Values and Tradeoffs for Decisions

For the purposes of this book, values are the things we care about when we make a decision. Some values can be judged directly. For example, a professional restoration specialist can estimate the monetary value he will receive from the sale of a refurbished automobile. In his profession, the sale price of automobiles gives him a direct indication of value—what it is worth to him. In other circumstances, value metrics are used to specify value. A collector of restored automobiles may value a car differently than the amount she paid for it. She may value how well the restoration matches the vehicle's original design based on a value metric of how realistic the restoration looks from a distance of four feet. This might not be a perfect reflection of consistency with the original design, but it may suffice for this collector's purpose. When a value can't be measured directly, a value metric that is reasonable and practical should be chosen. To simplify matters, the term values in this book refers to either values or value metrics.

In clarifying what we want, it is not unusual to find more than one competing value. It may be hard to find an alternative that provides both near-term benefits and big payoffs in the long term. We want both. Or we may want both low cost and rapid implementation. Even fairly simple decisions may involve multiple values. In those cases, we need to make tradeoffs that are consistent with our values.

An even swap is one way to do that. An even swap substitutes one value for another in a way that does not distort the overall value for the decision. For example, Michael, the decision maker introduced in Chapter 6, needs to determine how he will trade off time and money in his job decision. He must define the amount of salary he'd want in exchange for working longer hours. Once he finds the specific amounts that make him indifferent, say, x dollars for y hours, he can substitute one for the other in an even swap, thereby making it simpler to compare his alternatives.

Michael's Values and Tradeoffs

The previous chapter included an initial structure for Michael's decision of whether to take a new job with a startup company or stick with his current job. As he has thought about that decision, Michael has clarified what is most important to him about his job—what he values in this decision. His main value is job satisfaction, which is driven by two factors:

1. Income. Michael and his wife would like to make every investment they can in their children's futures: music lessons, travel abroad, and college. Making those investments on Michael's current annual $80,000 salary will be difficult.
2. Work hours. At his current 45 hours per week, and almost no out-of-town travel, Michael manages to spend adequate time with his family. “Having time for my family is one of the things I like about my current job,” he says.

Other factors could be important, such as commute time, promotion potential, and level of challenge. Some of his friends tell him that the excitement of working for a startup should make the offer quite attractive, but for Michael, excitement is not a major draw. “My job at the startup would be very similar to my current job, so it won't feel much different.” Ultimately for Michael, the two values of income and work hours are most important.

Since there is more than one value involved in Michael's decision, he will need to trade off some of one value for some of the other. Michael and his wife value a high income; it's important to them, given what they want to provide for their children. But they also value Michael's time at home. Because these values are not entirely compatible, the couple will need to consider trading off some time at home in exchange for more income—the even swap concept described earlier. Michael can wrestle with questions such as “If I knew I was going to be working an extra 10 hours per week, how much additional income would make me willing to give up that 10 hours of family time? And what if my work hours went up by 15 hours?” Once Michael finds his point of indifference, he can make substitutions to simplify his decision without distorting it.

Michael and his wife have quantified the tradeoffs between salary and time with family. Michael would be indifferent between:

• Giving up 5 hours/week of family time (that is, working 50 hours/week versus 45) and getting an extra $15,000 in income.
• Giving up 10 hours/week of family time by working 55 hours/week and getting an extra $30,000 in pay.
• Giving up more than 15 hours/week of family time by working 60 or more hours/week and getting an extra $60,000 in pay.

By making even swaps using these numbers, Michael can describe a job with different work hours and salary with a single equivalent dollar amount. That makes it much easier to compare. His current job is 45 hours per week at $80,000. Given his tradeoffs, working 50 hours per week at $95,000 would be worth just the same to him—$80,000 ($95,000 minus a $15,000 swap for giving up 5 hours/week of family time). A new job of 50 hours per week at $120,000 would be worth $105,000 to him ($120,000 minus $15,000), which is better than his current job. But if he ends up working more than 60 hours for $120,000, the value to Michael would be only $60,000 ($120,000 minus $60,000), not as good as what he has now.

Time is often an important component of decisions, and Michael's decision is no exception. Given where the children are in school, Michael's family is planning to stay in their current location for the next five years. After that, they may wish to change jobs and move to another state to be closer to their children's grandparents. Thus, Michael should compare the total equivalent five-year income for his job alternatives. He also needs to account for his time preference for money. Money received in the future is worth less than the same amount received today. Michael believes he would have to receive 10 percent more income a year from now to match the value of having the income now. This 10 percent is called his discount rate. So receiving $80,000 next year has a present equivalent value of $72,727 ($80,000 divided by 1.10). Similarly, $80,000 in two years is worth $66,116 today ($80,000 divided by 1.10 and again divided by 1.10, discounting for two years). Thus, five years of income at his current job would translate to a total equivalent five-year income of about $334,000. Discounting is widely used to translate cash flows over time into a single value. The approach is well explained in introductory finance texts.

* * *

Michael has clarified that the values in this job decision are income and work hours, and he knows how to trade them off. He also knows how to compare dollars today with dollars in the future, so he has addressed two of the three value challenges introduced at the beginning of this chapter: multiple wants, and outcomes spread over time. In the next chapter, the concept of expected value will be used to account for the uncertainty in Michael's outcomes. He will be able to calculate a single number for the total expected equivalent five-year income for each of his job alternatives, and choose the best one.

