The purpose of setting a budget system is to briefly forecast a company’s performance in the following year, and it can also be a result control system that makes people in the corporation work properly to achieve the objectives and give them incentives by bonus related to performance. From this point of view, the budget system should be reasonable, achievable, and also have some challenge to ensure the hard working.
HCC Industries was using “stretch” performance targets until 1987. The main idea of using “stretch” targets was to motivate managers to perform at the highest level possible by setting aggressive targets with probability of achievement between 75 % and 80 %. In order to motivate the managers, incentive system was directly related to the budget targets. The bonus potential for division managers was 30% of base salary and was equally based on profit before taxes (PBT) and subjective rating of performance depending on the degree of accomplishment of the targets in all seven performance areas. In case that only few of performance areas were not met, but the management considered them important, no subjective bonus would be provided. Objective bonus based on profit before taxes was provided as following: if 60 % of the budget was achieved, 80 % of the bonus potential was paid; if 100 % of the budget was achieved, 100 % of the bonus potential was paid; and if 140% of the budget was achieved, 150 % of the bonus potential was paid. Bonuses were paid quarterly at the level of 80 % of what was earned in order to prevent paying the bonuses that were not earned. However, philosophy of using “stretch” performance targets in HCC Industries did not work very well, since it encouraged thinking optimistically that pushed employees to perform at a higher level leading to innovation. This philosophy is advantageous for particular companies with a certain size that have an understanding of the markets and have an ability to influence them. HCC Industries was a small publicly held corporation which was just taking orders and not doing marketing. For this reason, there was little probability for the employees to enlarge the market and achieve an aggressive growth in sales every year. Performance targets were set too high and optimistic, they were unrealistic, unachievable, and not suitable for a company which could not make a sustaining growth by influencing the market.
One of the main disadvantages of “stretch” targets was that they were set too high. This led to the situation that for the last four years HCC Industries never achieved its targets. As a result, employees lost their motivation and commitment to achieve the targets; they were discouraged, and exert less effort by giving up trying, as they felt that “stretch” concept was causing the corporation not to achieve its plans. If a division keeps missing the budgets, employees feel like a failure. Taking into account that the employees could not achieve the targets for already four years, they had lost their confidence and became used to missing the budget and the enthusiasm to strive for the objectives was weakened. Although the targets were set at an unreachable level, the control system was not that tight. Even if the managers failed to achieve the targets, they may also be paid the bonus. For example, the managers were still paid 80% of objective bonus potential based on profit before taxes if they had just achieved 60% of the budget. So if a manager was not so ambitious, he did not have to worry about meeting the budget.
Moreover, important constraint to motivation of division personnel was that they did not know their bonus potential and the bases on which the bonus awards were made, as division managers did not want to disclose division-level financial information to their personnel. As a result, being unaware of the main objectives of the...