonstrates two different biases; the sunk cost fallacy and mental accounting, both blocking the idea of selling the car and buying a new one.
The sunk cost fallacy
‘Sunk cost’ is a cost that has already been incurred and cannot be recovered. Standard economic theory states that sunk costs should be ignored when making decisions because what happened in the past is irrelevant. Only costs that have not been incurred so far and are necessary to the decision at hand should be considered. This seems to be a logical process without letting emotions interrupt the process. However, in reality people prefer to sit through a boring movie instead of leaving halfway through because the ticket has already been paid for. Organizations continue to invest money in unpromising or doomed projects just because of the time and money they’ve already put in. The simple realization is that emotions have enough power to twist the logical process of decision making.
In the car example, the remaining cost of the car that cannot be redeemed, being 25% of the original price, is sunk cost, meaning it shouldn’t be part of the decision. What should be part of the decision is whether you can afford a new car. Assuming that buying the disappointing car has consumed all the money you could afford then you might need to look for a second-hand car that will be better tuned to you. Isn’t it quite natural to think like that? However, most people would stick to the disappointing car without even considering selling and buying another car they can somehow afford, just to avoid the feeling of recognizing they bought the wrong car. Ignoring sunk costs means openly admitting a mistake. This causes us a very unpleasant feeling that threatens our self-confidence, so we try to ignore it by pretending the spending was worthy.
Mental accounting
The decision to buy a car without having to consider the full current financial state of the buyer, based solely on the budget allocated for this specific purpose, is mental accounting. This bias, considering only the available money for a specific topic, is typical to significant categories of spending money, usually not top priority, but important enough not to ignore. The core cause behind this bias is different than the cause for evading sunk cost.
Maintaining a special ‘account’ for a specific need is actually a way to protect a need from being stolen by other needs. The protection is required because we don’t have the capacity and capability to view, every time we need to make a decision, the whole financial situation against the whole group of different needs and desires in order to come up with the right priorities. Thus, we create those accounts for worthy needs, and decouple them from re-considerations, even though from time to time we might make a serious error.
These biases seem reasonable for the average Joe, but what is their impact on managing organizations?
Like we saw in the previous post these biases are even more relevant for organizational decision making because of the decision maker’s concern about how these decisions might be judged by others, especially after-the-fact judgment based on the actual outcome. The point here is that if the fact that a significant sum was invested in something that produced no value then somebody has to pay for such a mistake. Ignoring the sunk cost reveals the recognition of money being wasted.
Thus, ‘sunk cost’ is a devastating element in organizational behavior being responsible for continuing with projects when it is already clear there is no value left in them. Another typical case is refusing to write-off inventory that has no chance of being sold, or refusing to sell it for less than the calculated cost. The direct cause is practical and rational: do not shake the boat, because if you do, then all hell breaks loose. This is much more devastating than individuals trying to keep their dignity by not admitting wasting money without getting real value.
The impact of mental accounting on organizations is HUGE! It encompasses all the aspects of what is called in TOC ‘local thinking’. It is caused by being unable to handle the complexity of considering the ramifications of any decision on the holistic system. Organizations are built of parts and it is simple enough to measure the performance of every part, even when its real impact on the organization is quite different. Evaluating the full impact of a decision on the whole organization is frightening, because it seems way too complicated.
The common way to reduce the impact of complexity is to assign an account to every product, big deal, and client, and consider only the data required for maintaining that specific account: the revenues, the costs and the calculated “profit”. We put “profit” in quotation marks because without considering the wider dependencies, including the capacity of critical resources, there is no good measure of the true added profit of the product/deal/client to the organization. Eventually current cost accounting methods are based on mental accounting to simplify the overall system.
Understanding the difficulty of considering all the dependencies within the holistic system is critical for the efforts of the TOC insights to overcome the difficulty without the resulting distortions. The basic thinking habits of people are set to bypass complexity in a straight-forward way of looking just on the decision at-hand and its immediate data, avoiding information that complicates the simple rules.
The TOC way of simplifying complex situations is by finding the few variables that impacts the outcomes much more than the level of the ‘noise’ (the inherent regular variation). The existence of uncertainty, on top of the complexity, actually simplifies the situation, because the variation introduces a level of noise that makes it practically impossible to optimize within that noise. Recognizing the limitation of optimization enables management to look just for the few variables that impacts performance beyond the noise and by this vastly simplifies the complexity and provides a way to make superior decisions. TOC may seem to a newcomer more complicated than the common way. Actually all it requires is a lot of common sense and clear recognition that approximately right is much superior to precisely wrong.
A Spanish translation of this article can be found at: www.simplesolutions.com.co/blog
Eli Schragenheim 