Know and Avoid Common Decision-Making Mistakes

To err is human, but don’t give up! You can learn to make better decisions. You have the intellect necessary to gather and objectively assess the relevant facts. Just slow down, conduct a level-headed analysis and get familiar with psychological biases that tend to derail sound decision-making for humans (so you can avoid them). Here are the common ones: Recency Bias: tendency to be overly influenced by recent events. Our memory of recent events is more salient than those of more distant experiences. This seemingly innocuous memory trait can seriously warp our ability to see the world objectively. And because our actions are influenced by our experiences and beliefs, overemphasis on recent events leads to skewed beliefs and inappropriate assessments. During the bull market of 2003-2008, many investors lost sight of the long-term history of the stock market. They invested as if the future would mirror the more recent past (i.e., steady gains). This occurred in the real estate market, too. But an objective review of the facts would have led one to conclude that the stock market goes up AND down, sometimes way down, and the real estate industry has long been marked by boom-and-bust cycles. Loss Aversion Bias: tendency to place a higher value on risk avoidance than gain. Investment involves risk, so persons with a high degree of risk aversion tend to make poorer investment decisions. For example, an overwhelming amount of data supports that the stock market is the best option for at least a portion of one’s long-term investment dollars, but many avoid the market for fear of loss. They choose to invest in more “safe” investments, such as U.S. government bonds, though statistics show that the choice is almost guaranteed to result in substantially lower long-term returns. Loss aversion plays out with investors in another interesting way — unwillingness to accept loss. So investors deal with a losing investment by rationalizing that it’s not a loss unless and until it is realized, meaning that until they sell out of the position at a loss, they hold onto it. They watch it go all the way to zero instead of doing the rational thing — cutting their losses early and getting their money redeployed into more promising and higher-yielding investments. Finally, car rental companies prey on this by getting us to buy additional “damage waiver” insurance, and phone companies try to get us to accept flat-fee service to avoid the risk of getting a surprise bill. Overconfidence Bias: tendency to overestimate one’s own abilities. Studies show that people tend to overestimate their intellect and abilities. For example, in a spelling task, students scored an 80% on average when they were “100% certain” that they scored 100%.1 Similar to this is optimism bias — the tendency for people to be overoptimistic about the outcome of current efforts or planned actions. This includes overestimating the likelihood of positive outcomes and underestimating the likelihood of negative outcomes, such as graduate school students overestimating the number of job offers they’ll get and starting salary. It seems that we develop beliefs and then look for supporting evidence. So experts suggest we try looking for evidence that refutes a conclusion or theory that we’ve concocted. Ask others to “poke holes ” or provide refuting information. Commitment Bias: tendency to support or justify a past decision in the face of contrary evidence. Irrational loyalty to an old strategy that was previously successful (staying the course) is not in our best interest. Some catastrophic airplane crashes have been the result of commitment bias. Pilots develop a myopic focus on their commitment to on-time arrivals and departures, and ignore clear and obvious danger signs. Businesses fall prey to commitment bias, too. Experts suggest we step back from the project or task at hand and ask, “If I were just arriving on the scene and reviewed the facts, is this solution the rational one?” Anchoring Bias: tendency to rely too heavily on one trait or piece of information when making decisions. When I was a senior in high school, the college I was slated to attend had a very active fraternity/sorority system. I didn’t know which would be best for me, but then I overheard a beautiful older woman say, “Sigma Alpha Epsilon is the best.” That’s all that mattered to me. I ignored every other piece of information and signed SAE. Clearly, my decision was irrationally anchored to a very small piece of information. Another example is overreliance on the beginning price (i.e., asking price) in negotiating purchase of goods or services. “Hey, this MUST be a good deal, it’s 30% off the asking price.” The subject buyer has anchored his/her assessment of “fair price” or “value” on a single piece of largely irrelevant information — the asking price. Finally, anchoring bias plays out in everyday life in the tendency of some people to let a single, terrible event dominate their psyche and decision making, such as when an individual avoids investing in the stock market because of a bad prior investment. Value Attribution: tendency to place value on a person or thing based on a very limited piece of data. First impressions work this way. When we know very little about a person or thing, we — consciously or subconsciously — imbue him, her or it with the qualities we perceive in the things in close proximity, such as the clothes or surroundings. This is why consumer product manufacturers try so hard to get their products seen with famous people. It’s why packaging matters and Mercedes dealerships are spotless and marble-clad. But if we want to make better decisions, we must keep in mind that context clouds our ability to see real attributes. We may turn down a pitch or idea presented by the “wrong” person, or blindly follow the advice of someone we highly regard. Similarly, our expectations of “context” influence our assessments. Value attribution bias hinders our ability to objectively assess value. Studies show that the price we pay for a ticket affects our enjoyment of the performance. So make a conscious effort to see things for what they really are and not just how they appear to be. Differentiate between “packaging” and real attributes. Initial impressions can be wrong, of course. No cure-alls protect you from these biases, but here are some suggestions. First, when you face a financial or business decision and the stress level is high, step back. Take a break, remove yourself from the stress and revisit the decision after you cool down. Second, if it’s a transaction or business deal you’re already in, ask yourself, “If I were just appearing on the scene, would I get in today at the current terms or would I decline?” Third, run the facts by a person you trust. Don’t argue with his or her answers, just give him/her the facts as best you can, and gain his/her thoughts and perspectives. Fourth, once you have developed your interpretation or viewpoint, test it. Look for refuting evidence. Fifth, remember Warren Buffett’s #1 Rule of Investing — Margin of Error. Our ability to assess and predict is imperfect, so leave a lot of room for error. Finally, be willing to cut your losses. Get out with what you can and move on to more promising endeavors. _{1 Adams, P. A. & Adams, J. K . (1960). Confidence in the recognition and reproduction of words difficult to spell. American Journal of Psychology, 73 pp. 544-552.} This article was written by the experts at The Business Owner. If you are the owner of a private business, go to www.TheBusinessOwner.com or call us at (800) 634-0605 for more no-nonsense how-to information.

