Efficiency is about doing more with less in terms of time, energy and materials. It means defining the successful formula with precision for each node of performance at anytime.

Budgeting and planning are dreaded chores for most managers. Never-the-less, a company cannot thrive without a plan. Planning related processes are intended to answer two critical questions in managing the enterprise: Are internal resources being efficiently allocated? Do targets represent strong, efficient, but achievable goals? For example, a bank branch can target, for a number of relationship managers, the average quarterly volume of deposits expected from each relationship manager, and average service transaction times at the branches. All of these are interrelated at the branch level. Furthermore, one can’t strike a value-maximizing balance among these items unless their impact on overall enterprise efficiency is taken into account. A “balanced scorecard” can’t approximate efficient targets because its targets include subjective determinations of what is “achievable”, and that determination is captured in a static relationship. Most businesses either end up with targets that are too low, and money is left on the table, or the targets are too high, which means demoralized managers with dysfunctional incentives, and the risk of losing them to a competitor.

Budgeting and Performance Planning

The conversation between the executive and store manager might look like the beginnings of an exercise in optimization, but there are two problems that will inevitably compromise any resulting targets. First, in most companies, targets are set by business unit managers and are generally understood to get translated into bonus plan targets. So, managers will go through an apparently objective review of historical growth for each line of business, then extrapolating those results with a modest upward bias. But their clear incentive will be to understate the true potential of their business, at least to some extent. Senior management can impose a global constraint by insuring that all the business unit targets add up to an earnings projection that can be sold to the investment community, but a lot of intercompany negotiations may need to take place to arrive at such a goal.

The second problem is that if there are a dozen or more key performance indicators per business unit, then these KPIs need to be weighted according to some criteria. Considering a large number of decision making units (a DMU can be a branch, a sales manager, a store, etc.) are allocated target values, it is clearly “unfair” to apply the same “standard” weight for all, If these weights are fossilized in a scorecard, then the business can lose its responsiveness to changing conditions in an attempt to look good against the embedded metrics, especially if they are tied to variable pay.

Conventional planning systems have no unified analysis around the inherent trade-offs faced by a manager trying to respond to a shifting market. Even if they agree on the trade-offs for this particular manager, they risk “local optimization” that may undermine overall enterprise efficiency.

Executives should aim for global optimization – accounting for the constraints of all business units at once. Such optimization can’t be done with a spreadsheet – it requires a more advanced modeling tool.

The first problem can be solved by a mechanism that separates target setting for the budget from target setting for bonuses, but this can only be reliably done for the company as a whole. The problem remains for “how to allocate an objectively set global target to the business units and decision making units below them”.

This latter problem, as well as the issue of establishing local targets that are globally optimized, is solved with the LBA EPO system. LBA EPO generates targets for resource allocation and target setting in dynamic manner, enabling managers to do their local best and serve the best interest of the enterprise as a whole.

Conclusion

• Corporations strive to improve performance, and make better decisions faster, in every area.
• BI systems collect massive amounts of data, and humans try to select and analyze a tiny portion of it. The result is a slow and highly politicized planning process, poor decision making, and dysfunctional organizational behavior.
• Attempts at remediation – like average-based KPIs and balanced scorecards – are actually a big part of the problem.
• It is not possible to achieve enterprise efficiency without all eyes pursuing their competitive potential all of the time.

Abstract

This paper analyzes the counterproductive effects associated with using budgets or targets in an organisation’s performance measurement and compensation systems. Paying people on the basis of how their performance relates to a budget or target causes people to game the system and in doing so to destroy value in two main ways: (a) both superiors and subordinates lie in the formulation of budgets and, therefore, gut the budgeting process of the critical unbiased information that is required to coordinate the activities of disparate parts of an organisation, and (b) they game the realisation of the budgets or targets and in doing so destroy value for their organisations. Although most managers and analysts understand that budget gaming is widespread, few understand the huge costs it imposes on organisations and how to lower them.

My purpose in this paper is to explain exactly how this happens and how managers and firms can stop this counter-productive cycle. The key lies not in destroying the budgeting systems, but in changing the way organisations pay people. In particular to stop this highly counter-productive behaviour we must stop using budgets or targets in the
compensation formulas and promotion systems for employees and managers. This means taking all kinks, discontinuities and non-linearities out of the pay-for-performance profile of each employee and manager. Such purely linear compensation formulas provide no incentives to lie, or to withhold and distort information, or to game the system.

