26 Nov 2001  Op-Ed

Why Corporate Budgeting Needs To Be Fixed

Not to mince words, but corporate budgeting is a joke, argues HBS professor emeritus Michael C. Jensen in this Harvard Business Review excerpt. The problem isn't with the budget process—it's when budget targets are used to determine compensation.

 

Corporate budgeting is a joke, and everyone knows it. It consumes a huge amount of executives' time, forcing them into endless rounds of dull meetings and tense negotiations. It encourages managers to lie and cheat, lowballing targets and inflating results, and it penalizes them for telling the truth. It turns business decisions into elaborate exercises in gaming. It sets colleague against colleague, creating distrust and ill will. And it distorts incentives, motivating people to act in ways that run counter to the best interests of their companies.

Consider just two examples. At one international heavy-equipment manufacturer, managers were so set on hitting their quarterly revenue target that they shipped unfinished products from their plant in England all the way to a warehouse in the Netherlands, near the customer, for final assembly. By shipping the incomplete products, they were able to realize the sales before the end of the quarter and thus fulfill their budget goal and make their bonuses. But the high cost of assembling the goods at a distant location—it required not only the rental of the warehouse but also additional labor—ended up reducing the company's overall profit.

Then there's the recent debacle involving a big beverage company. The vice president of sales for one of the company's largest regions dramatically underpredicted demand for an upcoming major holiday. His motivation was simple—he wanted to ensure a low revenue target that he could be certain of exceeding. But the price for his little white lie was extremely high: The company based its demand planning on his sales forecast and consequently ran out of its core product in one of its largest markets at the height of the holiday selling season.

Corporate budgeting … distorts incentives, motivating people to act in ways that run counter to the best interests of their companies.
—Michael C. Jensen

Such cases of distorted decision making are legion in business. No doubt, you could list similar instances that you've observed—or perhaps even instigated—at your own company. The sad thing is, these shenanigans have become so common that they're almost invisible. The budgeting process is so deeply embedded in corporate life that the attendant lies and games are simply accepted as business as usual, no matter how destructive they are.

But it doesn't have to be that way. Even if you grant that budgeting, like death and taxes, will always be with us, deceitful behavior doesn't have to be. That's because the budget process itself isn't the root cause of the counterproductive actions; rather, it's the use of budget targets to determine compensation. When managers are told they'll get bonuses if they reach specific performance goals, two things inevitably happen. First, they attempt to set low targets that are easily achievable. Then, once the targets are in place, they do whatever it takes to see that they hit them, even if the company suffers as a result.

Only by severing the link between budgets and bonuses—by rewarding people purely for their accomplishments, not for their ability to hit targets—will we take away the incentive to cheat. Only then will we eliminate the budgeting incentives that drive individuals to act in ways that destroy corporate value.

Cheaters prosper

Let's look more carefully at how budgets drive compensation and, in turn, behavior. In a traditional pay-for-performance incentive system, a manager's total cash compensation (salary plus bonus) is constant until a minimum performance hurdle is reached—commonly 80% of a budgeted target. (The target might be expressed as profits, sales, output, or any number of things; for our purposes, it doesn't matter what's being measured.) When the manager exceeds that hurdle, she receives a bonus, often a substantial one. The bonus then increases as performance mounts above the hurdle until the bonus is capped at some maximum level—120% of the target is usual.

The kinks in the pay-for-performance line—caused by the minimum hurdle bonus and the maximum cap—create strong incentives to game the system. As long as the manager believes she can make the minimum hurdle, she will naturally try her best to increase performance—by legitimate means or, if push comes to shove, by illegitimate ones. If the measure is profits, for instance, she will have a strong incentive to increase the current year's earnings at the expense of next year's, either by pushing expenses into the future (delaying purchases or hires, for example) or by moving future revenues to the present (booking orders early or offering special discounts to customers, for example).

