Bonus Systems as Tools for ‘Managing’ Managers – the Behavioural Effects of Performance-Based Financial Rewards

Many companies still employ traditional budgeting, i.e. annual budgets as devices for planning and controlling the business’s performance. These budgets determine targets for future performance, and allocate resources to reach these targets. Under this system, middle managers are typically evaluated and financially rewarded based on whether they meet targets set for their business unit. Consequently, as Fraser and Hope (2003a, 2003b) point out, budgets not only serve as technical devices for planning and controlling, they also “determine how people behave in any given situation” (2003a, p. xviii). This paper brings into focus one way in which traditional budgeting influences managers’ behaviour: the effects that using fixed individual targets to measure, evaluate, and reward managers has on their behaviour.

I start with a brief description of the typical reward system employed in traditional budgeting. Common problematic behavioural patterns that result from employing this reward system are indicated.

Then I discuss three approaches to avoid these behavioural effects:

The first two are comparatively conservative solutions which are compatible with maintaining most technical aspects of traditional budgeting, merely reforming its reward system. The third is a more radical solution. The final section is dedicated to undertaking a comparative valuation and discussion of the merits and drawbacks of these three approaches.

The annual budget, in traditional budgeting, allocates resources for business units and sets fixed individual targets¹ for managers functioning as heads of these units (usually middle management). Accordingly, this budget can be used as an evaluation tool: allowing one to compare a business unit’s actual performance against the target set for it; the business unit’s performance, in turn, reflects how well the responsible manager performed. It is therefore not surprising that budgets affect how managers act and, ideally, should motivate them to reach their targets.

In what follows, I restrict the scope of my investigation by accepting three presuppositions about traditional budgeting: Firstly, I assume that middle management is involved in the formulation of annual budgets, at least to a certain extent.² Secondly, for simplicity, I presume that bonuses are issued in the form of cash.³ Thirdly, I follow Jensen’s (2001, 2003) assumptions about how a ‘typical executive compensation plan’ is structured: that is, how managers’ performance is linked to financial rewards (pay-for-performance) in companies applying traditional budgeting (2001, p. 97). Jensen presents the following graphic:

In this reward system, middle managers earn a fixed salary, but may gain additional bonuses. If the performance of their business unit reaches a certain hurdle (Jensen suggests 80% of the set target, illustrated as ‘A’ in Fig. 1) a bonus will be paid; the value of bonuses can be successively increased by increasing performance, until a cap is met (Jensen suggests 120% of the set target, illustrated as ‘B’) (Jensen 2001, p. 97). Depending on how well the business unit performs, the manager receives a bonus between the amounts indicated as ‘A’ and ‘B’. I will refer to this as ‘the traditional reward system’, and I take it to be associated with traditional budgeting as it relies on the setting of annual fixed targets for individual managers.

Implementing such a compensation system, which offers the chance of financial bonuses, is designed to serve as an extrinsic motivator for middle management: if they succeed, they will be rewarded; if they fail, they will miss out on this opportunity.⁴ If I described the setting of individual targets as a motivational tool above, the pay-for-performance system thus seems to be intended as a further amplifier of positive behavioural effects. But even though potential bonuses based on reaching fixed individual targets are meant as a source of motivation to perform well, there are observable adverse effects.

Clearly, the aforementioned behavioural patterns amount to negative effects of traditional budgeting: leading to the withholding and distortion of information, and to the destruction of value for the organisation (Jensen 2003, p. 379). Moreover, they illustrate a tension between middle managers’ personal goals and those of the organisation. Three attempts to circumvent these adverse behavioural effects have been articulated by management scholars: two of which can be classified as comparatively conservative, compatible in large part with the traditional budgeting system. They merely suggest changes to the traditional reward system associated with, but not essential to traditional budgeting. The third represents a more radical approach.

An ideal solution should eliminate these negative behavioural effects, while being relatively easy to operationalize, i.e. impose as little change to other processes as possible.¹⁰ An evaluation of these approaches would, then, weigh off their effectiveness against their practicality. Out of the three approaches, Beyond Budgeting clearly imposes the most far reaching changes: if a more conservative approach appears sufficient to prevent the behavioural effects under discussion, most companies will perceive Beyond Budgeting as using a sledgehammer to flatten a nail.¹¹ Therefore, I first discuss the likelihood of success using the conservative approaches.

I am convinced that both the linear pay-for-performance and the bonus banking approach significantly weaken incentives to game the reward system. Here, I turn to the question of whether they prevent the gaming of target negotiation processes. For the linear pay-for-performance approach, I hold that success would depend on the determination of steepness of the pay-for-performance line. If the steepness is determined anew each year, then this system will not be able to reduce the tendency to negotiate ad hoc weak targets. Instead, it makes sense to maintain the steepness of the line across years; so that it is independent of annually negotiated targets. Under these conditions, the ability to negotiate weak targets will at least be limited.

The bonus bank system, as explicated by Stern Steward & Co, suggests divorcing the determination of targets for managers (i.e. the target negotiation process) from the formulation of annual budgets as planning devices. How this would affect managers’ honesty in presenting their forecasts of achievable performance and what resources they need calls for further empirical study; but it is plausible that the reliability of managers’ forecasts could be improved if these do not translate immediately into targets. Nonetheless, under this system, managers still have an incentive to avoid budget cut-backs by whatever means available (asking for the maximum resources one can justify, and spending resources left over at the end of a year). Fully eliminating these adverse behavioural patterns by changing the reward system – to the linear pay-for-performance system or to the bonus banking system – seems an idle hope. This gets clearer when one considers the reward-independent incentive to negotiate relaxed targets: the comparative ease of the manager’s time in work.

