Corporate Budgeting Is Broken—Let’s Fix It

Lying, cheating, scheming—is this what your company’s budgeting process is all about? Are your managers lowballing targets, inflating results, distrusting each other, making decisions using distorted information?

In the name of corporate budgeting, are people working against your company’s best interests?

Consider this all too typical story: To meet a quarterly revenue target, managers at a heavy-equipment manufacturer shipped unfinished products from their plant in England to a warehouse in Holland, for final assembly near the customer. The managers earned their bonuses —but the high cost of assembling the goods at a distance eroded the company’s profits.

It doesn’t have to be this way—if you take radical action. No, don’t eradicate budgeting—the budget process itself isn’t the problem. Rather, it’s the use of budget targets to determine compensation that wastes time and encourages deception. So, sever that budget-bonus link. Reward people for real performance, not just their ability to hit targets.

The Idea in Practice

Cheaters Prosper

In a typical pay-for-performance system, a manager’s total cash compensation (salary plus bonus) is constant until he reaches a minimum performance hurdle (usually 80% of budget target). Beyond that hurdle, he earns bonuses until he reaches a cap (often 120% of budget target).

This arrangement strongly encourages gaming the system. First, a manager may manipulate the setting of budget targets by withholding information about what his unit can really achieve, information the company needs for harmonious interactions among units. Then, he may pursue additional gaming options:

• If the manager thinks he can make the minimum hurdle, he’ll increase his performance by padding this year’s earnings at the expense of next year’s (e.g., pushing expenses into the future by delaying hires) or by moving future revenues into the present (e.g, booking orders early).

• If he thinks he can’t make the minimum hurdle, his incentive reverses. He’ll move earnings into the future to increase his chances of making a bigger bonus next year—postponing sales, pre-paying expenses, etc.

• If he’s nearing the bonus cap, he’ll again try pushing profits into the future.

The price of gaming? Distorted information and misguided decisions that erode the firm’s total value. For example, price hikes intended simply to meet bonus hurdles may be out of line with the competition and cost a company sales and market share.

Cutting the Budget-Bonus Link

Adopt a linear compensation plan. To remove the gaming incentive, reward people for what they actually do, not for what they do relative to what they say they’ll do. Here’s how:

• Linear bonuses. Make bonuses for a given level of performance the same whether the budget target is below or above the actual performance.

• Clear performance measures. Establish a single, clearly defined measure of overall business success—e.g., economic value-added. Conflicting goals such as “increase market share and profits” might tempt managers to aim for one goal at the expense of the other; e.g., boost market share by cutting prices, thereby reducing profits.

• Longer-term bonuses. Set bonuses for a number of years out based on longer term projections for growth and profitability. This avoids too much focus on the previous year’s performance.

• Compensation limits. Set upper and lower bonus limits outside the range of likely outcomes, to minimize gaming; e.g., raise bonus caps well above traditional levels.