Monday, January 23, 2012

The Problem with Winning

Most of us like to win.  Winning feels good, winning means we got the prize, winning...well, it sure beats losing.  A drive to win can sometimes be very useful in negotiations.  It can keep us sharp and aggressive and help us resist tactics designed to draw out unnecessary concessions.  The best hagglers are often people who take a great deal of pleasure in winning, and I don't think that's coincidental!  Unfortunately, the desire to win (and particularly our aversion to losing) can also hurt us in negotiations. Knowing how to harness your desire to win is a critical negotiation skill.

A Focus on Winning Can Distract us from our Interests

The goal of negotiation is to meet our own interests as well as possible.  If that's true, then winning or losing is virtually irrelevant.  Suppose you had to choose two deal outcomes.  One gives you a value of 100 happiness points.  The other gives you a value of 50 happiness points.  Which outcome do you prefer?

Does your answer change if you know that in the first case the same deal gave me 500 happiness points and in the second case it gave me 40?  Hopefully not -- but in my experience many people prefer the second outcome (where they "win") to the first (where their interests are better met but they "lose").

If we're engaging purely in value claiming then this doesn't really apply.  If the game is zero-sum, then if I get more than you it's entirely likely that you could have achieved an outcome that would have better met your needs.  But winning is still a sideline; what matters is how well your interests were met compared with the range of achievable outcomes.

I recently interviewed a man who negotiated the sale of drilling rights for natural gas on his property.  He and a group of other landowners joined together in an association and hired an expert attorney to negotiate on their behalf.  First, of course, they had to negotiate with the attorney.

In order to align the attorney's incentives with their own, they agreed to give him a percentage of whatever up-front payment was negotiated (above a floor level).  They deliberately didn't include any incentives on the royalty payment.  (A typical deal includes some per-acre up front payment followed by annual royalty payments which are a percentage of the value of gas that is harvested from the field.) When I asked why, he explained that the royalties are where the real money was, so if they gave the attorney any percentage of that it could turn out to be a huge amount of money.

The deal they'd signed was for 20% gross royalties, i.e. for every $1 of revenue from natural gas the landowners would be paid twenty cents.  I asked him why they couldn't have done a similar incentive system on royalties, e.g. giving the lawyer some percentage of any royalties beyond 20%.  For example, if they gave him 10% of any additional royalties and he negotiated a rate of 22% then they would get 21.8% and he would get 0.2%.  The reason was that that 0.2% could turn out to be much more than they would want to pay, but of course they would only be paying it if they in turn were getting $9 for every $1 the attorney got.

The landowners were happy with their attorney getting paid well for getting them a good deal but they based their strategy in part on a desire not to "lose" by paying the attorney a fortune.  This may have caused them to miss an opportunity to create a true "win win" whereby the attorney could make a fortune but only by making them a bigger one.  (This, by the way, is the only criticism I have of the way they approached the deal -- from what I can tell they got a very good outcome through a combination of thorough preparation and a very healthy approach to the deal.)

Competition can be Disastrous

One of my negotiation professors often begins his seminars with what game theorists call a dollar auction.  The rules are simple:

  1. The auction is for a $100 bill.
  2. The first bid must be for exactly $5 and every subsequent bid must be exactly $5 higher than the current high bid.  Thus, the bidding will go $5, $10, $15, etc.
  3. Bidding continues until the high bid stands for ten seconds.
  4. The winner pays his or her bid and receives $100.
  5. The second-highest bidder also pays his or her bid but receives nothing.
Typically there will be a lot of people interested in bidding low amounts.  When the bidding reached $40 or $50 there are typically only a few people bidding, but no one seems particularly worried.  When it gets to $80 or so the remaining bidders generally recognize that they're in a trap.  The problem is that since the number two bid also pays there is always an incentive to keep bidding.  For example, if your bid is $80 and the high bid is $85 you can either lose $80 or bid $90 at which point you stand to make $10...except of course that now the same incentive pushes the other party to bid $95.

Once the bidding goes over $100 there's typically a chuckle in the room.  Both bidders (there are rarely more since three people bidding will let one escape the trap) are now losing money but both have the same incentive to keep bidding.

Typically at some point below $200 one of the players gives in.  But not always.  He has seen auctions continue past $1,000 when both people are unwilling to lose.  Of course, by almost any rational measure two people who lose a lot of money purely because they don't want someone else to lose less money aren't exactly winning.

