Check out the latest issue of Harvard Business Review to read a very interesting article on non-linear relationships in business and the effect this may have on decision-making: “In recent years a number of professions, including ecologists, physiologists, and physicians, have begun to routinely factor nonlinear relationships into their decision making. But nonlinearity is just as prevalent in the business world as anywhere else. It’s time that management professionals joined these other disciplines in developing greater awareness of the pitfalls of linear thinking in a nonlinear world. This will increase their ability to choose wisely—and to help the people around them make good decisions too.”
In our experience the effect of non-linearities are difficult to grasp intuitively – some sort of modelling is usually required to gain insight. In addition to the excellent examples mentioned in the article, there are a few others that can be mentioned as well:
- Production constraints (you are fully exposed to the downside of unplanned production stops while the upside may be constrained by the dimensions of manufacturing equipment, facilities and more),
- Non-linear tax regimes (typical in oil and energy projects where the host country benefits from price increases while the company is exposed to the full downside if the price goes down),
- Economies of scale (cost per unit of production decreases as volume increases)
- Various types of real options (often linked to data collection programs where new information is used to optimize subsequent decisions causing a non-linear effect).
The authors of the article recommend four ways to avoid the pitfalls of non-linear influences on decision-making:
- Increase awareness of linear bias.
- Focus on outcomes, not indicators.
- Discover the type of nonlinearity you’re dealing with.
- Map nonlinearity whenever you can.
Non-linear relationships will always have the undesired effect of shifting the expected outcome either up or down compared to a “base case”. This means that a typical base case can become highly unlikely (low probability to actually occur) in a real life situation. Managers need to account for such effects to ensure they are making the right business decisions.
You can find the full article in HBR here: https://hbr.org/2017/05/linear-thinking-in-a-nonlinear-world