Target setting is possible even without budgets
by Olivier Fernandez
These days, the competitive environment is extremely challenging for most companies. The price, cost and innovation pressure is strong. At the same time, the expectations by the investors are very high: The return on the invested capital ought to be maximal. Companies set ambitious targets, which are defined for different organizational units and hierarchical levels within the company, in order to be successful in this environment.
Traditional budgeting and identification of fixed targets
The traditional budget process plays a central role for many companies in the target setting process. It is often considered the only possibility to define financial targets and to coordinate these in the organization. Absolute, fixed financial targets are usually linked to the idea of traditional budgeting. The revenues shall increase to 1000 and the EBIT shall reach 200.
I assume that fixed targets (still) dominate in the companies, even though other methods show significant advantages. What might be the reason for this? In my experience, the following soft factors play a central role:
- Easy to understand, with a clear message. A fixed number is easy to understand. Relative figures, which are probably also being compared to benchmarks, are harder to understand. This applies especially to employees outside of the financial organization. In today’s complex world, business leaders want to convey clear messages and plant them in the minds of the employees. It is easier to swear the organization to reach an EBIT of 200, than to communicate that you want to outperform an external benchmark by the end of fiscal year.
- Easily measurable. The comparison to external benchmarks (e.g. in the form of portfolios by comparable companies) is more demanding than the comparison with internally derived, fixed budget figures. In our company, I have often heard the argument that it is impossible to find any reasonable external benchmarks. This is either because companies have a (slightly) varied product portfolio or because direct competitors don’t need to publish any data.
- Fixed targets give a feeling of orientation. This might be the most important reason for holding onto fixed targets. A budget specifies – in a clear and detailed way – which sub-goals have to be fulfilled in order to reach the overall goal. Everyone knows exactly what he/she has to contribute in order to achieve this. During the year it can clearly be determined at any time, whether the company is on its target path or not. In case of deviations, specific measures can be taken to target the benchmark. This gives a feeling of orientation and ability to act, ultimately also for the management itself. You know where you’re standing and what you have to do to be “good” and “to perform”. The fact that fixed targets are often linked to variable salary components increases the wish for orientation even more.
Fixed targets are not up-to-date anymore
In today’s volatile business environment, fixed targets are not up-to-date anymore. Very soon, they become obsolete. A revenue growth, which was considered ambitioned but attainable in fall, can turn out to be unattainable or too little ambitioned by next springtime. If the market grows faster than expected in the budget, one can actually not be content with reaching the budgeted growth. In contrast, relative targets meet the needs of the changing environment. Here, the target attainment is measured retroactively after the relevant period has elapsed. Ideally, these targets are linked to external benchmarks. For example, the revenue growth is compared with the market growth or the financial performance (e.g. ROI, EPS, CFROI) is compared with benchmark companies.
The comparison with the external benchmark underlies a simple, yet convincing thought: In accordance with the given market conditions (and not in accordance with outdated assumptions!), we want to be better than our benchmark. Those who want to be successful must perform good or even better – in comparison with the competition – in the long run. Personally, I think this is an equally strong message for the employee and at the same time it makes a lot more sense than any fixed figure. Apart from that: What is the benefit for a company, if the organization is sworn to an outdated target?
Furthermore, benchmarking reflects the opinion of the investors. To them, companies which show a better-than-average performance are attractive. By that, they gain a better return than comparable investments. In the course of this it is irrelevant, whether investment alternatives (benchmarks) are identical or not. At most, investors look for more attractive industries and/or regions.
In comparison with external benchmarks, one is often not able to measure the target attainment level continuously and in detail. This “lack of orientation” faces a significant advantage: One is forced to constantly and intensively follow up the market and the competition instead of focusing on the internal view. This can only be good for the company!
A paradigm shift
Going from a traditional budgeting with fixed targets to relative targets with benchmarks is a paradigm shift. It has to take place in the minds and requires letting go of decade-long and optimized (thinking) processes. Such a change needs some time. This is one of the key findings, which I have come to learn as a project manager in our company. Those who have set their target system from fixed to relative targets with benchmarks have made a considerable process on their way to no budgeting.