michael jansen_2001_corporate budgeting is broken_let's fix it

8/10/2019 Michael Jansen_2001_Corporate Budgeting is Broken_Let's Fix It

1/10

Corporate

Budgeting

s Brol


2/10

Harvard

usiness

evie

November oo1

HBR

CASE

ruoy

Ro l loA

Are

Some

Customers

More

Equal

han Others?

P a u l .

u n e s

n dB r i a n

. J o h n s o n

Frnsr

PeRsoN

Ro11oB

Where Leadersh

p

Starts

Robert

.Eckert

D l rpERErur

orcE

Ro11oc

The

Inner Life

of Executive

(ids:

A Conversation ith Chi ld Psychiatr ist obertColes

Skate o

Where he Money

Wil l

Be

Ro11oD

Clay ton .

Chr is tensen,ichae l

aynor ,

ndMat t

Ver l inden

The Real

ReasonPeople

Won't

Change

Ro11oE

Robert(egan

nd

Lisa askowahey

Corporate

Budgeting s

Broken

Lefs Fix t Ro11oF

Michae lC.Jensen

How

to LoseYour

Star Performer

R011oc

Without Losing

Customers, oo

Nee l i endapud i

ndRober t

Leone

HBR

Iru renvrew

Ro11oH

Jim

l(el ly

of UPS:Reinvention

ith

Respect

J u l i a

( i r b y

BEST RACTTcE

Ro11oJ

Changing

a Culture

of Face ime

B i l lM u n c k

Toor- ( r r

Ro11oK

Welcome o the

NewWorld

of Merchandising

Scot t

.

F r iend

ndPat r ic ia

.Walker

EEE

w


3/10

Corporate

I BLdge

@


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o

lng IsBrokenE

L&'s

Fix

It

Trad tiona budqetinc

processes;r; .

t ime

distort

decisions,

and

urn OneSt

manaqers

nto

ChemefS.

I t doesn ' t

ave

o be hat

wav-

i f

you' re

i l l ingo

SeVe

the

ie

S

betwe.n

udgets

and

OmpenSatiOn.

by Michael

.Jensen

t,

I

l"

Copyright o 2001

Michael

C.

ensen.

All rights

reserved.

95


5/10

C o r p o r a t e

u d g e t i n g

s

B r o k e n L e t ' sF i x t

ORPORAT E UDGET I NG S

A

' OKE,

and

everyone nows

t. lt consumes huge amount

of executives'

ime, forcing them int o endless

rounds

of

dull

meetings nd ensenegotiations.

It encourages

anagers

o

lie

and

cheat,

owballing ar-

gets

and nflating esults,

nd t

penalizes

hem

or

telling

the truth. It turns businessecisionsnto elaborate xer-

cisesn

gaming.

t sets olleague gainst

olleague,reat-

ing

distrustand ill will.

And it distorts

ncentives,

moti-

vating

people

o act n

ways hat run counter

o the best

interests

f

their companies.

Consider

ust

two examples. t

one international

heavy-equipment

anufacturer,

anagers ere

soseton

hitting

their

quarterly

revenue arget hat

they shipped

unfinished

products

rom

their

plant

in

Englandall the

way

to a warehousen

the Netherlands,

ear he cus-

tomer,

or f inal assembly.

y shipping

he

incomplete

products,

hey

were able

o realize he

sales efore he

endofthe

quarter

and

hus

ulfi l l heir

budget

oal

an d

make

heir bonuses. ut

the high costof

assembling

he

goods

at a

distant

ocation

it required ot

only

he rental

of the warehouse

ut

also

additional abor-ended

up

reducing

he company's

verall

profit.

