I have given a good deal of thought to this issue of how companies go about negotiating objectives with their different business units. The typical process in such cases is that once the parent negotiates a budget with a unit, the budget then becomes the basis for the bonus. And they are also typically structured such that the bonus kicks in when, say 80 per cent of the budgeted performance is achieved. And the maximum bonus is earned when management reaches, say, 120 per cent of the budgeted level.

Now because the budget is negotiated between management and headquarters, there is a circularity about the whole process that makes the resulting standards almost meaningless. Because the budget is intended to reflect what management thinks it can accomplish presumably without extraordinary effort and major changes in status quo the adoption of the budget as a standard in unlikely to motivate exceptional performance. Instead, it is likely to produce cautious budgets and mediocre performance.

So, because of the perverse incentives built into the budgeting process itself, I think it is important for a company to break the connection between the budget and planning process on the one hand and the bonus systems on the other hand. The bonuses should be based on absolute performance standards that are not subject to negotiation. (Adapted from McWatters et al., 2008)

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