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Manager's Journal: Why Pay People to Lie?

By Michael C. Jensen. Wall Street Journal. (Eastern edition).

New York, N.Y.: Jan 8, 2001. pg. A.32 - Text Word Count 841

Subjects: Financial performance, Earnings forecasting,  

Managers journal (wsj), Goal setting

Document types: Commentary Copyright Dow Jones & Company Inc Jan 8, 2001

ProQuest document ID: 66257059 ISSN/ISBN: 00999660

Text Word Count 841

Abstract (Document Summary)

The end of the year brings out the creativity in managers as they seek to meet revenue targets and assure their bonuses. I once watched the management of a manufacturing company struggle to reach their year-end targets. In late fall, they announced a price increase of 10% effective Jan. 2. Now it may be that a price increase was needed, but it was not in line with the competition, nor was it likely that Jan. 2, of all dates, was the best time for the increase. A price increase on Jan. 2. would, however, cause customers to order before year-end and thereby help managers reach their targets.

Budget systems are based on the premise that managers should be rewarded for achieving targets and punished for missing them. Tell a manager that he will get a bonus when targets are realized and two things will happen. First, managers will attempt to set easy targets, and, second, once these are set, they will do their best to see that they are met even if it damages the company. The result: Almost every company uses a budget system that rewards people for lying and punishes them for telling the truth. Indeed, in some cases the more managers lie, the more money they make.

 

Full Text (841   words)

Copyright Dow Jones & Company Inc Jan 8, 2001

The end of the year brings out the creativity in managers as they seek to meet revenue targets and assure their bonuses. I once watched the management of a manufacturing company struggle to reach their year-end targets. In late fall, they announced a price increase of 10% effective Jan. 2. Now it may be that a price increase was needed, but it was not in line with the competition, nor was it likely that Jan. 2, of all dates, was the best time for the increase. A price increase on Jan. 2. would, however, cause customers to order before year-end and thereby help managers reach their targets.

Sound familiar? Such budget-gaming is rife. Missing your target is a costly mistake for a manager and, as this example shows, managers will go to great lengths to avoid it. In quest of their targets, many managers take actions that benefit themselves at the cost of their companies.

Consider this: Managers at a heavy equipment manufacturer were so set on making their targets that they shipped unfinished industrial products from their plant in England to the Netherlands. At great cost and inconvenience, they finished assembling their product in a warehouse close to their customer. By doing so, they booked the sale in the necessary quarter, assured their bonus, and lowered their company's profit.

Budget systems are based on the premise that managers should be rewarded for achieving targets and punished for missing them. Tell a manager that he will get a bonus when targets are realized and two things will happen. First, managers will attempt to set easy targets, and, second, once these are set, they will do their best to see that they are met even if it damages the company. The result: Almost every company uses a budget system that rewards people for lying and punishes them for telling the truth. Indeed, in some cases the more managers lie, the more money they make.

Managers, therefore, both game the realization of targets and conspire in the setting of targets. Here's how:

Gaming the realization of targets.

A manager who is in danger of just missing his target will accelerate shipments and revenues from next year into this year and move expenses from this year to next even though by doing so overall profits are reduced two years running. Similarly, managers have been known to load the distribution channel with more product than it can handle because shipping the product allows them to recognize revenues this year, rather than next. Managers do this even though they expect the product will be returned and even though they know that makes it harder to hit next year's target.

This can become fraudulent. In one case managers shipped fruit baskets that weighed exactly the same amount as their product and booked them as sales. In another, Informix, an Internet software company, and its auditor paid $142 million to settle lawsuits resulting from SEC charges that they fraudulently increased earnings by $295 million in the 1994-97 period. The SEC charged, among other things, that managers attempting "to meet or exceed the Company's internal revenue and earnings goals" moved revenues from one quarter to the previous quarter by backdating sales agreements.

Similarly Sabratek, a maker of health care equipment, has been sued for a series of alleged revenue enhancing frauds. Among the allegations are claims that the company delivered products to entities that had not ordered them, parked inventory, and stuffed the distribution channel.

Gaming the setting of targets.

Managers have information that is important in setting budget targets. However, once a reward system is tied to budgeting practices, managers have no interest in seeing such information accurately portrayed. Indeed it is in their best interest to underestimate what they can accomplish.

Such gaming starts a vicious cycle. If subordinates have an incentive to lie about what they cannot do, superiors are then led to lie about how much their subordinates can do. Now no one in the system can accurately estimate what truly can be done. The budget process has been corrupted and critical information has been hidden, destroyed or polluted.

Budgets play an important coordination role in companies. Once we establish a budget-targeting process that hides and destroys information, this coordinating role is severely hampered. Uncoordinated, chaotic actions that lead to high costs, low quality, missed opportunities, and dissatisfied customers are the result.

Almost no one in this system believes he is lying, and few would actually say they are doing wrong. Indeed, in most corporate cultures much of this is expected, even praised. Stopping it will not be easy.

To restore integrity to the process, we must begin not by telling managers to stop lying, although that would be laudable. Instead we must begin by eliminating the use of budget targets in compensation formulas. Only then can we be sure that we are paying people to perform, not to lie.