Then

here'she recent

ebacle

nvolving

big

bever-

age company.

he vice

president

f sales or

one

of

the

company'sargest egions

ramatically nderpredicted

demancl

or an upcomingmajorholiday.

is motivation

wassimple-he wanted

o ensure

low

revenuearget

that he

couldbe certain

f exceeding.ut he

price

or his

litt le

white ie was xtremely igh:The

company asedts

demand

lanning

n

his

sales

orecast nd

consequently

ran out

of its core

product

r.r

ne of

its argest

marketsat

the height

of the holiday

ell ing eason.

Suchcases f distorted ecisionmakilrg re egion n

business.

o doubt,

ou

could

ist similar

nstancesha t

you've

observed-or

perhaps

ven nstigated-at

your

own company.

he sad

hing

is,

heseshenanigans ave

become

so common hat

they're

almost

nvisible. he

budgeting

rocess

s so

deeplyembeddedrr

corporate

ife

that he attendanties

and

games

resimply

accepted

s

business

susual,no matter

how destrr.rctivehey are.

But it

doesn't

have

o

be

that way.Even

f

you grant

that budgeting,ike death

and axes,

will

always e

with

us,deceitful

behaviordoesn'thave o be.

That'sbecause

the budget

process

tself isn't the root

causeof the

counterproductive ctions;

ather, t's he

useof budget

targets

o determinecompensation. hen managers re

told they'll

get

bonusesf they each pecific

erformance

Michael

C.

Jensen,

he

Jesse

sidor Straus

ProfessorJ

Busi-

ness dntinistration,

nteritLts,

t Harvartl

Business chool

it"r

Boston,

s the ntanaging

lrectorof the

organizationttl

strategy

ractice

of the Monitor

Group,

collection

f

gloltal

p

rofess

onal se v ces

r tns

with headqua er

n Cambrd

ge,

Massachusetts.

96

goals,

wo things nevitably

happen.First, hey attempt

to

set

ow targets

hat

are easilyachievable.

hen, once

the

targets

are n

place,

hey do whatever

t takes

o

see

that they

hit them,

even

f the company uffers

s

a result.

Only

by severing he link between budgets

and

bonuses-by

ewarding

eople

purely

or their

accom-

plishments,ot for theirability o hit targets will we ake

away he

incentive

o cheat.

Only then will

we eliminate

the budgeting ncentives

hat drive ndividuals o act

in

ways hat destroy orporate

alue.

Cheaters

rosper

Let's ook more

carefully

at how budgetsdrive compen-

sation and,

in

turn, behavior. n a traditional

pay-for-

performance

ncentive ystem, manager's

otal cash

compensation

salary

lus

bonus) s

constant

nti l

a

min-

imum

performance

urdle s

reached-commonly

ov "

of a budgeted

arget.

The

arget might be expressed s

profits,

ales,

utput,

or any

number

ofthings;

or

our

pur-

poses,

t doesn'tmatter

what's

being

measured.)When

the manager

exceeds

hat hurdle,

she

receives bonus,

often a substantial

ne.

The bonus hen increases s

per-

formancemounts

above

he hurdle until t he

bonus

is

capped

t some

maximum

evel-rzouznf the target s

usual.

hissystems llustrated

n

the exhibit

A

Tlpical

Executive ompensation

lanl'

The kinks n

the

pay-for-perfornance

ine-caused

y

the minimum hurdlebonusand he maximumcap-cre-

ate strong

ncentives

o

game

he system.

s long

as

he

manager elieves

hecan

make

he

minimum hurdle,

he

will naturally

ry

her best o

increase

erformance-by

legitimatemeans

or,

if

push

comes o shove, y illegiti-

mateones.f the measuresprof i ts,or instance,hewill

havea strong

ncentive o

increasehe current

year's

earnings t the

expense

f next

year's,

ither by

pushing

expenses

nto

the future

(delaying urchases

r

hires,

or

example)or

by moving

future

revenues

o the

present

(booking

ordersearly or offerir.rg pecial iscounts o

customers,

or

example).

If, on the other hand, he manager oncludeshat she

can't

make he

minimum

hurdle,her incentives lip r8o

degrees.

ow

her

goal

s

to move earnings

rom the

present

o the

future.