While the evidence on the costs of these systems is not extensive, I believe that solving the problems could easily result in large productivity and value increases – sometimes as much as 50–100% improvements in productivity. I believe the less intensive reliance on such budget/target systems is an important cause of the increased productivity of entrepreneurial and LBO firms. Moreover, eliminating budget/target-induced gaming from the management system will eliminate one of the major forces leading to the general loss of integrity in organisations. People are taught to lie in these pervasive budgeting systems because if they tell the truth they often get punished and if they lie they get rewarded. Once taught to lie in this system people generally cannot help but extend that behaviour to all sorts of other relationships in the organisation.

The global pressure to reduce agency costs

The ultimate purpose of corporate governance is the minimisation of agency costs, i.e. the leakage of value inherent in the separation of ownership and management. When managers quietly shirk their responsibilities, or waste company resources, or use their positions to enrich themselves at the owners’ expense, the overall value of the corporation declines. That impairment lies well-hidden within the corporation’s overall operating, administrative, and financing expenses, as diverted or uncollected revenue, or as a higher cost of equity.

Agency costs are generally attacked using various governance tools such as board oversight, communication to investors, entrepreneurial incentives for managers, and clever methods for de-politicising decision making. Some improvements are driven by legal requirements, such as disclosure or minority rights, but most of the important agency cost reductions seen throughout history are the product of internal corporate process enhancements adopted by leading companies and spread, through competitive pressure, to the rest of the economy

Managers are rarely motivated by kindness to their shareholders in adopting such enhancements; they are, instead, responding to ever-increasing market demand for reduced investment risk and better overall returns. Thus, when it comes to reducing agency costs, every company has the choice of being a leader or a follower.

In the case of advanced nations, experimentation with new corporate governance standards is often costly and risky. Witness the implementation of Sarbanes-Oxley, which was hurriedly and unwisely put forth as a “one-size-fits-all” governance reform. In contrast, companies in developing nations are in the enviable position of paying attention to what works and what doesn’t in advanced nations, so all that remains is to bear the costs of proven changes and avoid the costs of failed or inefficient ones

Balancing firm-specific knowledge and director independence

Turkey is showing how it learns from the West in its evolution towards greater board independence. Mindful of the requirement for boards to provide rigorous oversight of management, Turkey’s corporate leaders are also aware that management remains one of the board’s key constituencies. Boards are obligated to bring their wisdom and experience to bear on the major issues faced by the company and to advise and guide their CEO accordingly. An adversarial relationship between board and management simply won’t do. A push towards too much independence too quickly will not serve the ultimate goal of good governance, which is the maximization of shareholder value.

Leading Turkish firms, especially those with the most internationally facing operations are diligently managing the transition toward more independent directors while retaining their historical board familiarity with the business and the bond of trust that must be maintained between managers and directors. This evolution is taking place in the context of an international governance environment encouraging great caution on the part of directors, especially relatively newer ones who aren’t as intimately familiar with the companies they are charged with overseeing. While the conservatism that attends such caution can be very frustrating to outsiders impatient for change, these slow moves are desirably functional, up to a point, as long as the transition is consciously pursued with unequivocal commitment

Enabling greater transparency

Turkish companies are also making great improvements in transparency. While board and management conservatism are certainly factors moderating the pace of improvement in transparency, this impediment is often more a matter of data integrity than of management integrity. Inevitably, managers who are too controlling about information invite suspicion, even if they are merely attempting to exercise quality control over often-unreliable data, which is still, unfortunately, the norm in a developing market like Turkey. It’s bad enough that such behaviour practically invites board or shareholder intervention, but worse when that intervention is based on poor, compromised, or easily-manipulated data

Leading Turkish companies are beginning to diffuse this situation with a dramatic improvement in the underlying quality of information. This enables wider and freer dissemination of information within the company right up to the board level. The best companies are beginning to take advantage of this change by providing their newly empowered boards this enhanced information as a window into the company, improving both the quality and relevance of their advice.

Of course, enhanced transparency can be unsettling to incumbent management that might be concerned about heightened accountability. But competitive pressures are quickly sorting out the leaders from the followers in this regard, largely through its powerful effect on reducing the firm’s cost of capital. The leaders among Turkish firms, in fact, are allowing non-management directors to design information content presented to the board instead of merely making do with management-generated reports. These boards are given access to the dimensional richness of performance information almost as soon as it is becoming available to management.

From better governance to better governing

All boards experiencing a growth in the percentage of independent directors are wrestling with finding the optimal line of demarcation that separates guidance from meddling. In Turkey, the trend toward more independent directors is co-evolving with the management information revolution. The best companies are consciously managing this co-evolution to not only catch up to Western standards for reporting and forecasting, but to exceed them in the use of information for internal target setting, disclosure, incentives and enhanced board-management effectiveness. In fact, the largest remaining sources of agency costs among the most internationally-facing Turkish firms have little to do with director independence or transparency. Instead, they are lingering side effects of the traditional model of management that plagues firms of even the most advanced nations.

