Incentive Compensation Under Rolling Forecasts

On
a recent webcast, I was asked: “If we move to rolling forecast and
eliminate annual budgets, how can we provide incentive compensation?
Are there approaches for building incentives off of a rolling
forecast?” I will answer that question in my next two blogs.

Most
organizations base incentive compensation on reaching fixed budget
targets. The standard reason for this is that they want to “pay for
performance.” In reality, nothing could be further from the truth. This
is one of the worst practices in management because what really happens
is that the organization “pays for negotiated results.” Instead of
rewarding the best performers/achievers, you reward the managers who
successfully negotiate the lowest levels of performance and execution.
As a result, your management process drives subpar performance. Forget
about “being the best you can be” or striving for the maximum
performance you can achieve.

I once
had a vice president of a major oil company tell me that he “would
never agree to a budget that he could not easily reach; it just would
not be prudent.” I was amazed that he would deliberately set the bar as
low as possible. I do not know where that manager is today, but I do
know that his company no longer exists.

This negative effect
compounds each year. When a low bar is reached, the mechanics of plan
design often limit their upside, so they have financial incentives to
slow performance so that next year’s target will also be easily
reached. Who is to blame? Your senior management bears that blame. They
are the ones who designed the incentive plan.

What should you
do instead? You should shift to relative targets set with a midterm
objective (three to five years out). This is close enough to be real so
progress toward the goal can be tracked even though reaching it in one
year may not be likely. The target also should be set relative to the
environment you will actually be operating in. Therefore the target is
set in comparison to your competitors, to your peers, and to
world-class performance. This may take the form of a value-based
measure such as economic value added or cash flow return on investment
rather than a fixed amount based on assumptions that will likely be
wrong.

In the next blog, I will address

more..

http://bigfatfinanceblog.com/2009/08/24/incentive-compensation-under-rolling-forecasts/