After all,

her

compensation oesn't

changewhether

she

misseshe

target

by a

linle

or a lot;

shestil l

gets

her full salary

assuming

he

doesn't

ge t

fired,of course). ut by shifting

profits

orward by

pre-

paying

expenses,aking

write-offs,

or

delaying he real-

izationof revenues

she

ncreases er chances f

getting

a argebonus he following

year.

his s a

variation

on

the

"big

bath"

heory

of corporate inancial

eporting:

f

you'regoing

o take

a loss, ake as big a

lossas

possible.

Finally, f the manager

s having

a

great year

and her

performance

s nearingthe

budgetcap,sheagainhas

an

incentive

o

push profits

nto

the

future.

Because

he's

HARVARDBUSINESS EVIEW


6/10

not

going

o

get

any

additionalcompensation

f

perfor-

mance

exceedshe level

at

which

he cap s

set,accelerat-

ing expenses

r

postponing

sales

will

haveno

negative

impact

on

her

current earnings,

ut

it

will raise

he

odds

that she'll eap

a

high

bonusnext

year

as

well.

This

per-

verse

ncentive

becomes ven

stronger

f

her current

year's erformances used n setting he followingyear's

targets,

s

s

often he

case.

When

these

kinds of

subterfuge imply move

profits

from

one

year

o

another-by

changing ccruals,or

ex -

ample

the

adversempact

on company

alue s

probably

small.But rarely

s the

activityso

benign.Usually,

he

shuffl ing

fdollars

esultsrom

decisionshat

change

he

operatingcharacteristics

f

a company,

nd t

generates

high, f sometimesidden,

osts

haterode he

otal

value

of

he

company.

e

saw

uch rosionn

he wo

examples

presented

arlier.

We

see

t

aswell in

the common

prac-

tice of

channel

stuff ing-when nanagers

hip oads

of

products

o

distributors

o meet mmediate

ales

oals,

A Typical

Executive

Compensat ion

lan

I

n a

trad

tiona

pay-for-pe

forma

ce

com

pe

n

satiot l

p lan,

manager

arns

hurd le

onus

when

per for -

mance

eaches

cer ta in eve l

A) .

he

bonus

ncreases

wi th

per formance

nt i l t h i t s

a max imum ap

B) .

he

kinks n the

pay-for-performance

ine

create ncentives

to

game

he

sys tem. hen

per for r -nance

pproaches

the

hurd le arget ,

manager

as s t rong ncent iveo

acce lera te

he

rea l iza t ionf revenue

nd

prof i t .

When

per formancei t s he cap, he m. lnager asa s t rong

incent ive

o

push

evenue

nd

prof i t

n to he

nex t

ear .

c o r p o r a t eB u d g e t i n g

s B r o k e n L e t ' sF i x t

even hough hey

krrowmanyof the

goods

will soon

come

back as returns.

And

we

see

t in

distorted

pricing

deci-

sions. he managers f

one

durable-goods anufacturer,

struggling o meet heir minimum bonus hurdles, n-

nounced ate one

year

hat they would

be

raising

prices

1oo/o

crosshe board on

January

2. The managersmade

the price hikes becausehey wantedto encourage us-

tomers o

place

ordersby

year-end

o

hey

could

hit

their

annualsales

oals.

But the

price

ncrease

was

out of

line

with the

competition

and

undoubtedlyendedup costing

the company ales

nd

market

share.

Evenmore insidious ffectsare common.One of the

main easonshat

big

companiesave

udgets

n

the

irst

place

s

to

help

coordinate he

disparate

parts

of

their

businesses.

y

openly sharingaccurate nformation and

basing ecisions

n

a common

etof

numbers,he hink-

ing

goes,

ou

ensureharmonious nteractions mong

units, eadir.rgo

efficient

processes,

igh-quality

roducts,

low

inventories.

nd satisfied

ustomers. ut as

soon

as

you

start

motivatingunit anddepartmentheads o falsify

forecastsnd otherwise ide or manipulate ritical nfor-

mation,

ou

undermine he salutary ffects f budgeting.

