BW Communities

Case Study:Variable Pay: Incentive To Sin

BW Online Bureau Nov 08, 2014

<div>Sanjiv Misra sat on the couch in chairman Jai Kalra’s office playing with a Rubik’s Cube on his coffee table, when Kalra walked in. “Open collar, on a week day?” asked Kalra. Misra smiled in response and said, “Had a PTA today, and did not want to look stuffy.” Kalra snorted out a laugh and said, “I know that feeling!” as he adjusted the blinds. “Your son is in high school?” Misra, replied, “The younger one, yes, 12th.” Kalra sat on the single couch across Misra and said, “Now as to the matter of Abhay Lal. It is very important that the figures pass muster; then our top line will record a growth of 11 per cent... we need that steady growth pattern to show... are you with me? “Understand, I win, you win, the team wins. Okay? At this point in time we are a good per cent short of targets. We have to cross the target, yes? The only chance we have of doing that is to cut a deal at a deep discount with Kimrana Agencies (distributor). You will need to structure the documentation in such a manner so as to obviate any senior level approvals, and pull in the True and Fair certification.” Misra looked at his chairman and then at his finger nails, long and  hard, when his mobile phone beeped a message. It was Narayanan Athreya. “We can meet when you are ready.” Misra wound up his meeting with Kalra and repaired to Athreya’s office. Athreya held a letter in his hand which he wagged before Misra, saying, “What is this? You have to be joking! You wish to quit? How can you? Good soldiers do not run away, they stand their ground...” Misra: A good soldier has a solid system backing him. Here, if a senior manager is even present in the bakery when the cake begins to burn, he can be arrested, even if he start the fire. Athreya: I need a strong watchdog here who can slap a system into place if it is coming apart. Someone who can smell a rat before the cat does... I urge you to not be irresponsible. And what is this ‘suboptimal’ system you mention in your note? Misra: The incentive system which is designed to encourage performance and not excellence....   Athreya: How do you mean? Misra: When I joined here six months ago, the package offered to me was 150, of which 100 would be fixed, 20 is what I could get if I stayed on a year and 30 was to be variable compensation. I told Harsh Pandyan in HR that if you offer a finance person variable compensation, there is a conflict! You want the finance fellow to not only confirm conformance to accounting practices and policies, but you will also want me to be honestly reporting them. Now if you put 30 per cent of my compensation on the hook, to win that 30, I may choose to do something wrong! So there is dissonance. Athreya: Like what? Doesn’t make sense... Misra: In project accounting, revenue recognition is based on gut, on guesstimating. But even here, say, you want me to implement a SAP module for Sri Lanka (Effren is the hub for SL, Bangladesh and Nepal) and you offer me a bonus for completion in six months. Or to get some factory up and running in six months. Or if we are a services company, then because assignments run into months, revenue recognition will happen month to month. Firms can adopt cash basis or accrual basis for recognising revenues. In the accrual accounting method, revenues are recognised when they are realisable, proportionate to the costs incurred until then. It does not matter that the payment itself will take place on a later date.   The recognition of that revenue is no doubt governed by GAAP, but accrual itself is subjective; I can choose to accrue some cost, and you may not have done so in my place. Or some aspect of the stage of completion -- I can choose to ignore the delays and instead declare ‘Project on time’, and recognise the revenue. Then I can pull in a couple of million dollars more, meet my numbers, and get my bonus. And they will never be the wiser for it, because I am the final authority that decides whether there is an impairment which needs to be factored into the project or not. As CFO, I have the unconditional choice to recognise two-thirds, half or one-third as completed. <img width="200" vspace="7" hspace="7" height="200" align="right" src="/image/image_gallery?uuid=30f4eff5-fbc1-47ef-9454-2faa362b4242&groupId=222852&t=1368789403879" alt="" /> Now, if you are asking me, as a CFO, to make a choice, then you are also warning me that 30 units (out of 150) of my compensation can get impacted... Is that ethical? As a finance man, I tell you this is dangerous. I can manipulate what I recognise as revenue and what I do not! Equally, you can incentivise me for helping you doctor the accounts. [Athreya