Chapter 3

Target Setting in Changing Conditions

Introduction

Target setting faces challenges from changing conditions. A target is set, and subsequently underlying conditions change. Therefore, the target needs to be revised and the changes incorporated into the budget, or this will lead to poor decision making. The static approach where no change is recorded is called the fixed approach, while a more dynamic approach is called a flexible budget. We will illustrate the differences in these approaches by using two examples: one using a traditional fixed budget and the other using a flexible budget adjusted for the impact of volume changes. We also look at using rolling forecasts to capture the changing dynamics of the marketplace. We recognize that objective measures only partially capture the underlying value generation of a business and view subjective evaluations as a way of offsetting uncontrollable events. Now let us move on to fixed target setting.

Fixed Budgeting, Standard Costs, and Variance Analysis

In manufacturing organizations where there is a direct and stable relationship between inputs and outputs, it is possible to use standard costs to develop the budget. The standard costs may be developed from financial data or from engineered standards. Standard costing makes the budgeting process easy, as the budget can be calculated from the standards, taking into account any changes (e.g., increase in wages). Another option is to develop budgets using external benchmarks (see chapter 4). Standard costing also allows for tight control through variance analysis. The main problem with standard costs is that they only focus on costs, whereas other issues such as on-time delivery and quality may be more important.

Variance Analysis

Variance reporting is an attempt to update the fixed budget targets after an event. Having fixed targets provides a useful control mechanism and allows variance analysis (usually monthly). Variance analysis provides an important overview of the financial performance of the organization and can highlight good performance as well as acting as an early warning sign of potential problems (called exception reporting), as can be seen in the Case Capsule 3.1.

The main problem with variance analysis is that it only highlights certain areas to be investigated further. It does not tell anything about why actual costs are different to budget, how this has occurred, whether the problems can be fixed, and what action needs to be taken. Therefore variance analysis indicates the beginning, not the end, of an investigation. It is still focused on what has happened in the past and is not future orientated. If variance analysis is used monthly, then the budget needs to be split on a monthly basis. This can cause further problems especially where businesses are affected by seasonal variations.

The fixed budget approach is inflexible because if the organization has had a major impact on the budget early in the process, or if there has been an error in the budget, these items have to be continually reported on. We have sat in meetings when it looked like a business unit had made a massive loss, whereas this was just an error in inputting the budget figures (e.g., a line item recorded as a negative instead of a positive). The budget templates are often inflexible so that these problems and errors cannot be changed once they are loaded into the budget and need to be reported as variances each month. Changes in organizational structure can impact on budgeting, such as time delays before new account codes can be activated to reflect the new structure. Therefore, fixed budgets are only useful for organizations operating in stable environments.

Another issue is that variance analysis is often seen as the accountants’ problem. With the time pressures of meeting month-end and year-end reporting deadlines, sometimes there is a lack of involvement by the business unit managers. Not surprisingly, business unit managers do not like variance analysis, as often factors are outside their control. Remember the case capsule on Astoria in chapter 2? Variance analysis should not merely look at differences between actual results and targets to enable actions to be taken; they should also ensure the decisions are strategically aligned. Strategies should be continually reprioritized as conditions change.

Flexible targets are useful if you have limited forecasting ability or are unable to make forecasts. The problem is that in periods of rapid change there is little historical data that can be used. We will now show how to make fixed targets more flexible so that you do not lose sight of the strategy.

How Can Fixed Targets Be Made More Flexible?

Flexible targets (e.g., flexible budgets, rolling forecasts) are useful to protect managers from factors that are outside their control. One approach is to recalculate the budget based on what managers are expected to achieve given the actual conditions faced during the measurement period.

Flexible Budgets

Flexible budgeting is the process whereby the budget numbers are revised to reflect the impact of subsequent changes in some of the key assumptions that underlie the budget, such as volume of the activity (e.g., sales, production), currency rates, interest rates, oil prices, or other factors.² This approach requires a good understanding of the cost-volume-profit relationships between key drivers of the business. Flexible budgets can be used to evaluate performance where volume drivers are important and where volumes are very difficult to predict. For example, they may be used by manufacturing managers who are held responsible for costs that vary with volume.³

A flexible budget may be geared to any level of volume and therefore can be based on the actual (as distinguished from the planned) volume attained during the budget period. A thorough knowledge of cost-volume-profit behavior enables management to determine what costs should have been if we knew what actual volumes would be when we developed the budget. A comparison between a flexible budget for any responsibility center and actual results achieved becomes a reasonable basis for evaluating performance. Differences between planned and actual volume, which may not be within the control of the person being evaluated, are eliminated from consideration. The controllability issue is discussed later in this chapter.

Rolling Forecasts

Another way of dealing with uncertainty and focusing on strategic issues is to use rolling forecasts. The idea is to provide rolling forecasts for a few critical performance measures (e.g., sales, profits, cash flows), and regularly track performance to targets. The rolling forecasts are continually updated for the organization’s critical performance measures and all cover the same period. These rolling forecasts are not linked to budget targets and rewards, so the problems associated with this are avoided. Rolling forecasts used as targets also have their disadvantages as there are time and cost considerations. We elaborate on forecasting in chapter 4, and rolling forecasts are an important part of the Beyond Budgeting approach we discuss in chapter 7. One of the Beyond Budgeting companies uses forecasts that are updated quarterly and are forecasted for the next six quarters (as shown in Table 3.1).⁴

We now examine the issues with objective performance evaluations and how allowing some subjectivity provides flexibility in the performance evaluation process.