Indeed,

he

whole

effort backfires. ouend

up with

unco-

ordinated,

haotic nteractionss

people

rake ecisions

on the basisof distorted nformation hey

receive

rom

other

unitsand rom headquarters.oreover,ince

man-

agers rewell

aware hat everyones attempting o

game

the

system or

personal

easons,

ou

create

an

organiza-

tion rifewith

cynicism,uspicion,

nd

mistrust.

When the

manipulation

of budget argetsbecomes

routine,moreover,

t

can

undermine

he

inte$ity

of an

entire organization. ncemanagers

ee hat

it 's okay

to l ie and concealnformation

o enrich

hemselves r

simply o hold or.ro their obs, hey soonbegir-ro extend

their dishonest

ehavior o

all

parts

of

the

company's

management ystemand

even o its

relationshipswith

outside

parties.

Managers tart o feed misleading nfor-

mation

to customers, uppliers, nd

employees,

nd

the

CEO

and

CFObegin o

"manage

he

numbers" o

influ-

ence he

perceptions

f

board

membersand Wall

Street

ar.ralysts.venboards f

directors

redrawn

nto

the

fray,

as

hey

endup

endorsing eceptiveeports o

sharehold-

ers.Sometimes,

utright

fraud ensues, s

we've seen

recently n

high-profile ases

nvolvingcompanies

uch

as

lnformix,

Sabratek, nd

Lenrout& Hauspie.

The

damage an

go

well

beyond he

wallsof individual

companies.

hink about

what happens,or

example,

ur-

ing a boom. As financialanalysts nd investors aise

expectationsor

growth

beyond

he capabilityof compa-

nies, .nany

managers

egin

o

borrow rom the

future to

satisfy

he

present

emands.

his results n an overstate-

ment of

earnings nd

cash lows or many companies

nd

an

exaggeration f the extent

of the

good

times. Con-

versely, uring he earlystages f an economic

lowdown,

as demand alls below

predicted

evelsand

inventories

,{ar9* ,{a(9er

"{a(9et

^(sodq*

s*dq*

^(s$dqe'

to"r"'

(}o"1""

N O V E M B E R2 O O 1


7/10

C o r p 0 r a t e u d g e t i n g s

B r o k e n L e t ' sF i x

t

build

up,

managers ften ind themselvesalling

shortof

their

bonus

argets.

When they and their companies ll

react n

the same,

redictable

ay-takingbig

bathsby

maximizing he

bad

news-the

cumulative ffect

s

o ex-

aggerate

he

economic

weakness,

erhaps

eepening

r

extending

he

recession.

acroeconomictatistics nd

evenpublicpolicyare ikelydistortedn the process.'

Getting he l(inl


8/10

C o r p o r a t e u d g e t i n g

s B r o k e n L e t ' s

F i x t

bonuses f factoryworkers.Based n

his

indings,Roy

estimated hat

productivity

n

the factory

he

studied

would

ncrease

y

33,2,

o r5o"z"f the targets

were

dis-

continued.Based

n

that research, s well

as

my

own observations f the

widespread,

estructive

effects f

gaming,

conclude hat the costs f

bud-

get-based onuses ar outweigh the benefits n

most, f not all,

situations.

Finally,

t 's important to note

that setting

extremely

aggressivetretch

goals,

s

s

so

com-

mon n business

oday,

an

tselfhave

dan'raging

repercussions.y establishing

he expectation

that managers i l l constantly

ush

o

exceed

reasonable

rowth

and

profitability

argets,

senior xecutivesanend

up creating dys-

functional

organizational

ulture n which

all the

problems

've

described re

ampli-

fied.That's

what

happened ecently

at one

h

prominent

multinational

corporation.A

new

CEO ame

n,andhe

suspectedhat unit

heads ere outinely owballingheirbr.rdget

targets nd hen delivering

mediocreesults.

