European Financial Management, Vol. 9, No. 3, 2003, 379–406

European Financial Management, Vol. 9, No. 3, 2003, 379–406
Professional Forum Paying People to Lie: the Truth about the Budgeting Process
Michael C. Jensen*
The Monitor Group and Harvard Business School e-mail: MJensen@hbs.edu

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 ofbudgets and, therefore, gut
the budgeting process ofthe critical unbiased information that is required to coordinate
the activities ofdisparate 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.
M y 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-Ioo% improvements in productivity. I believe the less intensive reliance
on such budget/target systems is an important cause of” the increased productivity of
Thanks to Joe Fuller, Nancy Nichols, Jennifer Lacks-Kaplan, Pat Meredith, Roger Marten,
Shibanee Verma, and Susanne Greenberg from Monitor, the editors of the Harvard Business
Review, and Michael Gibbs and Edwin Locke for their contributions to this piece. An executive
summary of this paper entitled ‘Corporate budgeting is broken – let’s fix it’ was published in the
Harvard Business Review, November 2001. An early version of this paper was given at the EF MA
Meetings in Athens, Greece in June 2001 before the wave of corporate scandals including Enron,
Worldcom and others. Because the paper is fully consistent with these later events I found little
reason to update it to include these more notorious examples of the phenomena.
Jensen, 2003. Published by Blackwell Publishing Ltd, 9600 Garsington Road, Oxford OX4 ZDQ, UK and 350 Main Street, Malden, MA

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
* Thanks to Joe Fuller, Nancy Nichols, Jennifer Lacks-Kaplan, Pat Meredith, Roger Marten, Shibanee Verma, and Susanne Greenberg from Monitor, the editors of the Harvard Business Review, and Michael Gibbs and Edwin Locke for their contributions to this piece. An executive summary of this paper entitled ‘Corporate budgeting is broken – let’s fix it’ was published in the Harvard Business Review, November 2001. An early version of this paper was given at the EFMA Meetings in Athens, Greece in June 2001 before the wave of corporate scandals including Enron, Worldcom and others. Because the paper is fully consistent with these later events I found little reason to update it to include these more notorious examples of the phenomena.
# Michael C. Jensen, 2003. Published by Blackwell Publishing Ltd., 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.

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