Insights

In this series of articles, we’ll review some of the most common mistakes that privately held companies make in approaching the question of incentives, before looking at a sketch of what I have seen work well.

Mistake #3: Bonuses based on performance against budget

Given the short-comings of discretionary bonuses, an obvious solution for many companies is to base bonuses on performance against budget. Hit the budget, get the bonus. Simple. But there is a major unintended consequence of this approach– it pays people to lie.

The case of a client I’ll call George, is instructive. George owns a privately-held plastic injection molding business and he was sharing with me recently his frustrations with the forecasts put together by his sales team each year. While George feels the business is fairly stable and sales should be fairly predictable, each year demand has been under-forecast by the sales team, leading to under-resourcing in the production department, lost sales and damage to the firm’s reputation for reliability.

The sales team incentive plan runs on performance against budget and the budget is set with the involvement of the sales team each year. The sales team responds to this arrangement by maximizing sales and minimizing the budget.

While George is aware of the in-built conservatism of the sales forecasts, the sales team is closer to the customer base than he is and he feels unable to rigorously challenge their projections.

Not only does linking incentives to the budget reduce the reliability of George’s sales forecasts, it means sales managers are being paid higher incentives than what George feels they truly deserve.

In order to build ‘buy-in’ to the numbers, many owners will, like George, involve the managers responsible for performance in the preparation of the firm’s budget. And the final set of numbers usually involves some degree of negotiation between the ‘aspirational’ goals of owners and the ‘realistic’ goals of managers.

But while the benchmarks set in the final budget make no difference to the wealth of owners (what matters to them is the actual results), that is not the case with managers whose bonus is tied to performance against budget.

For them, where the budget lands can make tens of thousands of dollars difference to their pay that year. And the higher the budget, the lower the probability they will be paid a bonus. So incentive schemes that use performance against budget to determine incentive payments encourage managers to negotiate for the lowest, most ‘realistic’, budget they can get away with. The problem is so widespread we even have a name for it: ‘sandbagging’. But what it really is, is lying.

Tying incentives to budget encourages a swag of dysfunctional behaviour, including:

• Low-balled budgets, leading to under-resourcing and in turn missed sales and missed profits.

• Hoarding of information by managers (sharing it with owners will weaken their negotiating position), which reduces the quality of decision making at the top.

• Time wasting: with meaningful amounts in bonuses at stake, it’s not surprising that the preparation of the annual budget is often drawn out over months as each layer of management negotiates with the next. Owners, of course, pick up the tab for this massive time wasting exercise.

• Money wasting: if a manager has negotiated and won some expenditure in his budget but fails to spend it, he weakens his negotiating position for that and other expenditure in the following year. Better to spend it on useless activity than loose the money for future years. Far from encouraging managers to trim their costs, tying bonuses to budget encourages them to pad their costs, building a buffer for the year when performance is sailing close to budget and they need to ‘pull out all stops’ to get their incentive.

And of course, by negotiating budgets annually, much of the risk of non-payment is taken out. Annual negotiation allows targets to be reassessed for their ‘reasonableness’ so that projections that were made for that new market or acquisition, can be reassessed 12 months in and ratcheted down to ‘realistic’ levels, ‘given what we now know’. And bonuses can still be paid, despite the woeful returns to investors.

Perhaps worst of all, tying incentives to budget and then negotiating the budget puts the vast bulk of honest, hardworking managers in an unenviable position. It forces them to either lie about what they think the business is capable of and benefit their families, or be truthful and watch as the rewards flow to others.

It generates a high degree of cynicism or a low degree of morale. It does not encourage managers to sustainably grow wealth for shareholders and it makes bonus payments made in this way very poor value for money for owners.

Next we’ll look at the dangers of cliff-payoffs in incentive programs.