Values in a Business Context

In the business world, the ultimate direct value is typically the economic value of the enterprise, or shareholder value. Thus, an alternative that will create $1 billion in shareholder value is better than one that will create $750 million. Shareholder value is typically measured using net present value of future cash flows, or NPV.¹ Most business alternatives have different time frames for costs and benefits; NPV uses discounting like that applied by Michael to compare these different time frames in an apples-to-apples fashion.

Businesses often track objectives that are not really direct values but rather means of achieving direct values. These are called indirect values. For example, the profit margin on sales revenues is simply a means to a higher direct value: shareholder value. Other indirect values include market share, sales per employee, costs per unit, and indices of customer loyalty. These indirect values may be necessary to generate the direct value, but it is important to keep a clear line of sight to the ultimate direct values we seek. Rewarding an indirect value like short-term profitability might end up reducing shareholder value, particularly if those short-term rewards lead management to reduce research and development, or investments in productivity, or other things that would have created long-term value for shareholders.

Intangible values can also create confusion, particularly when something like employee satisfaction or brand awareness must be weighed against profitability. Since quantifying the impact of intangibles can be difficult, there is a temptation to ignore these values. This happens too often in business and can lead to decisions that miss the mark. Would value really be increased if a company chose to ignore brand recognition in its decision making? Whenever possible, intangible values should be converted into terms comparable with tangible values. This can be done using the same type of even swaps used in Michael's job decision. Michael's decision required him to convert his intangible value of family time into dollar amounts that he could combine with the tangible value of income. The same can be done in other situations where intangible values are important.

Of course, some values cannot be traded off. In his job choice, Michael might not consider any job that requires moving his family during the next five years. Most profit-driven corporations will profess, “We won't do anything that violates our standards of ethical behavior, no matter how much profit is at stake.” Nonnegotiable values like these serve as constraints on choices and should be part of the decision frame. They are part of the scope that limits the alternatives to be considered.

In some business settings—not-for-profit organizations, internal service groups, and the public sector—non-financial values are crucial in decision making. In these situations, there may be multiple objectives; we need to include the most important ones even if they are non-financial. Similar to Michael's situation, we can develop quantitative measures of the degree to which the overall objectives are achieved. For example, a global health organization, whose objective is to dramatically reduce cases of malaria in developing countries, might track the number of deaths averted or the quality life-years added. An internal information technology (IT) service organization, whose goal is to maximize productivity through cost-effective systems, might measure improved factory throughput resulting from a new IT system. Quantifying non-financial benefits² is important in order to reach the best choice.

Making Tradeoffs in Business Decisions

Business decisions typically require a systematic approach to making value tradeoffs. That approach begins with a clear understanding of the consequences for alternatives, described as a mix of tangible and intangible outcomes that are uncertain and spread out over time. Making even swaps one step at a time translates this complex mix into equivalent values that can be compared easily, making the choice much simpler. The steps for these swaps, or substitutions, are summarized in Figure 7.1.

Things That Can Go Wrong

Clarity on values is essential for high-quality decisions, yet many things can prevent it. In some cases stakeholders do not understand or agree on the values at stake. To make matters worse, it isn't always easy to articulate what is valued when several things seem important. Making tradeoffs between competing values creates another opportunity for failure. For example, business expansion into environmentally sensitive areas may lead to endless debates about how to trade off the benefits of economic growth with environmental preservation—and decision makers may be hesitant to make their tradeoffs public.

The good thing in all this is that the act of clarifying values leads to meaningful conversations about how the difficult value judgments and tradeoffs will be made.

Here is a summary of things to watch out for when dealing with values:

• Lack of explicit discussion and/or agreement on values and the tradeoffs among them
• Poorly defined values or values that cannot be meaningfully measured or projected into the future
• A focus on indirect values rather than the direct values
• Inappropriate discount rates, improper adjustments for risk, and incorrect valuation of intangibles.

Judging the Quality of Values

The decision maker must assure that values are clearly defined and properly applied. A rating of 100% is needed before a decision can be made. In addition to avoiding the failures listed above, an informed decision maker will ask probing questions whose answers shed light on the quality of the value requirement for the decision:

• “Are we clear on what we want from this decision?”
• “Do our stated values incorporate the perspectives of all key stakeholders?”
• “Do we understand how to measure each of our direct values?”

Once information has been gathered and reasoning has been applied, we will have greater clarity about the value outcomes for each alternative. At this point, additional probing questions can be asked:

• “What tradeoffs must be considered in choosing the best alternative?”
• “How would the decision change if different tradeoffs were made?”

Being clear on values points us in the right direction, but which alternative will produce the most of what we truly want? Answering that essential question requires sound reasoning to combine our alternatives, information, and values. That is the subject of the next chapter.

Key Points to Remember

• In decisions, values are what we care about when comparing alternatives.
• For most businesses, the ultimate direct value is shareholder value—the economic value of the enterprise—and is usually measured using the net present value of future cash flows, or NPV.
• When more than one value is at stake, tradeoffs may be necessary.
• Decisions can be simplified by using even swaps to convert all values, including intangibles, to a common unit (such as dollars).
• Discounting should only be used to account for time preferences, not differences in risk.
• Certain equivalents, which account for risk appetite, can be used if potential losses are at least 5% of a company's shareholder value. Otherwise, we should use expected values for decision making.