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Paying People to Lie: The Truth About the Budgeting Process

28 Pages Posted: 12 Jul 2003  

Michael C. Jensen

SSRN; Harvard Business School; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI); Harvard University - Accounting & Control Unit

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Abstract

This paper analyzes the counterproductive effects associated with using budgets or targets in an organisation's performance measurement and compensation systems. Paying people on the basis of how their performance relates to a budget or target causes people to game the system and in doing so to destroy value in two main ways: (a) both superiors and subordinates lie in the formulation of budgets and, therefore, gut the budgeting process of the critical unbiased information that is required to coordinate the activities of disparate parts of an organisation, and (b) they game the realisation of the budgets or targets and in doing so destroy value for their organisations. Although most managers and analysts understand that budget gaming is widespread, few understand the huge costs it imposes on organisations and how to lower them.

My purpose in this paper is to explain exactly how this happens and how managers and firms can stop this counter-productive cycle. The key lies not in destroying the budgeting systems, but in changing the way organisations pay people. In particular to stop this highly counter-productive behaviour we must stop using budgets or targets in the compensation formulas and promotion systems for employees and managers. This means taking all kinks, discontinuities and non-linearities out of the pay-for-performance profile of each employee and manager. Such purely linear compensation formulas provide no incentives to lie, or to withhold and distort information, or to game the system.

While the evidence on the costs of these systems is not extensive, I believe that solving the problems could easily result in large productivity and value increases - sometimes as much as 50-100% improvements in productivity. I believe the less intensive reliance on such budget/target systems is an important cause of the increased productivity of entrepreneurial and LBO firms. Moreover, eliminating budget/target-induced gaming from the management system will eliminate one of the major forces leading to the general loss of integrity in organisations. People are taught to lie in these pervasive budgeting systems because if they tell the truth they often get punished and if they lie they get rewarded. Once taught to lie in this system people generally cannot help but extend that behaviour to all sorts of other relationships in the organisation.

JEL Classification: M40, M46, J33, G34

Suggested Citation

Jensen, Michael C., Paying People to Lie: The Truth About the Budgeting Process. European Financial Management, Vol. 9, pp. 379-406, September 2003. Available at SSRN: https://ssrn.com/abstract=423635

Michael C. Jensen (Contact Author)

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European Corporate Governance Institute (ECGI) ( email )

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Harvard University - Accounting & Control Unit ( email )

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