Norman Marks
This is a question about two related things: the monitoring and measurement of performance, and how (and if) management incents desired behavior and results.
In their 2009 report, Corporate Governance and the Financial Crisis: Key Findings and Main Messages, the Organisation for Economic Co-Operation and Development (OECD) identified:
- A lack of independence in the setting of objectives and measurement of performance
- Weak relationships between performance and remuneration
- Complex compensation programs that made it difficult to relate remuneration to performance
- Performance was not measured using metrics defined when strategies and goals are established.
- Compensation was not always linked to long-term performance.
- Risk was not considered when evaluating performance.
One of the interesting comments was that “remuneration and incentive systems that should be the focus of board (and sometimes regulatory) oversight need to be considered broadly and not just focused on the chief executive officer and board members”. I interpret this as recognizing that compensation drives performance across the entire organization, so focusing only on the top executives ignores the strong likelihood that the people making decisions in the front lines may be incented by bonus programs that are not consistent with organizational goals.
For example, consider the age-old issue of “empty revenue”. Many, if not the majority of companies set goals for sales and other employees based on revenue. This tends to encourage them to make decisions that grow revenue irrespective of the level of profit, customer satisfaction (e.g., knowingly selling products and services that don’t quite meet customer needs), and long-term value (e.g., moving revenue into the current quarter at a lower profit margin than if the sale was made in the next quarter).
Some years ago, my company acquired a business where internal audit participated in the process of reviewing whether departments had met or exceeded their goals. During the transition, the head of the new subsidiary’s audit team told me that he was denying the IT department’s claim that it had fully satisfied the goal of delivering a new financial system by the end of the quarter. The denial was based on the fact that, while IT has technically achieved the objective of implementing the system (it was in production), not a single report had been written for the users. It reminded me of a similar situation when I was in public accounting and my client had signed a contract that specified delivery of a “general ledger system”; the vendor billed for completion under the contract even though they didn’t provide a single report – not even a trial balance!
I would approach this question in a number of steps, a number of questions that help obtain an answer – and identify where there might be a gap:
- Assuming that the strategies and goals for the organization are approved by the board and will deliver longer and shorter-term value, consistent with organizational values and in compliance with applicable laws and regulations, were appropriate metrics established to measure achievement of those strategies and goals?
- How clear is the relationship between the metrics and compensation awards? Would a reasonable person agree that compensation is clearly linked to achievement of the strategies and goals, with an appropriate balance between shorter and longer-term performance?
- If there are issues relative to risk-taking, or behavior consistent with organizational values, do they affect compensation awards?
- Are the goals and strategies of each unit and manager clearly consistent with achievement of organizational goals? Is individual and unit performance measured based on their active contribution to the achievement of the goals, or are they motivated to behavior that is inconsistent with those goals and strategies?
- Is performance against objectives and goals measured objectively and fairly?
- Are performance awards consistent with stakeholder expectations for compensation?
Norman Marks, CPA, is vice president, governance, risk, and compliance for SAP's BusinessObjects division, and has been a chief audit executive of major global corporations for more than 15 years. He is the contributing editor to Internal Auditor’s “Governance Perspectives” column.
normanmarks.wordpress.com/
In their 2009 report, Corporate Governance and the Financial Crisis: Key Findings and Main Messages, the Organisation for Economic Co-Operation and Development (OECD) identified:
- A lack of independence in the setting of objectives and measurement of performance
- Weak relationships between performance and remuneration
- Complex compensation programs that made it difficult to relate remuneration to performance
- Performance was not measured using metrics defined when strategies and goals are established.
- Compensation was not always linked to long-term performance.
- Risk was not considered when evaluating performance.
One of the interesting comments was that “remuneration and incentive systems that should be the focus of board (and sometimes regulatory) oversight need to be considered broadly and not just focused on the chief executive officer and board members”. I interpret this as recognizing that compensation drives performance across the entire organization, so focusing only on the top executives ignores the strong likelihood that the people making decisions in the front lines may be incented by bonus programs that are not consistent with organizational goals.
For example, consider the age-old issue of “empty revenue”. Many, if not the majority of companies set goals for sales and other employees based on revenue. This tends to encourage them to make decisions that grow revenue irrespective of the level of profit, customer satisfaction (e.g., knowingly selling products and services that don’t quite meet customer needs), and long-term value (e.g., moving revenue into the current quarter at a lower profit margin than if the sale was made in the next quarter).
Some years ago, my company acquired a business where internal audit participated in the process of reviewing whether departments had met or exceeded their goals. During the transition, the head of the new subsidiary’s audit team told me that he was denying the IT department’s claim that it had fully satisfied the goal of delivering a new financial system by the end of the quarter. The denial was based on the fact that, while IT has technically achieved the objective of implementing the system (it was in production), not a single report had been written for the users. It reminded me of a similar situation when I was in public accounting and my client had signed a contract that specified delivery of a “general ledger system”; the vendor billed for completion under the contract even though they didn’t provide a single report – not even a trial balance!
I would approach this question in a number of steps, a number of questions that help obtain an answer – and identify where there might be a gap:
- Assuming that the strategies and goals for the organization are approved by the board and will deliver longer and shorter-term value, consistent with organizational values and in compliance with applicable laws and regulations, were appropriate metrics established to measure achievement of those strategies and goals?
- How clear is the relationship between the metrics and compensation awards? Would a reasonable person agree that compensation is clearly linked to achievement of the strategies and goals, with an appropriate balance between shorter and longer-term performance?
- If there are issues relative to risk-taking, or behavior consistent with organizational values, do they affect compensation awards?
- Are the goals and strategies of each unit and manager clearly consistent with achievement of organizational goals? Is individual and unit performance measured based on their active contribution to the achievement of the goals, or are they motivated to behavior that is inconsistent with those goals and strategies?
- Is performance against objectives and goals measured objectively and fairly?
- Are performance awards consistent with stakeholder expectations for compensation?
Norman Marks, CPA, is vice president, governance, risk, and compliance for SAP's BusinessObjects division, and has been a chief audit executive of major global corporations for more than 15 years. He is the contributing editor to Internal Auditor’s “Governance Perspectives” column.
normanmarks.wordpress.com/