Breaking the dysfunctional link between bonuses and budgets

The biggest disagreements in the management of large firms are those over strategic direction. These disagreements are exacerbated by perverse internal incentives in the planning process. The most perverse of them all is the practice of basing variable compensation targets on budget targets. This practice invariably turns planning into negotiation, encouraging business unit managers to understate the potential of their business in target setting. Most corporate managers in developed countries don’t even consider this budget dance to be fundamentally dishonest since it is the system they grew up with.

But it is worse than dishonest. It encourages caution on the part of business unit management out of concern that over-achievement in the current year will be penalized in subsequent years through the budget-based target setting process. It encourages accounting tricks to squirrel away excess achievement, if possible, to future periods so as not create unrealistic expectations for the following year. How much does this caution and manipulation cost shareholders who are paying their managers to maximize their profits? To the extent that this negotiation begins at the top of the company, the board is complicit in this value-destroying practice.

Some large companies are scrapping budget-based targets. Instead, they are developing target-setting with greater intelligence and integrity, such as improvement-based targets over multiple years, or targets based on peer benchmarks or implied shareholder expectations. While many of these techniques are relatively new, all the companies trying them have experienced the liberation of divorcing budgets from compensation targets. They are seeing more creative and aggressive plans from their business units, and a transformation in the roles of holding company executives from that of policemen and watchdogs to true partners in value creation.

Of course, such changes assume that top management wishes to shed their police roles. Many companies that retain the budget-bonus link do so expressly as a vestigial tool of management control. One of the great governance lessons of history, though, is that once authority can safely (i.e., with minimal agency costs) be delegated, the company will perform better if it is done, or eventually suffer if it isn’t.

Finishing the job of pushing down accountability for capital

Lean production has done wonders for squeezing working capital out of the system. But in many corporations, business units still have an insatiable appetite for developmental capital. Unit managers promise all manner of returns if they can get enough investment from the parent company. One side has specific knowledge of investment opportunities – the other has the cash. Most corporations do a messy job of resolving this imbalance in the investors favour, mostly by capital allocation through highly politicised discussions.

Some companies that have successfully de-politicised this discussion by demanding a return on capital threshold for the business units, below which they cannot earn rewards based on any level of earnings. But the most promising capital discipline technique is to base compensation on economic profit (net income less a capital charge)-a program that literally charges managers for the capital they utilise. Where this works, it works very well. Business unit wish lists quickly condense into manageable capital budgeting plans. The finance department becomes more of a partner than a gatekeeper.

Like the budget-target problem mentioned earlier, some corporate managers are reluctant to adopt a truly rational capital allocation method supported by sophisticated analytics, one that gets business unit managers to spend money as if it were their own, because it could mean giving up a major lever of control over the business units. Again, we refer to the verdict of history. If a method arises to safely delegate authority, you should bear the fruit of delegating it, or that fruit will go to your competitor.

Investment in financial literacy

The prerequisite to implementing any of the aforementioned changes is a high degree of financial literacy among both holding company and business unit managers. If managers haven’t had to make trade-offs between income and capital, they need to learn their balance sheet, how their income and capital are related to each other, how they are together related to their business unit’s activities, logically and intuitively, and how their plans relate to those activities and their financial results over time. This is a serious training effort over months or years. If it’s done right, all managers find themselves speaking a common language and no longer arguing about what is important, ready to take advantage of the greatest reduction in agency costs since the invention of the profit center.

The leading Turkish companies are in the early stages of pursuing this transformation. They have taken the hard-won lessons of the most successful firms in the world and are applying them to their own, rapidly evolving market. Our twenty-five years of consulting to some of the most prominent corporations in Turkey and the rest of the world tells us that the next major step in the evolution of corporate governance is at hand.

We see the essence of our work as circle of insight, impact, and trust.

- We work closely with clients to convert insights into strategies, whose implementation will have a substantial positive impact on performance.

- Consistently delivering impact earns the trust that is the foundation of lasting relationships. These relationships serve as a platform for still deeper insights and more significant impact.

-  We hope that our reach covers people as well as organizations. We seek to inspire enterprising and imaginative people, at Levend Beriker Associates and our client organizations, with unparalleled opportunities for professional and personal growth.

We have reason to believe that the classical budgeting and planning systems have overstayed their welcome and various attempts at improvement in workflow are proving to be difficult to implement and maintain. Our response to this problem is explained in Enterprise Target Setting.