June 12, 2002
Budgets vs. productivity
A fascinating example of "unintended consequences" at work. NCPA summarizes:
BUDGET GAMES DRAMATICALLY DECREASE PRODUCTIVITY
The alleged purpose of budgeting is to encourage managers to work harder by rewarding them for reaching certain targets. But according to recent research, budgeting can have the unintended consequence of decreasing short-term productivity by 50 percent to 100 percent.
More on Economic Issues from NCPA.
- In order to reach their budgetary targets, managers will tend to set goals that are easily attainable, distorting information and leading to an inefficient allocation of resources.
- For instance, mangers can pump up their sales figures for the current year by announcing late in the budget year price increases for the coming year, thus encouraging customers to buy now -- in effect robbing sales from the coming year.
- On the other hand, if managers realize that in a given year they won't be able to achieve the target, they will tend to delay sales and move profits to the following year.
- This behavior can have economy-wide effects -- for example, leading to an exaggerated decline in profits during a recession.
This doesn't mean that budgeting should be abolished all the way. It all comes down to the characteristics of the compensation scheme managers face:
- Nowadays, compensation schemes usually include a hurdle bonus upon achieving 80 percent of the budget, and a variable bonus that grows up to 120 percent of the budget.
- On the other hand, a linear bonus schedule that would do away with the target discontinuities and distortions.
A linear compensation system would reward managers for what they really do, instead of rewarding them for what they do relative to projections. This would not only benefit the companies that adopt this system, but also, the authors claim, raise the economy's overall productivity by 50 percent to 100 percent.
Source: "Budget Games," Economic Intuition, Summer 2001; based on Michael C. Jensen, "Paying People to Lie: The Truth About the Budgeting Process," Harvard Business School Working Paper No. 01-072, 200
Available online at the Social Science Research Network (SSRN)