A focus on winning can make value creation harder.  It can blind us to opportunities to find mutual benefits or creative solutions to problems.  At its worst it can cause negotiations to break down or negotiators to engage in mutually destructive behavior, all in the name of coming out ahead.  By all means, use your killer instinct but beware that it doesn't dominate your negotiations.

Thursday, January 5, 2012

Buying a Car (a personal case study)

My wife and I just bought a new car, after a decade of loyal service from our Honda Accord.  Car buying is arguably the classic negotiation, so I'm going to use my own experience as a case study.  This is not meant to illustrate the best way to get the lowest possible price; as we'll see, at one point I deliberately didn't push for the lowest price I might have gotten.  My goal here is to focus on how to approach a negotiation to maximize the chances of coming out with a result you're happy with.

Negotiation is costly

It might seem odd to hear it from me, but negotiation is a costly activity -- in time, in emotional energy and often financially.  One of the first steps, therefore, must be to assess the potential gains from negotiation work and plan your own investment accordingly.

The cars my wife and I were most interested in cost about $30,000.  The difference between what one might pay given absolutely no preparation and the lowest possible price is perhaps $2,000.  Most of that gain will likely come from the first few hours of research, with diminishing returns afterwards.  (For example, it's probably pretty easy to get within $500 of a dealer's normal walkaway price, but if you want to track down the special incentives that may be in play that's going to take more work.)

That forms a base point for thinking about how much time I want to invest in negotiation.  Someone else might well use that same information to make a different choice -- investing less time if they don't enjoy the process and time is scarce or more if they really want to get the best possible price or need to save every dollar possible.

Know thy Enemy

One of the most common mistakes people make in negotiation is failing to look at it from the other side(s).  Putting yourself in your counterpart's shoes is one of the best ways to find value-creation as well as value capture opportunities.  Once you understand their interests, their constraints and where you want to improve your knowledge you're in much better shape.

A car dealership faces some pretty significant challenges.  Their fixed costs aren't small, and they sell a relatively modest number of cars in order to cover them.  Their capital requirements aren't as big as one might think (the cars on their lot are largely financed by the manufacturer), but they still need to make several hundred dollars per car (on average), even allowing for future profits from service & maintenance.

The big problem with charging that kind of margin is that dealers are, essentially, commodity brokers.  The car held at one dealer is identical to the car (of the same model) at another dealership; in fact, dealers typically have swap agreements in place to maximize their effective inventory so if you're talking with multiple dealers about, say, a Subaru Outback 2.5i Limited in deep indigo pearl, they may be negotiating with you on the exact same car that just happens to be sitting in one of their lots.

Let's say you need to average $600 in profit from selling something.  Now imagine that you and two other people have equal right to sell it.  Do you expect to make $600?  Of course not...because if you're offering me a price that earns you $600, one of those other people is going to undercut you.  Then you'll undercut them, and so on until you're barely better than not selling it at all.

This brings us to the approach that websites like recommend.  Get the dealer cost from their website, then invite multiple dealerships in your area to offer you quotes.  Play one against the other until you've gotten the best possible price.

A great chess coach once wrote, "Your opponent also has a right to exist."  Car dealerships aren't just shrugging their shoulders and saying, "Wow, I wish we weren't dependent on making good margins in a commodity business."  What should we expect them to do in response?

First off, they should strive to maintain their biggest advantage -- information.  It's a safe bet that "dealer invoice" isn't going to be nearly as accurate as when sites like first got started.  We have to assume that a host of hidden payments make their true cost less than invoice.  (I was able to confirm this by asking one dealer what he recommended I do for research -- when he said, "The first thing I'd do is check out the websites that have dealer invoice data so you know exactly what my cost is," it was obvious that his cost was usefully less than invoice!)

Next, we should expect them not to cooperate with our efforts to turn the negotiation into an auction.  A hidden price doesn't help them much if they're bidding against each other.  Thus, we should see behavior that balances out their wish to get the sale with a recognition that a full-out auction should be resisted.

Sure enough, my request for bids from the four local Subaru dealers didn't come back with four clean, competitive bids.  One dealer called me and said that one of his Internet specialists would be putting together an offer but what he really wanted to know was whether there was a price I had in mind that would close the deal right there.  Another made an offer that was only a few hundred dollars below MSRP (i.e. way too high) but added that his email constituted a guarantee to match or beat any competitor's offer.  Another came in a bit better (but still too high) with a similar guarantee.

