Corporate Budgeting Is Broken--Let's Fix It

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 line managers to lie and cheat, lowballing targets and inflating results. And it turns business decisions into elaborate exercises in gaming. The sad thing is, budget shenanigans have become so embedded in corporate life that they're accepted as business as usual--no matter how destructive they are. The source of the problem is using budget targets to drive managers' compensation. In a traditional pay-for-performance compensation program, a manager earns a hurdle bonus when performance reaches a certain level. The bonus increases with performance until it hits a maximum cap. These "kinks" in the pay-for-performance line create incentives to game the system. When performance approaches the hurdle target, a manager will try to accelerate the realization of revenue and profit. When performance hits the cap, the manager has a strong incentive to push revenue and profit into the next year. To eliminate inducements to game the system, companies should adopt a purely linear pay-for-performance scheme that rewards actual performance, independent of budget targets. A manager receives the same bonus for a given level of performance whether the budget goal happens to be set beneath that level or above it. Severing the link between budgets and bonuses eliminates managers' motivation to lowball targets, and it takes away incentives to move revenues and expenses around when the end of a budget period approaches. Not only does this remove the costs of gaming, it also frees managers from all the time they traditionally had to devote to it.