MANAGEMENT ACCOUNTING
CONCEPTS AND TECHNIQUES
By Dennis Caplan, University
at Albany (State University of New York)
CHAPTER
21: Budgetary Incentive Schemes
Chapter
Contents:
- Introduction
- Example of a budgetary incentive scheme
- Exercises and problems
As discussed in Chapter 20, most budgets are built on sales forecasts, and hence, budgets are only as accurate as those forecasts. The sales force has the most accurate and complete information about future sales prospects. Therefore, sales personnel are the best source for the sales forecast, and one would expect the budgeting process to begin with input from the sales force.
Furthermore, the success of most companies depends in large part on the ability of the sales force to generate sales. In order to motivate sales personnel to work hard, many companies include sales commissions as an important component of sales personnel’ compensation packages: the more they sell, the more they earn.
For many companies, and in many industries, a straight commission is not viewed as equitable. Some sales representatives have “easier” sales territories or product lines. A fixed percentage commission applied to all members of the sales force seems unfair to sales representatives who are assigned more difficult product lines or territories. Many companies solve this problem by paying sales representatives a bonus based on actual sales relative to budgeted sales. The budget can be tailored for each sales representative, so that the difficulty of meeting and exceeding budget is comparable for all sales personnel. Such a bonus scheme rewards sales representatives for incremental effort and sales volume, relative to some baseline.
Taken together, the preceding three paragraphs create an obvious dilemma. The company relies on the sales force to accurately forecast sales for budgeting purposes, yet sales representatives, when asked for their forecasts, will budget conservatively. In so doing, they give themselves easy targets that help ensure that they will maximize their bonuses.
One possible solution to this dilemma is to not pay bonuses based on actual performance relative to budget. An alternative solution is to not ask the sales representatives for their forecasts, but simply to assign targeted sales goals. Neither solution is optimal, because the first solution limits the company’s ability to motivate the sales force using a bonus scheme that is generally perceived as effective and fair, and the second solution ignores information that would materially assist in the budgeting process.
One might wonder whether a better
solution is possible. In fact, budgetary incentive schemes that simultaneously
address these two apparently conflicting objectives have been used for at least
25 years. The example described in the rest of this chapter is adapted from a
bonus scheme that was used by IBM in
Example
of a Budgetary Incentive Scheme:
Instructors want students to work hard and to study diligently for exams. If an instructor also wants students to predict their performance on an upcoming exam, then the instructor faces the same dilemma as described above: how does one encourage students to provide accurate forecasts of future performance, and also provide incentives for students to exert maximum effort after the forecasts have been delivered. (In the absence of an incentive mechanism to encourage accurate forecasts, students are notoriously optimistic.)
Consider an exam with ten multiple choice questions, where credit on each question is “all or nothing” (no partial credit). Each question is worth five points, for a total of fifty points. Now consider the following extra credit opportunity related to that exam. One week before the exam, students are asked to forecast how many of the ten questions they will answer correctly. After the exam, they receive extra credit based on the number of points indicated in the box at the intersection of their forecast (the column headings in the table) and their actual score (the number in the far left-hand column of each row in the table). For example, if a student forecasts that she will answer six questions correctly, and actually answers seven questions correctly, she receives 13 extra credit points (the intersection of row 7 and column 6) in addition to her score of 35 (7 questions x 5 points per question), for a total of 48 points.
EXTRA CREDIT GRID FOR EXAM
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This scheme encourages students to forecast accurately, and once the students have made their forecasts, to study hard for the exam. To see that the extra credit scheme achieves both objectives, note the following:
When the student makes her forecast, she is choosing the column that will be used to determine her extra credit. Within each column, the numbers become larger as one moves down the table. Therefore, once the forecast has been delivered, students want to score as high as possible to maximize both the extra credit score and the total exam score.
Now consider the question of whether students have incentives to forecast accurately. At the time that the student makes her forecast, she has an idea of what her actual score will be. Hence, she has a best-guess of the row that will be used to determine her extra credit. In any given row, the maximum bonus occurs in the column for which the row heading equals the column heading. For example, if the student thinks she will answer five questions correctly, then her maximum extra credit from row “5” is ten, which occurs in the column labeled “5.” Therefore, if she thinks she will score five, she cannot expect to do better than to forecast five, the same as her expected performance. If she intentionally forecasts low (choosing a column to the left of column 5) or forecasts high (choosing a column to the right of column 5), she can anticipate earning less than ten extra credit points if she actually answers five questions correctly, as she predicts.
This extra credit scheme is an example of a budgetary incentive scheme that encourages individuals to both forecast accurately, and to exert maximum effort after the forecast has been delivered. Implicit in this scheme, and all such schemes, is a “baseline” performance level. For example, in the extra credit scheme, if the instructor anticipates that the median on the exam will be six, then it is important that students have approximately the same expectation. If the exam turns out to be more difficult or easier than anticipated, then students’ forecasts will be “high” or “low” on average, and the amount of extra credit earned will be less than otherwise would have been the case. The extra credit scheme would still encourage accurate forecasts and maximum effort, but it probably would not be perceived as “fair” after the scores are in. Hence, this specific scheme and all such schemes rely on some level of accuracy in management’s (or the instructor’s) information, but then uses that information to obtain still more accurate information from the individuals who are best informed (sales representatives or students, as the case may be).
Go
to the End-of-Chapter Exercises and Problems
Return
to the Table of Contents
Management
Accounting Concepts and Techniques; copyright 2006; most recent update:
November 2010
For a printer-friendly version, contact Dennis Caplan at dcaplan@uamail.albany.edu