fell silent as he thought for a long while. After a while he said, “Then?”] Misra: HR would not agree! But you now think — if I am the business head with targets and variable pay. The first thing that happens is gaming. In my budgets itself, I start to throw in spanners. Take projection of revenue. Even if I see the possibility of a revenue of, say, 900 units, I will put up a fight and say I will not do more than 750. That is my best estimate. Likewise, for the costs, even if I know of ways to limit the cost to say 75 per cent, I will say, sorry, there is labour inflation, there is tariff hike suspected, and I will lift the cost bar to 80 or 85 per cent. In  this way, what I do is that I press on you a lower budget, then go overachieve, and get my 30 per cent variable pay. This is how I start playing games! Athreya: But if I do not factor in the pessimism in the environ, I can end up over-estimating and under achieving, and then I lose my VP, no? Misra: This is what I mean. Your entire budgeting exercise is now a means to win the VP, whereas the VP is not a thing to leverage! See, the bonus has to be a rarity, an award for coping with the unusual and the unexpected. First of all, by revealing it to me, I begin to see it as a right, a must-win. But in the process you corrupt my soul, my learning, my professionalism. Now instead of actualising my potential, I begin to actualise my variable pay! So yes, a pessimistic scenario has many ghosts in the form of ‘what ifs’ — what if there is a petrol hike; what if there is a Bharat bandh; what if there is a stockmarket crash...But every player is going to get hit, not just me, so the playing field is level, hai ki nahin?  </div><div>break-page-break</div><div> Now see what happens. As your budget is lesser than your potential — I may even say, your doctored best estimate is actually closer to the real worst estimate — you are now bringing in an inherent laziness in the organisation. Two, if the CFO-CEO combine starts to play games at that level and promotes a lower target, everybody down below will do likewise. And by the time this hits the lowest guy in the chain, you are looking at a 20-30 per cent difference between potential and target! Yes, yes, yes, as much as that! That is my angst! Athreya: As a leader what are your options? I see how the arithmetic is playing out... and I can as easily see this happening in other organisations. This is dreadful! Misra: Many companies have had this discussion. The sad part is, they all know the disease prevails, they know the cause, and they know they don’t want out because the opportunity losses are not pleasing. Two exercises that we do — one is variable compensation and the other is budgeting — both are limiting exercises, they are not stretching exercises. Top management thinks that by introducing a variable compensation component, it is stretching the potential or helping managers achieve their stretch potential. They think that by putting a budget it can hold people to their forecasts. But to my mind, you can easily fool the system by playing around with these two things, if you are a glib talker or are an opinion leader. And everybody does it! And that is how everyone has gone about rewarding each other with stupendous jaw-dropping bonuses! In budgeting there are no heroes. Nobody sits down and says, ‘Achcha ab tum budget de do, main exceed karoonga!’ There are always challenges. There is always a cat-mat fight. Athreya: But for example, if you were to take a top line figure of 100, how will the first guy who receives this target resist it knowing that you were the guy who has already pulled it down? Misra: It will be the same. Everybody knows that sandbagging is the way it is. As I am pulling down my budget, I am involving my entire team in it na! I don’t pull the top line projection out of my pocket! I have my sales chaps, my business heads who will ponder and probe and chew pencil and tell me their capability for their region. Seven people working under me, helping me develop the budget, are watching me, Sanjiv Misra, cushioning the budgets; they are watching me saying, ‘nahin, nahin, put 12 per cent here, 2 per cent there, hold this back, we will pull out a trump card in third quarter...’, etc. Arre, when I am doctoring, tweaking, trimming, they are all watching me, even advising me, such as, ‘boss, south ka strategy abhi reveal mat karo. Pocket mein rakh lete hain, fourth quarter agar tension hai, then we will pull it out...’  </div><div>Bear in mind, I cannot develop the budget on my own. I have to work with four people to deliver the business to begin with. As they see me cushioning, everybody learns the ploy for their respective verticals or sub-teams. They will also hold back from me, over-demand from their teams, make a fool out of me, make a fool out of their teams and, in turn, be made a fool of by their sub-teams... it’s all in the family, we all look the other way. We know what’s going on, but we will choose to look the other way, for it is polite. Besides, at stake is the variable pay!  </div><div>break-page-break</div><div> What are the options? If as a leader I stretch somebody and say, ‘No no, I don’t like your budget, put 15 per cent top line, 15 per cent bottomline’, what happens? Next time that guy will say, boss will give me 15 per cent as target so let me lower the base figure even more. So he will come with a cushion to begin with because he knows 15 tak toh milna hi hai So everybody wagers, ‘how much should I tell him — 10 or 15?’ I know that when I go to Eduart De Vries, my Asia boss, he is prone to throw  everything out of the window without reasoning with me, and saying ‘10 per cent increase in top line, 10 per cent increase in bottomline, thank you very much, nice knowing you, add it to the budget!’ Athreya: And whatever is in between you manage? Misra: Absolutely! Because I know he is not going to listen to my logic, to my market behaviour. He will not tut-tut and say, ‘oh dear! Tough market, eh?’ He listens to every sob story making pitiful sounds, and yet tells everyone go get 10 per cent growth! So anybody who goes to him now, knows that if he presents 100, Eduart will scratch that and overwrite ‘110’. So a business head like Rohit Mattoo will pitch 90. ‘Steven toh 10 per cent badhaa hi deta hai, so let me go to him with 90 and grumble indulgently when he adds 10 more! Main bhi happy, Eduart bhi happy!’ It’s a game. Athreya: What do you do? How do you incentivise the leadership to deliver honest performance?? Misra: The jury is still out. After a point, people don’t look at being promoted. I have held the CFO title for 10 years. What do I look forward to? I don’t want to go overseas; I don’t want free holidays... So I have no incentive to do better, except if they tell me ‘go meet your target and take 50 per cent more compensation’. Finally, it is a money game, Mr Athreya; and if it is a money game, then you have to find a way to disburse the money, to link it to something — and that is always an imperfect measure. Now top that by saying your budgeting is based on that and your VP is based on that, it becomes a mugs game. There is no way out. Achha, listen to this: I have looked at our past many balance sheets. We make 4 per cent margins. We borrow — our cost of capital is in excess of 5.5-6 per cent... hmm? Clearly, we are eroding shareholder equity, we have destroyed shareholder wealth for the past 4 years. And in all these years, everyone has made full bonuses! How do you explain that? Athreya was alarmed. The numbers were suddenly talking. “How is that possible?” Misra: Because you give the shareholder what he is expecting.... Athreya: You mean the shareholder asked for less? Misra:  Well, you lower his ‘expectation’! He asked for more than what we budgeted... but he didn’t know we had already budgeted very low! See? Woh bhi happy, main bhi happy! Athreya: So just agree to a number, achieve it and get your VP.... hmm. Wait! You are saying that budgeting was in your control! Misra: You got it. Look, budgets do not go to the shareholders for approval anywhere! At no stage are we telling the shareholder how we incentivise our business heads for achieving business. The shareholders are a motley bunch of people with different kinds of expertise and interests. For example, my mother is a shareholder of ITC. Apart from writing to them once a year and denouncing the cigarette business, she banks her dividend warrants and returns to her crossword. She does not know what the MD is being paid as remuneration.  Or the market growth potential. My point is, only the board has a compensation committee which decides on the compensation packages... for the top 15 people. Here you can do whatever you want; it will never reach the people who are paying you, that is, the shareholders.... My point has to do with what you as a board or an organisation wishes to perpetrate or put your signature to. Can a manager take home Rs 40 lakh bonus one year, and deal with the fact that the following year he cannot? Let’s not kid ourselves; these are lifestyle bonuses; meant to hook you to the bait. So what do you do? Are we then not relying on the moral and ethical standards of the business heads and not on the strength of the process to deliver?  casestudymeera(at)gmail(dot)com Read Businessworld case studies on Facebook (This story was published in BW | Businessworld Issue Dated 03-06-2013)</div>