Introduction to Managerial Essay

This essay has a total of 4391 words and 19 pages.

Introduction to Managerial

Introduction to Managerial
Decision Making
Phar-Mor, Inc., the nation's largest discount drugstore chain, filed for bankruptcy
court protection in 1992, following discovery of one of the largest business fraud and
embezzlement schemes in U.S. history. Coopers and Lybrand, Phar-Mor's former
auditors, failed to detect inventory inflation and other financial manipulations that
resulted in $985 million of earnings overstatements over a three-year period.
A federal jury unanimously found Coopers and Lybrand liable to a group of
investors on fraud charges. The successful plaintiffs contended that Gregory Finerty,
the Coopers and Lybrand partner in charge of the Phar-Mor audit, was "hungry for
business because he had been passed over for additional profit-sharing in 1988 for
failing to sell enough of the firm's services" (Pittsburgh Post-Gazette, February 15,
1996). In 1989, Finerty began selling services to relatives and associates of Phar-
Mor's president and CEO (who has been sentenced to prison and fined for his part
in the fraud). Critics claim Finerty may have become too close to client management
to maintain the professional skepticism necessary for the conduct of an independent
The Phar-Mor case is just one of many in which auditors have been held accountable
for certification of faulty financial statements. Investors in the Miniscribe
Corporation maintained that auditors were at least partially responsible for the nowdefunct
company's falsified financial statements; at least one jury agreed, holding the
auditors liable to investors for $200 million. In the wake of the U.S. savings-and-
loan crisis, audit firms faced a barrage of lawsuits, paying hundreds of millions in
judgments and out-of-court settlements for their involvement in the financial reporting
process of savings-and-loan clients that eventually failed.
The auditing partners of Coopers and Lybrand, like partners of other firms held
liable for such negligence, are very bright people. In addition, I believe that they are
generally very honest people. So, how could a prominent auditing firm with a reputation
for intelligence and integrity have overlooked such large misstatements in Phar-
Mor's financial records? How could auditors have failed to see that so many of their
savings-and-loan clients were on the brink of failure? Critics of the profession suggest
that auditor neglect and corruption may be responsible. In fact, very rarely do audit
2 • Chapter 1: Introduction to Managerial Decision Making
failures result fromdeliberate collusion of the auditor with its client in the issuance
of faulty financial statements. Instead, audit failures are the predictable result of
systematic biases in judgment. This book provides the tools to help you avoid these
errors. By eliminating biases from your decision-making patterns, you can become a
better decision maker and protect yourself, your family, and your organization from
avoidable mistakes.
This book (Chapter 4, specifically) will provide evidence that it is psychologically
impossible for auditors to maintain their objectivity; cases of audit failure are inevitable,
even from the most honest of firms. Psychological research shows that expecting
objective judgment from an auditor hired by the auditee is unrealistic. Although
deliberate misreporting can occur, bias more typically becomes an unconscious, unintentional
factor at the stage where judgments are made. When people are called
upon to make impartial judgments, those judgments are likely to be unconsciously
and powerfully biased in a manner that is commensurate with the judge's self-interest.
Psychologists call this the self-serving bias (Messick and Sentis, 1985). When presented
with identical information, individual perceptions of a situation differ dramatically
depending on one's role in the situation. Individuals first determine their
preference for a certain outcome on the basis of self-interest and then justify this
preference on the basis of fairness by changing the importance of attributes affecting
what is fair. Thus, the problemis not typically a desire to be unfair, but our inability
to interpret information in an unbiased manner (Diekmann, Samuels, Ross, and Bazerman,
1997). The self-serving bias exists because people are imperfect information
processors. One of the most important subjective influences on information processing
is self-interest. People tend to confuse what is personally beneficial with what is
fair or moral.
We have begun a new century with a vast amount of knowledge about how to
use technology to integrate data and make routine decisions. However, computers
cannot make decisions involving values and risk preferences. Here, human judgment
is required. What advice was available to Coopers and Lybrand? The material in this
book would have introduced the firm's partners to a number of cognitive biases that
are predictable and likely to affect auditor judgment. Knowledge of these biases can
be used to make more rational decisions. By identifying cognitive biases and suggesting
strategies for overcoming them, this book gives managers the skills they need
to improve their judgment.
Although most managerial decisions concern considerably less than $985 million,
situations that require careful judgment arise continually in our daily lives. Such
judgment is a major component of managerial work at all levels of the corporate
world. Many managers accept judgment as innate: "Some people have it and others
do not." This attitude can waste critical human resources in organizations. While
decision-making skills may be partially innate, training can have a significant effect
on the quality of managerial judgment.
Judgment refers to the cognitive aspects of the decision-making process. To fully
understand judgment, we first need to identify the components of the decisionThe
Anatomy of a Decision • 3
making process that require it. To get started, consider the following decision situations:
• You are finishing your MBA at a well-known school. Your credentials are quite
good, and you expect to obtain job offers from a number of "dot com" start-ups.
How are you going to select the right job?
• You are the director of the marketing division of a rapidly expanding consumer
company. You need to hire a product manager for a new "secret" product that
the company plans to introduce to the market in 15 months. How will you go
about hiring the appropriate individual?
• As the owner of a venture capital firm, you have a number of proposals that
meet your preliminary considerations but only a limited budget with which to
fund new projects. Which projects will you fund?
• You are on the corporate acquisition staff of a large conglomerate that is interested
in acquiring a small-to-moderate-sized firm in the oil industry. What firm,
if any, will you advise the company to acquire?
What do these scenarios have in common? Each one proposes a problem, and each
problemhas a number of alternative solutions. Let us look at six steps you should
take, either implicitly or explicitly, when applying a "rational" decision-making
process to each scenario.
1. Define the problem. The problemhas been fairly well specified in each
of the four scenarios. However, managers often act without a thorough understanding