Objective Versus Subjective Uses of Performance to Target Comparisons

Performance to targets can be evaluated in an objective or a subjective manner. For example, an objective approach would be to focus on quantitative targets to assess performance. These quantitative targets may include financial measures (return on investment [ROI], return on capital employed [ROCE]) as well as nonfinancial measures (e.g., number of accidents per year). If the actual performance is better than expected, then the performance is rated favorably as a positive number or index. A more subjective approach, while taking into account performance to targets, would be to make adjustments for uncontrollable factors such as the impact of the global financial crisis. This adjustment may be made through a peer review by other managers at the same level, or by the senior management team.

Objective Use of Financial Targets

Objectively using performance targets generally means using quantitative measures in a situation where performance is specified at the beginning of the evaluation period. Financial measures are considered more objective as they can be independently audited, and the responsibility for measuring financial performance is independent of the process (e.g., the financial controllers are in control).⁵ Furthermore, profit and the accounting numbers are often the language of shareholders, and therefore using such measures allows the business to meet external objectives. The final argument for using financial measures in performance evaluation is their “contractible” nature. This means that financial numbers can be used in a performance contract and can show why a manager did or did not achieve contracted performance targets. Therefore, it comes as no surprise that firms tend to assign a high weighting to financial measures in incentive compensation systems.⁶

Limitations of Using Objective Targets

There are a number of limitations when targets are based on objective financial and nonfinancial measures. The problems with financial and nonfinancial measures are well-known; they are often described as being imperfect and inaccurate because of measurement issues or the problems when measures are aggregated at the organizational level.⁷ Financial measures, for example, are often incomplete as key dimensions of performance are omitted (e.g., improvements in personnel and product quality), and they can be misleading when examined at the organizational level.⁸ Another issue with objective financial measures is that they are historic and backward looking.⁹ Focusing on performance targets set annually causes managers to take short-term actions, as the outcomes of many managerial decisions, both favorable and unfavorable, are not evident until sometime in the future.

Another issue with using preset objective targets is that they may not be a good indicator of performance. It could be that the performance targets were set at a level that was too easy to be achieved, or the good performance has resulted from good luck such as windfalls from unexpected changes in currency rates, or it could be the result of gaming actions. Managers may have achieved the good performance results by taking a range of actions to meet their fixed budget targets. Some of the games managers play include pulling income forward from future periods by delaying expenses or increasing revenues when a target is not attainable, negotiating easier targets, and accelerating sales near the balance date to meet the budget target.¹⁰ Alternatively it could be that poor performance has resulted from events that were outside the manager’s control.

The Controllability Principle

Managers are often evaluated and held accountable for events over which they had only partial control.¹¹ This violates the controllability principle, which is based around the view that holding managers accountable for items over which they have little control and linking this to incentive compensation increases their risk.¹² If managers are not compensated for the additional risk they bear then the organization will suffer the costs of their frustrations, reduced motivation, and possibly greater management turnover.¹³

However, there has been considerable debate in the literature over the controllability principle. An alternative view is that managers should be evaluated on uncontrollable events because they have to deal with a number of factors that influence financial performance (e.g., market, economy, competitors).¹⁴ The argument is that managers should not be protected from uncontrollable events if they can take actions to reduce the organization’s exposure to losses.¹⁵ Clearly, knowing and identifying which events are controllable or uncontrollable is important so that the use of objective measures remains valid. The following case capsule highlights the issue.

However, are all these events uncontrollable, or could Robert have taken actions to reduce the impact of the currency changes? What would have stopped Robert from looking at a futures contract, hedge, or a foreign currency option? In this way, the U.S. client would not have to carry the risk of the falling U.S. dollar. The issue for debate is whether certain events are uncontrollable or whether the risk of such an uncontrollable event can be mitigated or managed. If a risky event can be mitigated, then the managers could be held accountable for a wider spectrum of events.

Research shows considerable diversity in the way the controllability principle is being used in practice.¹⁶ Case study research often provides examples where the controllability principle is not used. Whereas a recent survey finds that 25% of the financial controllers in Canada adjusted for the effects of uncontrollable variables when the budget variances were being evaluated, and around 32% of the responding U.S. firms adjusted the budget numbers to take out the effects of uncontrollable events.¹⁷

To overcome some of the problems of evaluating performance relative to fixed and objective performance targets, some flexibility can be introduced by allowing subjective performance evaluations.