If, on the other hand, the manager concludes that she can't make the minimum hurdle, her incentives flip 180 degrees. Now her goal is to move earnings from the present to the future. After all, her compensation doesn't change whether she misses the target by a little or a lot; she still gets her full salary (assuming she doesn't get fired, of course). But by shifting profits forward—by prepaying expenses, taking write-offs, or delaying the realization of revenues—she increases her chances of getting a large bonus the following year. This is a variation on the "big bath" theory of corporate financial reporting: If you're going to take a loss, take as big a loss as possible.

Finally, if the manager is having a great year and her performance is nearing the budget cap, she again has an incentive to push profits into the future. Because she's not going to get any additional compensation if performance exceeds the level at which the cap is set, accelerating expenses or postponing sales will have no negative impact on her current earnings, but it will raise the odds that she'll reap a high bonus next year as well. This perverse incentive becomes even stronger if her current year's performance is used in setting the following year's targets, as is often the case.

When these kinds of subterfuge simply move profits from one year to another—by changing accruals, for example—the adverse impact on company value is probably small. But rarely is the activity so benign. Usually, the shuffling of dollars results from decisions that change the operating characteristics of a company, and it generates high, if sometimes hidden, costs that erode the total value of the company. We saw such erosion in the two examples presented earlier. We see it as well in the common practice of channel stuffing—when managers ship loads of products to distributors to meet immediate sales goals, even though they know many of the goods will soon come back as returns. And we see it in distorted pricing decisions. The managers of one durable-goods manufacturer, struggling to meet their minimum bonus hurdles, announced late one year that they would be raising prices 10% across the board on January 2. The managers made the price hikes because they wanted to encourage customers to place orders by year-end so they could hit their annual sales goals. But the price increase was out of line with the competition and undoubtedly ended up costing the company sales and market share.

Even more insidious effects are common. One of the main reasons that big companies have budgets in the first place is to help coordinate the disparate parts of their businesses. By openly sharing accurate information and basing decisions on a common set of numbers, the thinking goes, you ensure harmonious interactions among units, leading to efficient processes, high-quality products, low inventories, and satisfied customers. But as soon as you start motivating unit and department heads to falsify forecasts and otherwise hide or manipulate critical information, you undermine the salutary effects of budgeting. Indeed, the whole effort backfires. You end up with uncoordinated, chaotic interactions as people make decisions on the basis of distorted information they receive from other units and from headquarters. Moreover, since managers are well aware that everyone is attempting to game the system for personal reasons, you create an organization rife with cynicism, suspicion, and mistrust.

When the manipulation of budget targets becomes routine, moreover, it can undermine the integrity of an entire organization. Once managers see that it's okay to lie and conceal information to enrich themselves or simply to hold on to their jobs, they soon begin to extend their dishonest behavior to all parts of the company's management system and even to its relationships with outside parties. Managers start to feed misleading information to customers, suppliers, and employees, and the CEO and CFO begin to "manage the numbers" to influence the perceptions of board members and Wall Street analysts. Even boards of directors are drawn into the fray, as they end up endorsing deceptive reports to shareholders. Sometimes, outright fraud ensues, as we've seen recently in high-profile cases involving companies such as Informix, Sabratek, and Lernout & Hauspie.

The damage can go well beyond the walls of individual companies. Think about what happens, for example, during a boom. As financial analysts and investors raise expectations for growth beyond the capability of companies, many managers begin to borrow from the future to satisfy the present demands. This results in an overstatement of earnings and cash flows for many companies and an exaggeration of the extent of the good times. Conversely, during the early stages of an economic slowdown, as demand falls below predicted levels and inventories build up, managers often find themselves falling short of their bonus targets. When they and their companies all react in the same, predictable way—taking big baths by maximizing the bad news—the cumulative effect is to exaggerate the economic weakness, perhaps deepening or extending the recession. Macroeconomic statistics and even public policy are likely distorted in the process.

Excerpted with permission from "Corporate Budgeting Is Broken—Let's Fix It," Harvard Business Review, Vol. 79, No. 11, November 2001.

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Related HBS Working Paper by Michael Jensen.