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How to Establish Compensation Targets

Some experts on corporate pay contend that a company's choice of performance targets is less of an issue than how the targets are established.

4Jun

"We've seen the ruination of many firms" as a result of compensation practices that encourage earnings management, says Michael Jensen, a renowned finance professor at Harvard Business School and a principal at Monitor Group, a consulting firm in Cambridge, Massachusetts. And while the incentive of choice during the market bubble was stock options, Jensen contends that few companies have responded by tailoring their bonus programs to discourage abuse.

Some experts on corporate pay contend that a company's choice of performance targets is less of an issue than how the targets are established. The fundamental problem, says Jensen, is that most companies base their bonus targets on internal budgets.

In an article entitled "Corporate Budgeting Is Broken — Let's Fix It," in the November 2001 issue of the Harvard Business Review, Jensen insisted that the standard practice of tying bonuses to the budgeting process "encourages managers to lie and cheat, low-balling targets and inflating results. It penalizes them for telling the truth." He added that such an approach "turns business decisions into elaborate exercises in gaming.... And it distorts incentives, motivating people to act in ways that run counter to the best interests of their companies."

Jensen went so far as to suggest that incentive compensation should be divorced entirely from the budget-setting process. There's some evidence that companies were embracing Jensen's criticism even before it was offered. A recent survey of 237 companies by consulting firm Towers Perrin found that the percentage of companies that tied bonus compensation to budgets fell from 69 percent in 1996 to 60 percent in 2001, the latest year for which such data was available (see "New Carrots, Old Yardsticks?" for more).

Even some companies that tie internal budgets to performance targets may disconnect the process if gamesmanship rears its head. One example is DRS Technologies, a defense-electronics manufacturer based in Parsippany, New Jersey, that has grown from $50 million in revenues in 1989 to more than $1 billion today. If managers downplay their expectations in the budget process for the coming year based on the prior year's results, the company will not set its bonus targets to reflect what it considers to be unacceptable forecast projections, but will instead set bonus targets higher than the forecast.

"We're not going to pay them to break even," says Richard Schneider, CFO of DRS. "We're not going to pay a bonus for what amounts to less than superior performance."

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