Five Decision-Making Concepts Everyone Should Understand
Updated: Oct 14, 2019
We all make decisions every day, most of them before lunchtime. We decide on tasks and form thousands of opinions throughout the day. Some of us also make decisions that extend beyond ourselves. We maybe the decision-makers in our organizations, families or communities. Most decisions involve money, time or both. The following concepts are vital for decision-makers of all backgrounds.
Make Decisions That Align With Long-terms Goals
The decision-making process should always start with long-term goals. It is not possible to make a smart decision on what you need to do today if you don’t understand where you want to be in the future. Good decisions can only be made the context of a longer-term plan. For instance, an organization with a long-term goal of penetrating the European market shouldn’t open an office in Bolivia even if Bolivia may be a very viable market. Many organizations get off-track because they either don’t have long-term goals to guide them or they ignore the long-term goals and waste energy chasing the flavor-of-the-month.
This situation is known as the good idea trap. When an idea is good own its own terms but poor in the context of the long-term objectives or doesn’t maximize the limited resources of the organization.
Acknowledge Finite Resources
The most important concept in decision making is that all organizations have finite or limited resources like money and time. This concept should be at the core of almost all decisions. Because organizations have limited resources the decision maker must consider the fact that not all “good ideas” can be funded and some rationalization process needs to take place. Traditionally we call this resource limitation a “budget” or a “plan.”
This is the process of pushing the concept of limited resources down in the organization. This resource limitation also applies to the time people spend on projects and tasks. The manager of those human resources needs to be accountable to for ensuring those limited people resources are used wisely or in pursuit of the goals of the organization. For example, if you have three initiatives all costing $10,000 but you have a resource constraint of $20,000, then you can only pick two of the three initiatives even though all three are “good ideas.” If a fourth initiative is introduced, then one or the other two must be discontinued to fund the fourth initiative if it best furthers the organizational goals. Decision makers must understand the resource constraints and then prioritize the alternatives.
There’s No Reward Without Risk
Taking risk is the means by which a return or value is created. In theory, an organization that takes no risk (which is really hard to do) can not create value. The key for decision makers is to ensure the risk taken matches the potential reward. An easy example is investing in a new product or location. If it takes a million dollars to create a new product that, even if sold to 80% of your customers, only generates a $100,000 in profit over five years (excluding cost of investment), then there is a risk and reward imbalance. Companies who invest in new markets or products have a high risk because of lack of track record or experience so they need to ensure that the return at some reasonable level of success makes sense. The world is littered with profiteers promoting a 20% return without any risk. This dream scenario is not possible; investor beware.
Use Assets Wisely to Create Value
Fundamentally, value is created when an asset is utilized. An asset can be a machine, a building, time, education, etc. For instance, it is better to own a restaurant with a 30-person capacity serving 100 meals a night versus a restaurant with 100-person capacity serving a 100 meals night. The restaurant with the 30-person capacity is more fully utilizing it resources versus the restaurant with a 100-person capacity. The revenue may be the same but the restaurant with the lower capacity has lower fixed costs which are be spread over the same number of meals.
This is the life of a real estate developer who takes raw land and decides which asset best utilize the land – apartments, condos, retail, a single-family home. This decision is referred to as the highest and best use of the land. Airlines, hotels, apartment owners or any other high fixed cost businesses understand this concept well. These are ultimate tests of understanding the interplay between price and utilization. The decision made must consider the right capacity and then determine the best way to maximize the use of that capacity.
The Cost of Something is Much Greater than Its Price
What something costs is rarely its “price.” Even if you buy a carton of milk at the store for $3.00, the cost is not $3.00. The cost is $3.00 plus the cost to go the store and the time it took you to get there. You can expand this concept to the cost of a meal at a restaurant, it is the food cost plus that meal relatively proportion of the other fixed costs like rent, electricity, staff, etc. Larger decisions like purchasing a new financial system or expanding to a new market involve many hidden costs related to people’s time and distractions to other important initiatives. So, the right question for the decision maker is “what is the direct cost and what is the total cost of the contemplated project”. Some of the costs included may be “soft” or “opportunity” cost which may be hard to quantify but should be considered.
Decision Making Checklist
What are our long-term goals? Is the decision consistent with those goals?
What are our resource constraints? Does the decision maximize those limited resources?
What are the risks? Is the reward commensurate with the risks?
Are we creating the right capacity, and do we have a plan to maximize the utilization of that capacity?
What is the total cost of this decision?