So what about the more radical approach? In eradicating fixed targets for individuals, Beyond Budgeting should theoretically succeed in eliminating the possibility of individual managers gaming the reward system. Performance evaluation based on Beyond Budgeting focuses on relative targets, comparing a team’s performance with that of peers or competitors (Hope and Fraser 2003a, p. xix) – which managers cannot influence by unreliable forecasting. Accordingly, there is reduced opportunity, and ideally incentive, to try to negotiate relaxed targets. Resource allocation, subsequently, is not determined by a yearly budget; instead resources are made “available and accessible to front-line teams as and when required through fast-track approvals and easier access to operational resources” (2003a, p. 24). Hope & Fraser further claim that “[t]his approach overcomes much of the game playing associated with resource allocation” (2003a, p. 24); if we accept this assessment, Beyond Budgeting also removes the second adverse behavioural effect of gaming target (and resource) negotiation. This approach, at least in theory, promises the highest potential of success.

Unlike the first two approaches, Beyond Budgeting is an holistic programme of extensive change that affects both technical and behavioural/sociocultural aspects of companies’ operations and strategy; much of which is incompatible with traditional budgeting approaches. Since it requires not only alterations to a company’s processes of budgeting, evaluating and rewarding, but to its whole organisational structure, changes in behaviour patterns resulting from transitioning from a traditional budgeting system to Beyond Budgeting may be manifold and unpredictable. Without further in-depth research, it is extremely difficult to evaluate both whether the theoretical premises of the Beyond Budgeting system are convincing and, secondly, to estimate whether it can successfully be implemented across firms and sectors, given the comprehensiveness of its demands and the variety or organisational priorities and cultures. On top of processual changes, Beyond Budgeting calls for changes to company culture and, with it, senior management’s leadership culture: requiring the cultivation of a climate of mutual trust rather than control (Hope and Fraser 2003a, p. 32). As outlined above, this may require changes in company leaders’ implicit assumptions about human nature. A successful implementation of Beyond Budgeting accordingly does not merely rely on middle management to accept changes to processes they are accustomed to (as with the other two approaches), but may also require senior management to change fundamental beliefs about how people are motivated, and how much control is required in leadership. Moreover, senior management is expected to relinquish a certain level of control, which may be met with resistance. Although it is likely that the implementation of one of the more conservative approaches would also be met with some level of reticence by managers,¹² their responses may reasonably be expected to be more limited in the face of more modest reforms.

Hitherto, I have assessed the three approaches by weighing off effectiveness against practicability; emphasising that a viable solution must be easy to operationalise. Yet, we should also consider the sustainability of the changes achieved: Petersen (2010) claims that the REMM may amount to a self-fulfilling prophecy: “If we are seen as REMM men and treated like REMM men we might begin to act like REMM men.” (p. 47.)¹³ This would imply that rewards systems developed with the background assumption that people generally aim to maximise their own benefit focus solely on eliminating the possibility that the system is gamed, and effectively provoke people to find new ways to game the system. If Petersen (2010) is correct, negative behavioural effects could only be overcome in a sustainable manner if the underlying perception of human nature is incorrect, or the nature it describes is malleable. Above, I indicated that, of the three approaches, only Beyond Budgeting is completely incompatible with the REMM. It might be concluded that Beyond Budgeting is the only approach promising sustainable success, yet this would be rash. The implementation of bonus banking, especially that suggested by Stern Stuart & Co, already includes some limited changes to company culture, such as long-term goal-orientation amongst senior staff, and an extension of the reward-scheme to non-managers (Bischof et al. n.d., p. 6–9). Not only is the reward system changed, but also the evaluation process: it is thus possible to combine this approach with a change of the control exercised by top management, i.e. a shift of the company culture towards greater mutual trust and decentralised decision making. The bonus banking approach may be theoretically compatible with the presumption of the REMM of human nature, however, it appears to be more congruent with its rejection.¹⁴ If combined with additional measures (e.g. granting flexitime, the right to work from home, etc.) which manifest a shift in company culture, I believe that the bonus banking approach can represent a more sustainable solution. The linear pay-for-performance approach, on the other hand, is not associated with any real changes in company culture.

Linear pay-for-performance and bonus banking approaches introduce reforms to traditional budgeting’s reward system to reduce the negative behavioural pattern of middle managers gaming the reward system for the highest possible bonuses. Of these two approaches, bonus banking has the better chance of additionally effecting a pivot from reliance on yearly targets towards using long-term strategic goals as an evaluative principle; ameliorating the tendency of middle managers to give unrealistic planning premises to the yearly budget. The bonus banking approach is, on that basis, preferable. Beyond Budgeting promises even better results, but it is unclear how realistic achieving drastic changes to companies’ organisational structure and culture would be, and at what cost it will come.

Based on these considerations, weighing the risk of resistance against the benefits of preventing value destroying behaviour, and achieving a higher goal congruence between managers and the company in the long run: I believe that bonus banking is the most promising approach. It is a sensible middle ground between the linear pay-for-performance strategy, which is comparatively timid, and the Beyond Budgeting strategy, which can only sensibly be chosen when a company also faces significant problems resulting from technical aspects of the traditional budgeting system (a possibility bracketed in the present analysis). However, the culture of the company in question – that is, its level of change-adversity and the negative behavioural patterns shown, as well as its market for potential manager reappointment – will play a relevant role in individual decisions of implementing or not implementing any strategies discussed.¹⁵