Sunday, January 17, 2010

The Cost of Coffee - How Built in Brain Rules Mislead Economic Decisions

I had promised myself not to blog today (too busy working), but just a few minutes ago I saw a prime example of cost world thinking gone wrong:


I am sitting in a coffee shop, drinking coffee. Awhile ago, a family sat down at a table close to mine and began discussing a rather peculiar management policy in force at this shop: 30-60 minutes before closing, the shop won't brew more coffee if it runs out. This is to ensure that no coffee, and thus no money, is wasted.

If you run your business from a Cost Accounting perspective, a policy like this makes sense. Most companies have policies like these, policies designed to minimize cost. When the financial crisis struck in 2008, cost cutting was the method most companies used to balance the reduction in Net Profit. Stands to reason, right: Net Profit = Throughput – Operating Expense. Therefore, if Throughput drops, the only recourse is to reduce Operating Expenses.

This reasoning is simple, analytical, easy to understand, and totally daft!

I am sure you have figured it out already: The profit from selling a single cup of coffee will pay for making an entire pot. Even more important: Not selling a cup of coffee will annoy customers. They may go elsewhere.

Once lost, it may be difficult to gain a customer back. Think of the stores where you do not shop, the suppliers you no longer use, because somebody else provided better service. If one of those places improved, would you start using them again? Probably not. First of all, how would you know about their improvement? You no longer use their services. Second, even if someone you trust tells you about them, you have now built a relationship with someone else. That bond might be difficult for someone else to cut.

In the case of the coffee shop, just about everyone can figure out that their policy is a bad one except for the coffee shop owner. If she understood, she would change the policy.

What is it that makes the problem difficult to understand for the coffee shop owner? There are two likely contributing factors:

  1. Cost focus by education and culture. Most people believe cost is always the most important factor to control. Even if they understand better, they have a deep rooted belief cost is the only factor they can control.
  2. Loss aversion. The human brain has evolved to make very quick decisions about very simple things. To do that the brain uses simple decision rules. One of those rules is that it is better to hang on to what you have got, rather than risk it to get more.
Of course, Loss aversion, the decision rule in the brain, shapes and reinforces the cost focus in our economic models and in our culture.

Raising the amount of money involved does not necessarily make us more inclined to reason about the situation. Instead, it raises the amount of stress involved and makes us rely even more on our built in decision rules.

Once the decision has been made another of the brain's decision rules, Confirmation bias, sets in. Confirmation bias makes us look for evidence that confirms our decision, regardless of whether that decision was a good one.

So much for individual thinking, but it gets even more difficult to calculate the cost of a cup of coffee because of Groupthink. Humans are social animals. We are so social that belonging to a group is often more important to us than thinking critically about decisions.

Groupthink is a strong social force. It is the reason why people tend to stick with the same political affiliations as their relatives. It is one of the reasons why we got into the financial crisis of 2008. It is also the reason why it is unlikely that a coffee shop employee will suggest to the boss that she should change the policy about not brewing coffee the last hour before closing the coffee shop. An employee that did that would risk losing his boss's approval and jeopardize his standing within the group.

Note that the employee might feel this pressure even if the employer would be delighted to have input from the employee. It is one of the built-in brain rules.

There are plenty of techniques for reducing the pull of the decision rules that mislead us. The problem is that to get someone to be interested in learning to use these techniques, we need to appeal not to the part of the brain that reasons, but to the part of the brain that makes decisions using the very rules we want to teach them how to work around.

Then, and only then, can we help people figure out the true cost of a cup of coffee, or the true cost of more important business decisions.

3 comments:

okhydrocephalussupport said...

I like this.

I worked at a small coffee shop, and the owners often reminded us that .. I think it was a medium cup paid for the pot of coffee.

And I definitely don't like going onto a coffee shop and not being able to get coffee. Why would they even bother being open, then?

Catus Lee said...

True.

Very often owners focus on minimizing the visible "downside" risks while leaving the upside benefits unattended.

A client of mine claimed that he want to build a stronger and capable operation team for the expansion of his retail chain. But when he look at the near future of the the inflated payroll related to hiring some good people to build a talent pool, he retreated and "believe" that the business should grow through spreading out the current pool of people and hire only as needed.

The growth was much slower that what we believed could be, the highly profitable business lost some good money, let alone the effect of pushing those incapable up the ladder for the sake of growth.

Having a reasonable and sensible view of a situation/business is not very common sense. :)

Tobias Fors said...

HI Henrik! Thanks for this excellent post. A few weeks ago I read an interesting article (can't find the link again) about an organization that had set out to help microfinanced businesses. One of the things they found could make great impact was education about the very things you write about here. You do a great job educating! Thanks again. /Tobias