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.