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Bennett Stewart on Management Incentives

I've 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 percent of the budgeted performance is achieved; and the maximum bonus is earned when management reaches, say, 120 percent of the budgeted level. There is thus virtually no downside and very limited upside.

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 accomplishpresumably without extraordinary effort and major changes in the status quothe adoption of the budget as a standard is unlikely to motivate exceptional performance, especially since the upside is so limited. 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's 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 upon absolute performance standards that are not subject to negotiation.

Required:

Critically evaluate this quotation.

Source: B. Stewart, "CEO Roundtable on Corporate Structure and Management Incentives,"Journal of Applied Corporate Finance,Fall 1990, p. 27.