Sunday, January 15, 2006

Confirmation bias filters reality

Confirmation bias leads decision makers to readily accept information that reinforces their pre-existing views of reality and to reject information that challenges those views.

Confirmation bias is important because it often leads to decisions that damage the organization because these decisions do not reflect reality as viewed by customers, competitors, employees, and other key constituents.

Bill Gates tapped confirmation bias to make the most valuable business decision in history. In the early 1980s, IBM was looking for an operating system for its PC. Gates paid $75,000 to license one from Seattle Computing. Gates sold IBM the rights to the OS for use on IBM PCs for a pittance. IBM, assuming that no PC-clone market would emerge, granted Gates the license for the OS on the clones. IBM had convinced itself that Gates was naïve about the emergence of PC clones. If Gates was right, IBM reasoned, then IBM was no longer the marketing powerhouse it believed itself to be. When the PC clone market grew, Gates profited from IBM's confirmation bias.

Some companies have developed the means to overcome this tendency towards confirmation bias. In general, an organization’s ability to sustain superior profitability in an industry depends heavily on how well it performs the specific activities that create value for customers. Customers measure that value based on ranked purchase criteria such as price, quality, and product line breadth – which often vary by industry and customer group. Companies compete for the highest score on these purchase criteria through the way that they perform specific activities – such as manufacturing, marketing, sales, and service. When successful companies seek to enter a new industry, they may not fully understand that the capabilities that made them successful in their core business might not help them compete in the new industry.

This is important because successful executives often believe that their ability to build a profitable company naturally enables them to succeed in whatever industry they choose. This excessive self-confidence can lead executives to enter new businesses without a full understanding of the requirements for competitive success. If unchecked, this can lead companies to invest in new markets despite their inability to perform the capabilities required to be profitable in the new market – thus wasting shareholder’s money. In effect, these executives’ self-confidence can have the potentially destructive effect of reinforcing a tendency towards confirmation bias – leading them to ignore information that does not reinforce their initial decision to enter the new market.

Wal-Mart understands well how to apply to new industries the capabilities that enable it to win in its core market. Wal-Mart’s initial success as a discount retailer was based on three capabilities – its use of superior purchasing scale to drive down its suppliers prices, its ability to generate accurate and timely information within each of its stores about which merchandise is in high demand and which is not, and its ability to move specific merchandise quickly from suppliers to stores where it is selling. Wal-Mart has become so large that it needs to expand into large new markets in order to sustain its 14% five year average earnings growth. Wal-Mart’s management recognizes, however, that such expansion must be made only in new markets in which Wal-Mart’s capabilities will give it a competitive advantage. In 1983 Wal-Mart decided that pharmacy retailing passed the test – building an in-store pharmacy that by 2000 generated over $6 billion in annual revenues.

Few companies are able to overcome their confirmation bias to assess such diversification initiatives as effectively. Decision-makers should evaluate whether investing in a new market will pay off. To do so, they should assess the profit potential of the industry, identify the ranked customer purchase criteria (CPC) of the industry’s customers, evaluate how well incumbents satisfy these CPC, understand the capabilities that enable the leading companies to create value for customers, and audit how well their companies can perform these critical capabilities relative to the incumbents in the industry.


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