10/13/2015 Jensen on Incentives 1 Jensen on Capital Budgeting Chris Lamoureux Copyright 1996-98 © Lamfin, Inc

04/19/23Jensen on Incentives 1

Jensen on Capital Budgeting

Chris Lamoureux

Copyright 1996-98 © Lamfin, Inc.


Method vs. ProcessJensen’s focus is on process. Historically

most - if not all - of the focus in corporate finance was on method.

But even a tiny bit of consulting with CFOs makes it clear that bad process can destroy the best method, and that with a good process, method is:

1. Not all that important; and

2. Usually optimized (I.e, it is derivative to process)


Why Pay People to Lie?

In a January 8, 2001 editorial, Michael Jensen argues that, “we must [eliminate] the use of budget targets in compensation formulas. Only then can we be sure that we are paying people to perform, not to lie.”

What is this about?


Budgets Induce Lying

Jensen argues that when confronted with a standard budget / reward system, managers have incentives to play two types of games that he argues destroy firm value:

– The Realization of Targets

– The Setting of Targets.


Gaming the Realization of Targets

• Timing – If a budget is already met, I will shift the realization of revenues to next year, and possibly front-end costs. Conversely, if it appears that I may come up short, I may encourage shifting the realization of revenues. This could be accomplished by marketing tricks (Price rise scheduled for January 2, next year), or fill the channel – verging on fraud.


Gaming the Realization of Targets 2• Accounting Tricks –

– Take gains on the defined benefits pension plan as operating revenues.

– Sell assets and realize gains – lease assets back.

(Internally, the timing issue is probably the most relevant.)


Gaming the Setting of Targets

The key to understanding this is the notion that the manager has information that his superiors do not.

A well-functioning budget process would entail a flow of valuable information up the corporate chain of command. When compensation is tied to the budget, this information flow / co-ordination function is corrupted.


Eliminate Budgets as Targets

Jensen argues that telling managers to stop lying will not solve very much. He concludes:

[W]e must begin by eliminating the use of budget targets in compensation formulas. Only then can we be sure that we are paying people to perform, not to lie.


A solution ?Jensen provokes thought, but does not propose a

solution.

Budgets are used in compensation schemes to create incentives for managers to work harder.

An alternative to the standard methods would be to have a scenario budget. Managers identify important risks and opportunities which they may confront, and elaborate how results might be impacted by different scenarios.


Specific Knowledge & Divisional Performance

The underlying issue in Jensen’s 1999 article in Journal of Applied Corporate Finance is that performance measurement and incentives should be tailored to reflect the extent to which information is decentralized within a company.

Thus, there is a suggestion that introducing disparate activities into an organization is costly.


Knowledge & Performance 2.

This ties in to the question of spin-offs and organizational focus. If it appears that it is very costly to put into place an effective organizational design, then perhaps the problem lies with the corporate structure.

(This is discussed in relationship to the strategic aspects of break-ups.)


Alternative Systems

1. Cost Centers

2. Revenue Centers

3. Profit Centers

4. Investment Centers & EVA

5. Expense Centers


Cost Centers

Here, the incentives are for a divisional manager to minimize costs.

This system may be gamed by:

1. Sub-optimal quantity manipulation

(May lead to stock outs / excess inventory.)

2. Sub-optimal quality manipulation

(May destroy customer base / loyalty.)


Cost Centers 2

CFOs are often critical of what they call an “engineering mentality.” They sense that “engineers” want the latest technology and to show off their skills, when this may not be consistent with value maximization.


Revenue Centers

Here, incentives are to maximize revenues. This is often thought to be a corporate objective in a marketing-focused company; (although sometimes market share is targeted).

This system may clearly gamed by:1. “Mortgaging the future.”2. Cannibalizing other product lines / divisions.

(Imagine that Buick tried to maximize revenues, for example.)


Profit CentersWhen the knowledge required to make decisions

about the product mix, quantity, and quality is specific to the division, and therefore costly or impossible for managers at higher levels in the hierarchy to obtain, the profit center can be an effective performance measurement system. In these cases it is desirable to use profits as a performance measure while giving profit center managers rights over factors such as the product mix, quantity and quality. (p. 12)


Profit Centers 2.

Problems with profit centers include accounting for inter-division complementarities.

Another problem is substituting capital for operations. (No incentive to preserve capital.)


Investment Centers - EVA

Here we evaluate profit after subtracting a capital charge. Since this is not a ratio, there is not a scaling problem.

This solves the substitution of capital problem that exists in a profit center.

It is still static and no panacea.


Expense Centers

A service function that does not charge its “internal customers” may under-produce its services.

Presumably management higher in the organization knows exactly how much of this service is needed and simply creates incentives for the local manager to provide that level of service at minimum cost.


Big Picture: Dynamic Optimization

A problem with all of the systems discussed above is the focus on the short-term, or static optimization.

There is no easy way to trade off the competing needs to induce discipline, discourage shirking, and assess talent on the one hand from inducing creativity and a long-term perspective, on the other hand.


Moog as an Extreme

I spoke with a group of CFOs about these issues in Spring, 2001. It was clear that corporate solutions vary widely.

At one extreme is Moog. This seems to be organized almost like a university. It is assumed that all employees are working for the team.


Real Options shifts Focus

A dynamic focus means that when you make a decision, you do not act as if you are committing the company to a locked-in stream of future cash flows. Rather, you are positioning the company to make future decisions.

A key here is identifying the optimal reaction to future states of nature.


Lilly and PCS – An Example

In November, 1994, Eli Lilly acquired PCS from McKesson for $4.1 billion in cash. In January, 1999 Lilly sold PCS to Rite Aid for $1.6 Billion in cash.

PCS is a provider of pharmacy benefit management services.

Lilly did not see this as failure.


Real Options Case: Enron

In June 1999, Enron opened 3 natural gas-fired power plants in Mississippi and Tennessee (near pipelines). These were cheap, inefficient plants with operating costs 60% higher than state-of-the-art plants. Most of the time, they would be idle.

Why? – Volatility in electricity prices means there will be times (possibly rare), when firing up these plants will be very profitable.


Enron Cont’d.

Note how the optimizing solution of Enron is not induced by any of the 5 systems discussed by Jensen.


“Breaking Up is Good to Do”

Having reviewed the problems with designing optimal processes for multi-division firms, it is not surprising that transactions which move in the direction of separating a division from the rest of the company may create value.


Sources of Value Creation

1. Increase in Analysts’ Coverage

2. Attract new investors

3. Improved operating performance – better incentives / focus.

4. Improved Governance and strategic flexibility.

Documents

10/13/2015 Jensen on Incentives 1 Jensen on Capital Budgeting Chris Lamoureux Copyright 1996-98 © Lamfin, Inc