Most firms spend more time on negotiation than on strategy when it comes to setting targets. In these firms, planning is traditionally tied to the budgeting process, which in turn is linked to variable compensation: a unit negotiates a target with its corporate office and then its managers are paid the incentive if they meet the target.
This system does not incentivize units to develop ambitious plans for the future as that would make it tougher on them to get bonuses. It does the opposite: it encourages units to negotiate the lowest targets possible so they can easily achieve them.
Corporate officers are not oblivious to this, which is why they usually design incentive compensation systems with pay-out caps so they do not over-reward performance relative to negotiated targets. Yet in most cases these caps are mostly redundant as it is in the interest of managers to meet or barely beat expectations so they are not rewarded with higher targets the following year. Managers that negotiated low targets in one year and achieved a performance that was 2X or 3X the target will find it much harder to get away with lower targets the following year. Hence, everyone plays the game.
Corporate plays the same game with The Street. Executives issue earnings projections for the following year and proceed to meet them with the hope of pleasing analysts and investors. While this game may seem to please short-term minded investors and analysts, it does not fool lead steer investors that are looking for sound long-term investments in well-managed companies.
For evidence of this, one only has to turn to the most prominent lead steer investor of them all, Warren Buffett, who has written about this in his popular annual letter to shareholders:
“…be suspicious of companies that trumpet earnings projections and growth expectations. Businesses seldom operate in a tranquil, no-surprise environment, and earnings simply don’t advance smoothly… We are suspicious of those CEOs who regularly claim they do know the future – and we become downright incredulous if they consistently reach their declared targets. Managers that always promise to ‘make the numbers’ will at some point be tempted to make up the numbers.”
It is time to put the strategic back into the planning process. Our next article will show you how.