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Raising The Bar of Your Incentive Plan with Automatic Goal Setting

When I was a newly-minted MBA, my boss came to me and said “The Big Guy”— his boss and the head of our division — had suggested I pull together our division budget for the next year. So, I eagerly applied what I had learned in business school about forecasting and planning to create a budget reflecting our aggressive strategy. I confidently placed my handiwork on my boss’s desk, and was soon bewildered by his head-shaking. “The analysis is fine,” he said, “but these numbers are too high. The Big Guy will never go for them.”

“Oh, that’s all?” I replied. The Big Guy was one of those hard-charging, Type-A personalities who walked around the office talking about bear-hugging our customers and crushing our competitors. I could not conceive of him being taken aback by an aggressive budget, and prevailed upon my boss to present my numbers.

The Big Guy immediately began shaking his head. “The numbers are too high.” He went on to explain, “Look, whatever numbers we present, we’re on the hook to make them. Our bonuses depend on it. So, you need to come back with numbers you are certain we can make.” I asked him, a bit cheekily, what numbers he wanted, and he matter-of-factly responded with revenue and profit growth numbers he felt were achievable.

Jack Welch, the legendary CEO of General Electric, took a dim view of this annual ritual, calling it “an exercise in minimization. You’re always getting the lowest out of people, because everyone is negotiating to get a lower number.” This problem may exist even if incentives are not tied to budget goals, but it is certainly compounded by that linkage.

Breaking the Counterproductive Link Using Automatic Goal Setting

What if annual budgeting for business planning purposes could be separated from incentive plan goal setting? The good news is that it can.

Throughout the years, we have had experience with a number of “non-budget-based” incentive systems used by many companies in various parts of their incentive programs. These systems tend to work better than budget-based systems, especially when they are calibrated to scale incentive awards with long-term shareholder value creation over several years.

Setting aside incentive plans based entirely upon subjective judgment, there are three general alternatives to non-budget-based goal setting in incentive plans:

  1. Profit- or value-sharing plans
  2. Stable goal ranges
  3. Relative goals

Profit- or Value-Sharing Plans

Profit-sharing or value-sharing plans take many forms. The basic idea is to fund a bonus pool from a fixed percentage of the company’s profit or change in profit; no budget is necessary. Versions of this type of plan are common among private companies, employee-owned companies and service firms where the scale of the business is closely related to the number of bonus-eligible employees. Companies can divide the bonus pool in any number of ways, from a pro-rata distribution of predetermined shares of the pool to ways that may incorporate individual or team budget expectations, or a mix of methods. In all cases, having the pool itself funded on profit improvement focuses people on growing the pie together before thinking about how it will be split.

A useful and popular variation on profit-sharing is to formulaically base incentives on the percentage (as opposed to dollar) change in profit versus the prior year. At Intel, bonuses based on percentage of target for each executive go up or down in proportion to profit as a percentage of the prior year’s profit. Ball Corp. pays bonuses based on the percentage change in economic value added (EVA), another kind of profit measure, versus the average of the past two years’ EVA. In these and similar cases, the performance targets in the incentive plans are set using the same formula each year without reference to plans or budgets.

Basing incentives on a percentage growth rate largely overcomes the problem of scale that can afflict plans based on sharing of dollar profits. Otherwise, if the participant’s payroll grows at a different rate from company profit or value, or if individual shares of the pool remain constant over time, the plan can easily become miscalibrated, creating rewards that are not in proportion to performance.

Stable Goal Ranges

Some measures, such as gross margin, return on invested capital (ROIC) and earnings or revenue growth can become long-term standards of performance that live in incentive plans year after year. Some companies put these measures on two axes of a matrix, such as earnings growth versus ROIC, so managers doing better on one or both dimensions can earn higher awards. The key is to establish stable goals (i.e., those that persist unless some fundamental change occurs in the business). This approach ensures that higher incentive awards track with higher value creation reasonably well across a broad spectrum of performance over the long term. In addition, stable goal ranges that persist year after year and incorporate the same goals into overlapping plan cycles make it easier for participants to remember the goals and manage against them over time.

Stable goal ranges need to be carefully calibrated so that long-term standards of performance produce competitive returns for shareholders at target and superior returns at maximum, leaving the lower end of the goal range to trigger smaller awards for legitimate achievements, and no awards for substandard achievement. Proper calibration based on careful modeling of the plan’s pay versus performance characteristics allows a “one and done” implementation that can last for years.

Relative Goals

Many companies have formula-based target setting embedded in their long-term incentive plans in the form of relative measures. Although there are many variations on the theme, the conventional leverage is that 25th percentile performance yields threshold payouts, 50th percentile performance yields target payouts, and 75th percentile performance yields maximum payouts. Once calibrated, the use of relative measures in such plans can be helpful, particularly for long-term incentives because they take into account the impact of externalities that managers cannot control.

