Tuesday, July 26th, 2016
The human mind struggles to understand nonlinear relationships. Our brain wants to make simple straight lines: if the price of coffee is $2, you can buy five coffees with $10, 10 coffees with $20, and 15 coffees with $30. But in business there are many highly nonlinear relationships, and we need to recognize when they’re in play, because if not, we often end up making poor decisions.
Consumers and companies fall victim to linear bias in numerous real-world scenarios. A common one concerns an important business objective: profits. Three main factors affect profits: costs, volume, and price. A change in one often requires action on the others to maintain profits. For example, rising costs must be offset by an increase in either price or volume. And if you cut price, lower costs or higher volumes are needed to prevent profits from dipping.
Unfortunately, managers’ intuitions about the relationships between these profit levers aren’t always good. For years experts have advised companies that changes in price affect profits more than changes in volume or costs. Nevertheless, executives often focus too much on volume and costs instead of getting the price right.
Why? Because the large volume increases they see after reducing prices are very exciting. What people don’t realize is just how large those increases need to be to maintain profits, especially when margins are low.
Companies typically fail to account for this pattern—in part because they focus on averages. Averages mask nonlinearity and lead to prediction errors.
Summing-up: It’s time to develope greater awareness of the pitfalls of linear thinking in a nonlinear world. This will increase our ability to choose wisely—and to help the people around us make good decisions too.