Friday, June 19, 2009

Who Pays, Who Uses, Who Decides?

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Yesterday I introduced the concept of utility, what something is worth to a particular person or company. Utility represents the importance of money, time etc. and can be relatively independent of such things as calculations of expectation. Let’s take it a bit farther today.

Suppose you’re the owner of a small business in need of new equipment. The equipment will cost about $100,000. Your gross income is about two million dollars per year. Of that, 1.8 million is committed to rent, supplies, and payroll. That equipment will cost half of what’s left. In addition you have to live with the equipment for years to come. How much attention will you pay to getting good equipment at the best price you can?

Now let’s change the scene a bit. Instead of a small business owner you’re a purchasing agent in a large company. On your desk at the moment are twenty requisitions for purchases that will cost between ten thousand and a million dollars each. Among those is a requisition for the same equipment needed by the small business above. How much time and effort will you spend getting the best price and making sure the equipment is the best you can get for the money?

Almost certainly the small business owner will pay a lot more attention to this purchase than will the agent in the large company. In the small business $100,000 represents half of the available monetary utility. To the purchasing agent it is a miniscule fraction of what he spends every year. Furthermore, the agent won’t have to live with that equipment. In fact he probably won’t even know how well it works once it’s installed. For the purchasing agent, the actual use of the equipment probably has no utility whatever. However for the business owner the use of the equipment has a high utility, in fact the very existence of his business may depend on it.

Does this mean that large companies are doomed to pay inflated prices for inferior equipment? Not at all. Those large companies that move decisions to the lowest level feasible can get the advantages of good decisions made by people motivated by high utility of the outcome. The wise company will shift most of the purchasing decision to the manager of the department where it is to be used. A purchasing agent can help by using his industry contacts and knowledge to get the best price, but the department that actually uses the equipment should have the biggest say in the matter.

The above illustrates some of the different stakeholders involved in almost any decision. For simplicity let’s concentrate on purchasing decisions, though this applies to decisions ranging from where to go on vacation to if we should invade Afghanistan.

First, there is whoever is going to use the purchase. This person or department derives utility from how well the purchase does its job and therefore has a high interest in getting something that works well.

Second, there is the person or company paying the bill. That person or group of people will have an interest in keeping the cost down.

Third, there is whoever is making the decision. Decision-making power alone, however, does not motivate to either keep costs down or to acquire something that works well. In fact if the decision-maker is neither paying the bill nor using the purchase he may well not care very much about either cost or effectiveness.

We can make a table of this as follows:

Decision-maker pays for purchase and uses equipment - Will be motivated to save money and get good equipment.

Decision-maker uses equipment but does not pay for purchase -Will be motivated to get good equipment but not to save money.

Decision-maker pays for purchase but does not use equipment - Will be motivated to save money but not to get good equipment.

Decision-maker neither pays for purchase nor uses equipment - Will not be motivated to either save money or get good equipment.

Clearly the person or group that both uses and pays for the equipment has the greatest motivation to both keep down costs and buy something that will work well. In fact, if it comes to a trade-off between cost and performance, they are also in the best position to evaluate that trade-off

It should come as no surprise that the best decisions are made when decision-makers, users, and payers are all the same person or small group of people. And of course the worst decisions are likely to be made when the decision-makers neither use nor pay for the purchase. Care in decision-making tends to be a direct result of how much utility the decision-maker has at stake. That is an important reason that decisions should usually be made at the lowest organizational level feasible, and made by someone with a vested interest in both cost and performance.

The astute reader will have already thought of an important area in which decision-makers neither use nor pay for what they spend money on - government. That is one reason government can be so inefficient. Its employees who make spending decisions seldom have much investment in the money they spend; after all it’s not their money. Neither do they derive much utility from the use of what they buy with that money. The government employee who buys anything from a gross of paper to an army tank is not spending his own money and is unlikely to use either the tank or the paper. His utility comes not from the money he spends or the purchase he makes, but from the raise or promotion he gets for following procedures. If he has an opportunity to get a better product or a lower price, he may do so, but only if he can do it within the rules imposed on him.

“But how about local governments?” you ask. “Surely their employees have more motivation to spend wisely. After all, their neighbors see the results and don’t want their local taxes wasted.” That was the case years ago, when local governments spent mostly local tax money. It is not the case today. Local governments get much of their financing from state and even federal funds. They tend to see it as free money, money that costs them nothing in terms of utility. In fact I remember a county commissioner telling me that he thought it was his duty to get as much federal money spent in the county as he could, regardless of how efficiently it was spent. That man was reputed to be a fiscally conservative republican!

We have a similar problem with government regulation. Some regulation is necessary of course, but it is easy for regulators to go overboard. They do not spend their own money to hire enforcement officers, and the burden of following those regulations falls on someone else, not them. They are able to impose loss of utility on others at no loss to themselves.

As long as decision-makers in government and business have little interest in saving money or getting a good return for what they spend, we will have waste. The only way to get better decisions is for the decision-makers to have a stake in both the cost and the outcome of their decisions. They must put their own utility at on the line.

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