Tuesday 1 May 2012

Information relevance

Short post today, but it's about decision making.  Often people get bogged down in too much information, making it very difficult to figure out what the best choice is in a given situation. In order to have clarity to make the right decisions it is important to weed out confusing information that should not affect the outcome and focus on the important information.  There are two main criteria for determining what information should be considered.

Different under competing alternatives

Costs or benefits of a decision only matter if they are different between your choices.  This helps prevent confusion.  Imagine you're travelling a lot and considering whether to rent an apartment in another city, or to just stay in a hotel.  When adding up the costs, you wouldn't include the cost of the plane tickets, your house in your home city, or how much your wife will spend on movies and popcorn for the days you're away.  All of these costs will be the same, whether you rent an apartment or stay in a hotel.

Seems obvious, right? But it's easy to forget.  Imagine you're deciding whether or not to buy a new bike so you can save the environment and not drive to work, and you add up the costs of the car you're saving vs. the cost of the bike.  How would you do it?  You might start by adding up the costs of owning the car, dividing it by the number of days in the year, and multiplying the result by the number of days you'll be biking in order to figure out how much money you save.  

The problem with this approach is that you would be including a lot of irrelevant information.  You need to subtract costs that are the same between alternatives.  Information like monthly car payments, insurance and changing summer tires for winter ones are the same whether you buy the bike or not. Relevant information would be the gasoline you would save, wear and tear on the vehicle in the form of repairs and oil changes, as well as the cost of the coffee you'd buy at the gas station that instead you'll get for free at the office because you're biking.

Has a bearing on the future

From a management decision-making perspective, information is only pertinent if it has a bearing on the future. 

We as human beings get stuck in the past.  We want to rectify our mistakes, atone for our sins, and redeem what went wrong.  This zeal to fix history can lead us around and around in circles of bad decisions.  We look at ten thousand dollars spent on outdated inventory that nobody wants to buy and we keep it around, not wanting to purchase new inventory because of the money we already lost. We avoid going back to school for a degree in the field we want to be in because we just finished an unrelated degree that we don't really want to use.  We avoid having a second child because the first one started dealing drugs to his kindergarten class.

This thinking will always lead to bad decisions, because to set the future, the only relevant information is information that pertains to the future. 

The example

The biggest example of irrelevant information is a sunk cost. A sunk cost is always irrelevant because it does not meet the two criteria above.  You've paid for a machine, but a better machine comes out next year that makes more money.  Should you replace your machine? The money you've already paid is a sunk cost.  You've paid it whether you replace the machine or not, and that money has no bearing on the future. The right decision can only be made by looking at the cost and value of the new machine, not the money you spent on the old one.

Here's an example to help you remember. I'm very proud of this example.  I woke up this morning and thought about it.  I think I may have dreamed it last night. This example is actually the reason for this blog post.  

Imagine you are a zoo keeper and you purchased a large African elephant last year for $200,000.  It was a deal because he was a damaged floor model - he was missing his left ear.  You expect the elephant to live 30 years and drawing in $1000/day on average and cost $200 in food and upkeep. Things are going well, but a year later you hear about a man selling a healthy elephant.  He costs $250,000 but would bring in $2000/day instead of $1000.  Sadly there's not enough room in your zoo for two elephants, so your first elephant would have to be sold off and you could only get $100,000 for it.

It's tempting to say "I just spent $200,000 on the one-eared elephant last year.  I want to get another year out of it before buying the new elephant so I don't waste it."  That would be wrong though.  You've already spent the money so it's the same among alternatives and has no bearing on the future.  The one-eared elephant is a sunk cost.  And sunk costs are always ear-elephant.


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