Read More >>

Tips for Wringing Out Cost and Improving Gross Margins

1. Purchase, Don’t Expedite. Time is money. Given a little time, a purchasing manager worth his/her salt should be able to wring a significant amount of cost out of any purchase. So give him/her incentive and time. Expedited orders add substantially to freight cost, and when you need it quick, your bargaining power is weak.
2. Use ABC Stratification. The ABC inventory control method derives both its simplicity and effectiveness from the 80-20 rule: 80% of a company’s revenue is derived from 20% of its offerings. Additionally, within this 20%, you should learn what components make up 80% of the cost of these products, and then work to continually reduce the cost.
3. Competition Is Key. As cost control legend Henry Figgie, Jr. says, “Competition is the key to any free market system.” It’s also the key to cost control in your business. Always get bids from multiple vendors. Always let each vendor know you’re getting bids from others and that price matters. Always open your door to new vendors and new quotes. Never single-source.
4. Standardization of Materials. Avoid use of special, unique, rare or exotic materials. Move to items, parts or materials that are common and available for low prices from a variety of sources. Identify the expensive parts you purchase. Find substitute parts that could be used instead. If necessary, re-engineer the product or part so cheaper generic parts can be used.
5. Reduce Shipping Cost. It’s not just about the cost of the purchased items, but rather total delivered cost. Shipping (freight, delivery) costs must be minimized, too. Watch them. Track them. Always specify the lowest cost. Talk to your vendors about how you can lower shipping cost. After all, what you want is the lowest delivered cost.
6. Eliminate Graft, Conflict of Interest. The person who handles your purchasing spends significant dollars. You definitely don’t want this person to have any reservations about screwing down costs at every opportunity. Do not hesitate to switch vendors. Do not allow this person to accept, nor any vendor to provide, gifts or perquisites of any kind to your purchasing manager. Annually send a letter to each vendor that communicates this policy.

This article was written by the experts at The Business Owner. If you are the owner of a private business, go to www.TheBusinessOwner.com or call us at (800) 634-0605 for more no-nonsense how-to information.

Read More >>

ABC Inventory Control to Boost Profit and Carve Out Tax-Free Cash

The skill of a company in procuring (i.e., purchasing) parts, product and managing inventory can be the difference between success and failure. This is because:

1. The profitability of a business — or lack thereof — is established by the gross profit margin. That is, the profit left over from each sale after the direct expenses are deducted. For many businesses, the primary direct expense is procured product.
2. Inventory ties up a significant amount of cash in many businesses. Poor inventory management can drain a company’s cash, raise financial risk by requiring higher levels of borrowing, and erode profits due to outsized inventory spoilage, obsolescence or theft.