Subjective Uses of Performance to Target Comparisons

Subjective evaluations are becoming popular because they allow more complete evaluations of performance and can overcome some of the common problems with using objective targets, as discussed in the previous section.¹⁸ The European Corporate Governance Institute recommends adding a subjective element to incentive compensation plans because this can reduce the risk to the organization and the employee from uncontrollable factors, windfalls, and gaming the system.¹⁹

Subjectivity can also improve the performance evaluation process when done by experienced evaluators. The use of subjectivity may also be more appropriate for senior managers who are used to dealing with ambiguity and complexity. For example, General Electric’s CEO Jeff Immelt was evaluated in 2008 based on processes that included a mix of quantitative and qualitative performance measures.²⁰ Immelt’s performance in 2008 was based on a subjective assessment of measures including revenues and organic revenue growth, earnings, earnings per share (EPS), cash flow from operating activities, return on total capital, percent margin, sustaining operating excellence and financial discipline, retaining an excellent team with a strong culture, managing the company’s risk and reputation, building an excellent investor base, leading the board’s activities, and stock price.

There are a number of ways that subjectivity can be incorporated into performance evaluation and incentive compensation plans, including²¹

Some evidence shows that allowing subjectivity in evaluations is even more common than using objective performance to target comparisons.²² Subjective evaluations linked to incentive compensation plans are also increasing in popularity.

Advantages of Subjective Evaluations

Subjective performance evaluations have numerous advantages including that they allow superiors to take into account other factors so the evaluation is more accurate and complete, as evident from the General Electric example earlier. Subjective evaluations could take into account a manager’s ability to react to unforeseen situations or could make use of new information on market conditions, competitors, and so on that has come available since the formal objectives were set, to adjust for outdated targets.²³ Subjective evaluations can also filter out the impact of uncontrollable factors, as discussed earlier. Including a degree of subjectivity in performance evaluations may also help avoid some of the problems (e.g., game playing) with the use of financial measures, for example, by taking into account the impact on quality when managers take short-term actions like cutting costs. Subjective evaluations also provide some insurance to employees to minimise the risk of losing their incentive compensation payment due to uncontrollable events.²⁴

Disadvantages of Subjective Evaluations

Subjective evaluations are challenging to implement properly. Often valid measures are lacking and a range of targets may form the basis of subjective evaluations. Some indicators are favorable to the subordinate manager while other indicators are unfavorable. The weighting of the indicators becomes a source for perceptions of unfairness. Subjective evaluations can also been seen as unfair and biased, and there may be game playing to improve ratings (e.g., favortism bias).²⁵ Research shows that superiors often find it difficult to give bad news in evaluations and so give everyone higher ratings (leniency bias), while other research shows that ratings tend to be toward the average as evaluators find it difficult to differentiate between people (centrality bias).²⁶ Some evaluators also rate their employees higher because this also reflects on their performance and how they are as a manager (self-serving bias).

How to Improve Subjective Evaluations?

The growing popularity of subjective evaluations and the problems associated with poor subjective evaluations warrant attention. One of the ways to improve subjective evaluations is to train the evaluators in the process of evaluation. The process of setting up the objectives or goals of the manager at the start of the year must be clearly followed. Subordinates need to receive regular feedback on their performance. They are able to make the changes necessary to meet their targets. In addition, the evaluation processes should follow the elements of natural justice: ensuring fair processes where the subordinates are able to voice their opinions, treating all subordinates fairly and equally, and ensuring the evaluation procedures are laid out well in advance and adhered to.²⁷ These issues are all important in ensuring managers can see the relationship between their actions, the target and rewards, the concept of line of sight we discuss in chapter 1.

Another point is to only use senior managers who have experience in the business unit. The evaluators have walked in that manager’s shoes for that business unit, recognizing the limitations in performance measures, and taking into account other factors. If target setting is an art, then the subjective use of a range of targets is the art of arts. Chapter 6 further develops the complexities with using multiple targets for financial and nonfinancial measures.

Summary

Change is inevitable. Target setting is based on certain conditions. When subsequent conditions change, the targets need to be reviewed. In the budgeting process, fixed targets and standard costs are useful for organizations operating in stable environments. Variance analysis is one way to update the fixed budget targets. When organizations are operating in dynamic environments, comparisons between actual performance and fixed budget targets result in poor decision making.

Targets can be made more flexible by adjusting the fixed budget numbers for the impact of changes in volumes and other factors. Rolling forecasts are another option where performances to targets for a few critical KPIs (financial and nonfinancial) are regularly updated so they indicate the expected level of performance. Relative performance targets can also be used to make performance targets more flexible.

Taking a more flexible and subjective approach to performance evaluation is growing in popularity, especially in incentive compensation contracts for senior managers. Traditionally, performance evaluations have been dominated by an objective approach whereby performance to quantitative targets (and usually financial targets) are evaluated based on preagreed standards. There are a number of problems with using objective performance to target comparisons (e.g., gaming, controllability issues). Using subjective performance evaluations allows superiors to adjust for differences between actual performance and the preset target by taking into account the uncontrollable, balancing short-term and long-term objectives, as well as the intangibles such as customer and employee relationships. Yet as the winds of change come through all forms of target setting, the realization is that only at the end of the day, with 20/20 hindsight, can you know with certainty what the business performance is or should have been. Target setting relies on the ability to look to the future, given the winds of uncertainty that blow your way as you stretch back the bow to take aim.

Key Learning Points