Whether you've anticipated your counterpart's responses or not, it's important not to lose control of the negotiation.  Even if you do have an aspiration price already in hand, don't share it yet!  You can make an outrageous offer if you like, but in my view your best bet is to keep steering the negotiation (or, rather, negotiauction) in the direction that favors you.  In this case you want to make clear that you plan to keep talking with multiple dealers so they know they won't get the sale with anything much higher than their reservation value.

As I was soliciting bids I was also researching other price information.  As I mentioned I didn't have much faith in the dealer invoice number (just under $29K) but Edmunds offers another useful number -- the average price at which this car (including options) has been sold at in your region.  For us, that was $29,775.

Beware of Bias

As I discussed here, one thing I do after every negotiation is a review with a focus on where I went wrong or could have done better.  As we'll soon see, in this case I exhibited two very common "mind bugs": susceptibility to anchoring and small pie bias.

Remember how I knew that the dealer invoice number couldn't be right?  Despite that knowledge, it stuck in my head as a "real" number and subconsciously I considered it the dealer's BATNA.  This combined with small pie bias led me to set a target price of $29,500 for our car when I went in to negotiate with the dealer with whom we'd done our test drive.  At this price I'd be almost $300 better than the average deal.  The dealer's margin would be about $500 (if only the invoice number was really his cost), which was enough to be better than me going somewhere else and high enough that I could close the deal without losing a whole day haggling.  (I love to negotiate but I only love haggling when it's on behalf of someone else; again, know thyself!)

Close the Deal

Negotiating for a car is part theatre.  Prices get written down.  Salespeople go talk to their boss to see whether there's anything they can do with your unreasonable demand.  Ours went about like this:

I started off by explaining that I'd looked up the invoice information and was only willing to pay a small premium to it.  I made it clear that I had solicited bids from other dealers and was still in discussions with them but that my preference was to give him the business since he'd spent real time helping us compare models, test drive, etc.  I was open to closing the deal that day but only if I was happy with the price and otherwise I would have to go back to the other dealers.

He came back with a printout of what he said was the actual invoice for the car we were interested in.  It was pretty low on details but gave the invoice price at $29,700, over $700 higher than what was on Edmunds.  He explained that in order to cover their costs they aimed to make $800 per car, so his offer was $30,500.  At this point I took a different approach than the normal back-and-forth.  I told him that we might have a problem because my walk-away price was lower than his cost.  I was willing to agree today to a price of $29,500 but that anything higher than that would mean that I went back to the other dealers.

He went "behind the curtain" and came back with a price of $29,910.  I reiterated that I had put my cards on the table but was no longer haggling; either he could do $29,500 or not.  He left and returned with $29,596.  When I repeated my position he said, "Come on, it's less than a hundred bucks.  I'm doing all the moving here!"  A few minutes later he did another round trip, muttered, "My boss is not a happy man," and agreed to my price.

Despite his protestations, I suspected I hadn't been ambitious enough.  Three iterations was less than I expected, although I do know that a car dealer hates to see a customer leave to think it over.  Sure enough, that very evening one of the other dealers (the one who had asked me for a price) decided they'd waited long enough for me to go to them and made an offer of $29,000.

Know the Rules

Once you agree on a price, a car dealer typically does everything they can to make that deal feel fixed in stone.  They bring out paperwork, ask for a deposit, etc.  You want to make sure you know what you're actually committed to.  In this case I knew that the paperwork was non-binding and the deposit could only be applied to actual expenses incurred by the dealer if I didn't take the car.  Thus, I had every legal right to take the lower offer (or to try to squeeze it even lower).

Instead, I called the salesperson I'd met with and explained what had happened.  I told him I understood my legal rights but that the sale was still his if he would come down $400.  He conferred with his boss and, as expected, agreed to the lower price.

Why did I leave money on the table?  First, personal preference.  I don't like to waste people's time, and while I don't think test drives and talking with a salesman incur any obligation I also know that I'll feel better (assuming he did a good job) giving him the business.  Second, going with the other dealer would have involved some additional time and potential risk.  I'd already found one "trick" in the offer (on paper it looked like it was even lower, but not all the fees were identical) and there was some cost in time to going to this different dealership and confirming that everything was as it seemed.  With those considerations in mind I preferred to close the deal quickly with a $400 improvement rather than to try for more.

Enjoy the Prize

While I strongly encourage negotiators to review their performance and identify mistakes, don't let that ruin the experience or taint the results.  Trish and I now have a new car that we're very happy with.  I didn't get the lowest possible price but I got one I'm very comfortable with and didn't sink too many hours into either the research or haggling.  Negotiation should be fun and rewarding; if you're not enjoying it, and the outcomes from it, that's your real problem.