ABC inventory control is a relatively simple, widely used way to wring out cost, improve gross margins and increase inventory turns. Increased “turns,” of course, lower the amount of inventory-on-hand. If inventory-on-hand can be lowered from $500,000 to $300,000, the result is $200,000 in positive cash flow. If the business uses the accrual system of accounting for tax purposes, the windfall doesn’t trigger tax.

80-20 Rule: Focus Where You Can Have the Most Impact

The ABC inventory control method derives both its simplicity and effectiveness from the 80-20 rule. So, to begin to understand and apply ABC inventory control, the business owner should begin here: 80% of a company’s revenue is derived from 20% of its offerings. Every business owner should know which of his/her products or services produce the lion’s share of the revenue and profit. Additionally, within this 20% you should learn what components make up 80% of the cost of these products. As Harry Figgie says in his The Cost and Profit Improvement Handbook, “These are the parts that make up the largest share of the company’s material costs.” Armed with this basic information, the business owner can sit down his/her purchasing manager and begin looking for ways to lower cost and reduce the amounts kept on hand.

Divide and Concur

Building on the simple 80-20 rule, ABC inventory control methodology calls for each purchased item to be separated into one of three groups: A, B and C. “A” items are those relatively few that represent the highest cost and generally the greatest investment. As such, these items should be given considerable attention so:

• stock levels of these expensive items are minimized so the cash tied up in inventory is kept as low as possible, and
• stockouts of these items are rare despite the low levels maintained on hand

Conversely, items that cost the least are categorized as “C” items and can be purchased much less frequently, such as once per year. Doing so will reduce the time required to deal with ordering (and thus free up time to focus on A items) and render little financial consequence because the total dollar amount is insignificant. Of course, all other parts are labeled “B” items. These items can be ordered in smaller quantities than C parts, maybe monthly or quarterly, but much less frequently than “A” parts. The accompanying table shows a sample breakdown of purchased items divided into categories A, B and C. The table also contains the basic data used to sort them. As you can see, four of the 30 inventory items (13%) have been designated “A” parts and account for 88.7% of total annual purchases (in dollars). Eighteen of the 30 (60%) have been designated “C” parts and account for just 1.8% of total annual purchases. The balance (8 of the 30 or 10%) are “B” parts. Laid out this way, it is easy to see the simple logic: 89% of this sample business’ costs come from just 13% of its purchased items. Focusing on this subset will greatly simplify the purchasing and inventory management tasks. And, by focusing on the few that will yield the greatest results, the results can be significant. It entails minimizing the on-hand count of these items, frequent monitoring of stock levels for each, and frequent reordering. The high cost of these items provides the return on the extra time spent. The C items account for a full 60% of the purchased items but consume less than 2% of the costs. It makes no sense spending much time on these items, so they should be set up to require minimal effort. Typically this means buying just once or twice a year. The accompanying table labeled “Inventory Reduction Examples” shows how the ABC method can drastically reduce the amount of cash tied up in inventory. Here, a 62% reduction of the cash tied up in inventory.

Margin Improvement

In addition to inventory reduction and the important positive cash flow impact that a reduction can provide, ABC is a powerful tool for helping the business owner determine where to focus his/her energies to successfully wring out cost and improve gross profit margins. With the simple analysis provided, the number of inventory items that require cost reduction focus is cut by 80% or 90%. Time, of course, is scarce for all of us. Scarce for our employees as well. This is the power of ABC inventory control methodology. By knowing where to focus, one can gain a maximum return on one’s investment of time and energy. The result can be the very survival of one’s business, or the difference between just getting by and making some real money. After all, 20% of the businesses make 80% of the profits. Apply ABC inventory control to your business and you’ll be well on your way to the top 20%. Note: This article was adapted by David L. Perkins, Jr. using, in part, information contained in “The Cost Reduction and Profit Improvement Handbook” by Harry E. Figgie, Jr. This article was written by the experts at The Business Owner. If you are the owner of a private business, go to www.TheBusinessOwner.com or call us at (800) 634-0605 for more no-nonsense how-to information.

Read More >>