Compensation processes linked to budgets create non-ideal outcomes via negotiations and gaming implications. Managers are often assigned compensation that is driven by maximizing performance on their specific budget as opposed to maximizing results for the holistic enterprise.
Summary: For planning and budgeting, the big No-No is to reward performance based on budget results. Negotiations and gaming both have serious negative impacts on the planning & budgeting process. Both create gaps between higher level expectations and proposals from lower levels. Compensation should be relative to external benchmarks, internal benchmarks, or historical trends. More...
Summary: The budgeting process often lends itself to gamesmanship because of the compensation and incentive packages followed within the organization. This is because managers are often assigned compensation that is driven by maximizing performance on the budgets and/or functions that the manager “owns.” We need to to design compensation and career growth rewards that have an optimal mix of incentives that drive towards both company level success and individual motivation. More...
Compensation is a topic that fills journals and libraries. For planning and budgeting, the big No-No is to reward performance based on budget results. Subsequent compensation programs further exacerbate the problem. Why is this a big No-No? Don’t we want to motivate people? Don’t they respond to compensation incentives? The answer is absolutely. Yes, we want to motivate people. Yes, people respond to compensation incentives. However, do they respond in the way that we want them to respond? Will we get what we are expecting? Of course, they will respond to measurement and compensation! We are very likely to get the result that is being measured. However, performance problems are in the second order implications to the incentive or measurement: negotiations and gaming. Both have serious negative impacts on the P&B process.
Immediately upon a performance measure being proposed, negotiations spring into play. On one side, upper levels of management want the target bar raised as high as possible. Stretch targets further dictate that the bar is still not high enough and that it should be higher. On the other side, the one being measured wants the target bar as low as possible. We want firm assurance that we can clear the bar with normal and certainly not Herculean effort. There are too many uncertainties as reality unfolds to set the bar any higher than necessary.
How does this negotiation process translate into the typical planning or budgeting process? It guarantees gaps between higher level expectations and proposals from lower levels. Each is covering itself. Delays ensure as deals are worked out. The plan is changed, updated, revised, changed, updated, revised, … as each side maneuvers for position. The winner is the best negotiator, the most powerful, or the one who hid the most information. Never is the result a win-win unless the “win-win” is “dictated” or “proclaimed” by the //winner//.
Once the negotiations are complete, the real games of Olympic proportions begin. People will make choices that move the needle on the performance gauge in their favor. At best, this may result in accelerating/decelerating expenditures or accelerating/decelerating sales. Very often, these changes are not in the best interest of the enterprise. At worst, this may drive unethical or illegal behavior with very severe consequences. (For a more in-depth discussion, please see Corporate Budgeting is Broken)
The best solution to this performance trap is to disconnect compensation from budgeting. Instead, compensation should be relative to external benchmarks, internal benchmarks, or historical trends. Sufficient for now is a single word – Disconnect! (ajs)
Ref: 1 Michael C. Jensen, “Corporate Budgeting Is Broken—Let’s Fix It,” Harvard Business Review, 79/10 (November 2001): 95-101.
The budgeting process often lends itself to gamesmanship because of the compensation and incentive packages followed within the organization. This is because managers are often assigned compensation that is driven by maximizing performance on the budgets and/or functions that the manager “owns.”
When a manager must maximize performance on a decentralized scope, they tend to protect their own turf and focus on local and/or short term actions rather than those that have a synergistic value to the entire enterprise. The manager becomes conditioned to make attempts to over budget (add in fat) to their plans so that when actual performance comes in below plan, they look like they have delivered value. It is that perceived value that drives their incentive and compensation. Few managers will ever admit to this focus, they will always support the overall objective at least in words -- deeds are a different matter.
However, what really occurred for the enterprise is that the resources that the manager over-sold in their budget might have been able to be used elsewhere in the enterprise within established spending limits for more critical or needy services and functions. This environment can breed healthy competition between departments or managers, but often leads to a budget planning process that focuses more on maximizing compensation and performance targets, rather than on overall company profitability. Those managers that are more charismatic in selling their organizations’ budget needs often win out, as opposed to the manager who may be more productive in supporting overall profitability and efficiency for the company.
The obvious next step is to work with the appropriate authority to design compensation and career growth rewards that have an optimal mix of incentives that drive towards both company level success and individual motivation. For example, stock options could be given to managers based on exceeding division or company level targets. This incentive would set a context of holistic company level performance in two ways. One, the target to meet is one that requires partnership and maximizing of resources with one’s peers. Two, the reward itself, stock options, grows as overall company performance grows.
A more complex measure would be external or competitive benchmarks. However, these add a level of complexity that may offset their value.
To incentivize personal performance and minimize those managers that ride on coat-tails of others, a second package that rewards performance on operational (non-financial) metrics could be implemented. Examples include performance targets for quality (defects), delivery (cycle time), safety, and morale.
It is often the carrot that is dangled that gets eaten. We need to point the stick that holds the carrot to guide all players toward the right direction. (ss)
- Develop compensation incentives based on internal and external benchmarks, market comparison, etc. to establish more consistent and objective performance targets and to reduce negotiation requirements and gamesmanship.
- Design compensation plans and rewards that have an optimal mix of incentives, including career growth, that drive towards both company level success and individual motivation.
- Avoid compensation plans that are primarily tied to an individual's budget performance.
- Value analysis of FTE activity for the process "perform planning/ budgeting/ forecasting."
- Activity analysis of FTEs for the process "perform planning/ budgeting/ forecasting."
- Percentage of employees with compensations affected by variances.
- Percentage of employees with compensation affected by profit.
- Distribution of the total cost of the process "perform planning/budgeting/forecasting" by individual cost element.
Leading Practice Statements
- Report on key performance indicators which are aligned to business objectives and management rewards.
- Link with performance measures that are both financial and operational measures that are in line with benchmarks of industry data.
- Use benchmark information as an input into the budgeting/planning process Move To Data Management
- Report key performance indicators which are aligned to business objectives and key result areas
- Include more than financial information; focus on operational performance
- Provide targets that focus on market share and competition
- A reduction in budgeting cycle time and improved planning and budget process can be achieved by implementing business rules that can be applied to budget models and disseminated quickly to potentially thousands of end user planning contributors.
- Driver-based business rules can ensure the basis for planning is relevant to operational managers and that planning is embedded into everyday management processes.
- Corporate vision statement used in balancing bottom up iterative planning
- Maximize ability to evaluate business data by using an analytics solution
- Average personnel cost per FTE for the process "perform budgeting/planning/forecasting."
- Personnel cost (including benefits) of the process "perform planning/ budgeting/ forecasting" per one thousand US Dollars revenue.
- Cycle time in days to complete the annual budget cycle in the most recent fiscal year.
- Cycle time in days to complete the financial forecast.
John Corden. "Using Analytics To 'Hit It Out of the Ballpark'" Financial Executive (May 2004)
- Mainly used to determine compensation
- Compensation can be determined in better ways
- More important for compensation than profitability