Cost Savings Bias & Corporate Mental Accounting

Those of us that have been involved in corporate cost reduction programs will no doubt have been exposed to the bias and sometimes illogical nature of decisions made.  To understand the reasons behind these sometimes odd decisions we can look to a corporate version of what in the individual is called “Mental Accounting”.

Mental Accounting is a set of cognitive processes individuals use to rationalise money they have, use and save.  People tend to group expenditures into groups such as “rent/food/essentials” or “entertainment/holidays/non-essentials”.  One group might be seen as having priority over another if funds are constrained.  A similar approach as suggested by Richard Thaler ¤ is taken with income.  Funds coming to an individual is categorised by their source.  So, income from salary or wages are treated differently from income from gambling, the latter being seen as a “windfall” gain.  With a windfall the usual care taken with expenditure might be ignored.  An example provided by Thaler describes the treatment of casino winnings by a successful gambler.  Winnings are habitually placed in a different pocket/location from seed money.  This amount, often called “house money” is freely gambled away without concern because of its windfall status.  Cutting into seed money might well be treated differently.

Mental accounting also causes us to make apparently illogical decisions.  Again, an example describes how a shopper when told they can get a $5 discount on a $15 calculator, will drive across town to get their saving.  The same individual will probably pass up a $5 saving and not drive across town when purchasing a $250 jacket.  The question is why?  In both cases the saving is $5 and each $5 would have the same monetary value. 

So what has “mental accounting” to do with corporate cost reduction programs?  Based on the writer’s experience, cost reduction opportunities are often treated differently depending on where they lie in the organisation.  A saving of a few cents per product in manufacturing operations, which may impact on quality or customer satisfaction, and which may only amount to a few tens of thousands in total savings, will be pursued aggressively.  Whereas a larger saving in an overhead area such as Marketing spend or advertising may be seen as “off-limits”.  Why the difference?

Perhaps one area of difference that might explain this apparent paradox is the degree to which each area can be measured.  In manufacturing, direct costs are usually known with some precision.  Likewise the reduction of a certain input or charge to a lower cost item can also be defined in a measureable way.  While the ability to measure does not equate to a proper risk analysis, it does often provide business leaders with a feeling of confidence, justified or otherwise.

In the case of overhead costs the picture is less clear because of the difficulty with measurement.  Expenditure on overheads is usually clear cut, but benefits are not so certain.  An old anecdote about expenditure on advertising provides an illustration – “A Sales Marketing manager states that 50% of his advertising expenditure is a complete waste; – trouble is, he doesn’t know which half is which”.  This comment could also be made about expenditure on training, auditors or insurances.

Mental Accounting also impacts on “sunk costs”.  Thaler provides an example where you buy a pair of shoes; when you wear them for the first time you find they don’t fit well.  He goes on to predict the following:

a.       The more expensive the shoes, the more times you will persist in wearing them.

b.      When you cease to wear them, the more expensive the shoes, the longer they will stay in your wardrobe.

Anyone who has been involved in an expensive but failed software implementation will recognise the “corporate mental accounting” version of this story!  Failed capital equipment investment projects would also provide a similar example.

How can we eliminate or at least manage the impact of “corporate mental accounting?”  The following steps can be seen as providing a start:

1.       Treat every dollar of expenditure as being equal in value and importance.

2.       Be focused on measuring the benefit of each dollar of expenditure regardless of where in the business it is spent.

3.       Ensure all functional areas recognise that the money they get to spend is not “free”.

4.       Finally, cost reduction programs should focus on eliminating waste, regardless of where it is found, rather than on cutting costs because you can.

 

If you need help putting together your waste elimination program and avoiding the negative impacts of “corporate mental accounting” then don’t hesitate to contact us at at andrew.downard@adsupplychain.com.au or call +61 (0)419 581 705.

 

 ¤Richard H Thaler “Mental Accounting Matters” Journal of Behavioural Decision Making (1999)

 

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