On a recent webcast, I was asked: “If we move to rolling forecast and eliminate annual budgets, how can we provide incentive compensation? Are there approaches for building incentives off of a rolling forecast?” I will answer that question in my next two blogs.

Most organizations base incentive compensation on reaching fixed budget targets. The standard reason for this is that they want to “pay for performance.” In reality, nothing could be further from the truth. This is one of the worst practices in management because what really happens is that the organization “pays for negotiated results.” Instead of rewarding the best performers/achievers, you reward the managers who successfully negotiate the lowest levels of performance and execution. As a result, your management process drives subpar performance. Forget about “being the best you can be” or striving for the maximum performance you can achieve.

I once had a vice president of a major oil company tell me that he “would never agree to a budget that he could not easily reach; it just would not be prudent.” I was amazed that he would deliberately set the bar as low as possible. I do not know where that manager is today, but I do know that his company no longer exists.

This negative effect compounds each year. When a low bar is reached, the mechanics of plan design often limit their upside, so they have financial incentives to slow performance so that next year’s target will also be easily reached. Who is to blame? Your senior management bears that blame. They are the ones who designed the incentive plan.

What should you do instead? You should shift to relative targets set with a midterm objective (three to five years out). This is close enough to be real so progress toward the goal can be tracked even though reaching it in one year may not be likely. The target also should be set relative to the environment you will actually be operating in. Therefore the target is set in comparison to your competitors, to your peers, and to world-class performance. This may take the form of a value-based measure such as economic value added or cash flow return on investment rather than a fixed amount based on assumptions that will likely be wrong.

In the next blog, I will address the role played by rolling forecasts. This week I am in Washington, D.C., and Richmond, Va. Let me know if you want me to stop in and discuss your target-setting. ###