of the problemto be solved, leading themto solve the wrong
problem. Accurate judgment is required to identify and define the problem.
Managers often err by (a) defining the problemin terms of a proposed
solution, (b) missing a bigger problem, or (c) diagnosing the problem in
terms of its symptoms. Our goal should be to solve the problem, not just
eliminate its temporary symptoms.
2. Identify the criteria. Most decisions require the decision maker to accomplish
more than one objective. When buying a car, you may want to
maximize fuel economy, minimize cost, maximize comfort, and so on. The
rational decision maker will identify all relevant criteria in the decisionmaking
3. Weight the criteria. Different criteria will be of varying importance to a
decision maker. Rational decision makers will know the relative value that
they place on each of the criteria identified (for example, the relative importance
of fuel economy versus cost versus comfort).
4. Generate alternatives. The fourth step in the decision-making process
requires identification of possible courses of action. Decision makers often
spend an inappropriate amount of search time seeking alternatives, creating
a barrier to effective decision making. An optimal search continues only until
the cost of the search outweighs the value of the added information.
4 • Chapter 1: Introduction to Managerial Decision Making
5. Rate each alternative on each criterion. How well will each of the
alternative solutions achieve each of the defined criteria? This is often the
most difficult stage of the decision-making process, as it typically requires
us to forecast future events. The rational decision maker will be able to
carefully assess the potential consequences of selecting each of the alternative
solutions on each of the identified criteria.
6. Compute the optimal decision. Ideally, after all of the first five steps
have been completed, the process of computing the optimal decision consists
of (1) multiplying the ratings in step 5 by the weight of each criterion, (2)
adding up the weighted ratings across all of the criteria for each alternative,
and (3) choosing the solution with the highest sumof the weighted ratings.
The model of decision making just presented assumes that we follow these six
steps in a fully "rational" manner. That is, decision makers are assumed to (1) perfectly
define the problem, (2) identify all criteria, (3) accurately weigh all of the criteria
according to their preferences, (4) know all relevant alternatives, (5) accurately assess
each alternative based on each criterion, and (6) accurately calculate and choose the
alternative with the highest perceived value.
There is nothing special about these six steps. Different researchers specify different
steps—which typically overlap a great deal. For example, in a wonderful recent
book on rational decision making, Hammond, Keeney, and Raiffa (1999) suggest eight
steps: (1) work on the right problem, (2) specify your objectives, (3) create imaginative
alternatives, (4) understand the consequences, (5) grapple with your tradeoffs, (6)
clarify your uncertainties, (7) think hard about your risk tolerance, and (8) consider
linked decisions. Both of these lists provide a useful order for thinking about what
an optimal decision-making process might look like.
In this book, the term rationality refers to the decision-making process that is logically
expected to lead to the optimal result, given an accurate assessment of the decision
maker's values and risk preferences. The rational model is based on a set of assumptions
that prescribe how a decision should be made rather than describing how a
decision is made. In his Nobel Prize-winning work, Simon (1957; March and Simon,
1958) suggested that individual judgment is bounded in its rationality and that we
can better understand decision making by explaining actual, rather than normative
("what should be done"), decision processes. While the bounded-rationality framework
views individuals as attempting to make rational decisions, it acknowledges that
decision makers often lack important information on the definition of the problem,
the relevant criteria, and so on. Time and cost constraints limit the quantity and
quality of available information. Furthermore, decision makers retain only a relatively
small amount of information in their usable memory. Finally, limitations on intelligence
and perceptions constrain the ability of decision makers to accurately "calculate"
the optimal choice from the information that is available. Together, these limitations
prevent decision makers from making the optimal decisions assumed by the
The Bounds of Rationality • 5
rational model. The irrational decisions that result typically reflect a reliance on intuitive
biases that overlook the full range of possible consequences. Decision makers
will forego the best solution in favor of one that is acceptable or reasonable. That is,
decision makers satisfice. Rather than examining all possible alternatives, they simply
search until they find a solution that meets a certain acceptable level of performance.
The field of decision making can be loosely divided into two parts: the study of
prescriptive models and the study of descriptive models. Prescriptive decision scientists
develop methods for making optimal decisions. For example, they might suggest
a mathematical model to help a decision maker act more rationally. Descriptive
decision researchers consider the bounded ways in which decisions are actually made.
Why use a descriptive approach when a prescriptive approach should lead to an
optimal decision? My answer is that there is plenty of good advice available, and yet
most people do not follow it. Why not? Because we fall victim to a variety of predictable
errors that not only destroy our intuition, but also hinder our tendency to
implement good advice. We need to understand these mistakes before moving on to
wiser decision strategies.
Although the concepts of bounded rationality and satisficing are important in
showing that judgment deviates from rationality, they do not tell us how judgment
will be biased. These concepts help decision makers identify situations in which they
may be acting on the basis of limited information, but they do not help diagnose the
specific systematic, directional biases that affect our judgment. Fifteen years after
the publication of Simon's work, Tversky and Kahneman (1974) continued what he
had begun. They provided critical information about specific systematic biases
that influence judgment. Their work, and work that followed, led to our modern
understanding of judgment. Specifically, researchers have found that people rely
on a number of simplifying strategies, or rules of thumb, in making decisions. These
simplifying strategies are called heuristics. As the standard rules that implicitly
direct our judgment, heuristics serve as a mechanism for coping with the complex
environment surrounding our decisions. In general, heuristics are helpful, but
their use can sometimes lead to severe errors. A central goal of this book is to identify
and illustrate these heuristics and the biases that can result fromthemin the managerial
setting. I will use examples of a variety of heuristics and biases to explain how
people deviate froma fully rational decision process in individual and competitive
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