He

quickly

eorganizedhe companyo estal>

lish clearer ccountabil ityowr.rhe line,an d

then he

aunched

n intensive ampaign

o

get

everyoneo set

stretch

goals

or

he coming

ear,

with

their bonuses anging n the bllar.rce.he

*

v

. ' . :

t

rI

effort blew up

in the

CEO's

ace.

The budget-setting

rocess

ecarnre

year{ong

exercise

n

nternecine

arfare.

(nowinghat

heir

bonuses inged

on

their

abil ity

o hit the new ar-

gets,

ine managers att led lverhe way

he overall

corporate tretch

goals

or revenues

nd

profits

shouldbe

allocateclmong he businessnits.Each, f cotrrse,ried

to reduce is

or her unit 's arget. veryime revised

oals

were

circulated,ewargunrentsroke ut.Ar.rd

hen

he

targets

were

eventuallyinalized,

hings

got

evenworse.

Within months, tost

unit heads ealiz-edl-rey ouldn'tbe

able o

reach

heir stretch

oals,

nd

hey

et

he

year

al l

into he ank n

a

way hat

sconsistent

ith

pushing

ev-

enues nd

profits

out to the future.'Iheywere

clearlyhop

ing that

by takinga

bath

his

year

hey would

be

given

lower

argets ext

year.

Needlesso

say,

he

CEO'senure

was

short.

Mal


9/10

C o r p o r a t e u d g e t i n g

s

B r o k e n L e t ' s i x t

coming

year.

f, after some

point,

market sharecan be

increased

nly

by

cutting

prices,

nd thus

prof l ts,

he

manager

o

longer

hasa basis or making easoned eci-

sions.

he

conflicting

oals

liminatehisability o act

pur-

posefully.

When usi ng multiple

performance

measures

for

individualmanagers, ompanies

houldbe careful o

establish single, learly efinedmeasure f overall usi-

ness

uccess,uch seconomic alue

dded. hatwill

give

managers

basis

or

making trade-offsamong

perfor-

mancemeasures

hen

hey come nto

conflict.'

A second xamples the

use

of ratios s

performance

measures.lere I can

be

blunt: Don't

do

it.

Using atios,

suchas salesmargin

or

return

on

assets,nevitably

ro-

duces

aming.

hat's

ecause anagersan ncreasehe

measuren two

ways: y ncreasinghe

numerator

r

de -

creasing

he denominator.f, for example,

company

tracks

erformance

ccordingo marginas

a

percentage

of sales, anagersan

ncreaseheir

pay

bysimply utt ing

b: rck

ales

sel l ing

nty he highest

margin

products)

instead f working o

increase

he

margins

n all

prod-

ucts. he result: otaldollars f profit all,andcompany

value

erodes.

The

positioning

nd

slope f the

bonus ine

work n

tan-

dem to determine he amount

of

money a manager

receives

or a

given

evel

of

1-nrformance.

oving hc'

ine

to the right on the-

erformance

cale,or

instance,

akes

it harder o

get

an

additional ollarof

bonus,

hilc

pro-

viding

a steeper

lope

makes

t

easicr

o

get

hatdollar.n

setting

he

ine,executives avea er.rdencyo focus

on

he

short erm. n

particular,

heyoftcn

position

he

ine

based

on

he

prioryear's erformance.

hat educes

he

isl


10/10

Don't

backtrack. Evenafter manurgers

ecome ntel-

lectually

onvincedhat

a l inearbonus chedules

desir-

able, hey

nray

stil l

argue br

a compromise

lan

that

again

allows

budget

argets

o influence ompensation.

n

a

number

of companies haveworl

michael jansen_2001_corporate budgeting is broken_let's fix it

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