Overcoming “Short-Termism”

If a company rewards management based on earnings growth, then sets the next year’s earnings target based on the current year’s achievement, would that be a short term plan or a long-term plan? Most companies, noting the annual cycle in measurement and rewards, would call that a short-term plan. But in terms of how incentives drive management behavior, such plans are anything but short term. Decisions that might slightly hurt earnings this year but significantly boost them next year will be taken under this incentive plan. Over the two years, management (and the shareholders) would end up ahead. On the other hand, if next year’s goal is to be based on a budget figure yet to be determined, why would executives risk hurting their bonuses this year while also having their goals bumped up next year?

“Short-termism” is a major, enduring governance challenge. Budget-based goal setting reinforces short-term behavior at the expense of long-term value creation. In a well-implemented incentive plan, setting goals without reference to budgets can extend management’s decision-making time horizon by making cumulative rewards proportional to cumulative performance over time. In other words, managers behave as if formulaic plans are long-term plans.

Managers are more likely to set stretch goals knowing that such goals will not penalize them.

Furthermore, the longer an automatic goal-setting mechanism is in place, the more it reinforces long-term thinking. And a well-calibrated incentive plan with such mechanism at its heart can last for decades. In 1966, Nucor instituted an incentive plan that provided a share of profitability above a threshold level of profit, with that threshold formulaically ratcheting up based on prior performance and new capital investment. This plan remained intact, essentially unchanged, for 36 years, during which time Nucor went from a near-bankrupt joist maker to one of the largest, most successful steel makers in the world. Ball Corp. implemented its EVA-based incentive plan in 1992 (with the help of the author). This incentive plan has remained essentially unchanged for more than 26 years as Ball has handily outperformed both its packaging and aerospace competitors. In both these cases, the companies attribute their outperformance in significant part to their distinctive incentive plans and the long-term thinking they encourage.

These results are not isolated instances. Research I conducted in 2005 on the S&P 500 found that the 5% of companies using exclusively formulaic goal setting in their incentive plans significantly outperform their sectors’ peers that use more traditional budget-based goal setting.

Implementing Formula-Based Incentive Targets

Managers and boards that are not used to taking their hands off the wheel and “trusting the algorithm” may have a hard time accepting automatic goal setting. But formula-based goals do not have to be as good as those produced by strategic and financial planning. They just have to be good enough to overcome the sandbagging and governance issues created by budget-based incentive plans. In other words, the predictive quality of an incentive plan goal is not nearly as important as the quality of the overall incentive in terms of its impact on driving value-maximizing behavior. Companies are better off with incentive plan targets that may be occasionally too low or too high, but encourage aggressive planning, than they are with budget-based goals.

In practice, formula-based incentive goals can often be quite good compared with budget-based goals. They work particularly well at mature companies whose value is closely tied to key metrics, such as earnings or returns, over multiyear periods. Automatic goals can work even better if the goal-setting formula factors in the expected improvement in those metrics as implied by the company’s current value.

Admittedly, some companies are less amenable to automatic goal setting. These include distressed businesses or companies heading for restructuring, which may have no measures that reliably link to value over two or three years.

The biggest obstacle to implementing automatic goal setting, however, is management that has mastered the budget game. Such managers are understandably reluctant to give up plan-based goals for formula-based goals. To them it may feel like giving up control over their pay. But once they live with automatic goals through just one budget season, they generally end up pleased to be rid of the distraction of budget negotiations. They can instead spend the last quarter of the year focused on managing their business rather than the distraction of managing the expectations of their CEOs or boards.

Additionally, automatic goal setting strengthens key relationships throughout the organization. Beyond building trust between management levels, it enhances collegiality among functional staff, who tend to oversee the budget process, and their operating colleagues. Instead of debating goals in a corporate tug-of-war between finance, HR and the divisions, these different areas work together up front to set up the plan, including metrics and a goalsetting mechanism, to help establish the right balance of making the plan attractive to management while ensuring that rewards relate to value creation over time. Once the plan is in place, automatic goal setting enables executives to act as true partners in value creation, planning for the financial and talent resources associated with aiming high.

None of this is meant to negate the benefits of planning. Companies that employ non-budget-based goal-setting mechanisms also have rigorous planning processes. In fact, under automatic goal setting, planning becomes what it was meant to be — an assertion of what is possible instead of what is achievable. Management becomes more likely to set stretch goals knowing that such goals will not, in effect, penalize them. And if the company’s situation changes, making its goals clearly unrealistic or unwise to pursue, it is free to address that problem directly, making modifications as needed without the task of having to also modify the incentive plan.

Marc Hodak is partner at Farient Advisors.

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