How to drive dynamic decision-making and action: From fixed to relative performance contracts (Part 1)

by Niels Pflaeging, Founder, BetaCodex Network

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For decades,
organizations of all sizes and from all kinds of industries have curated and
perfected management practices such as fixed target setting, target
negotiation, planning, budgeting, forecasting, plan-actual variance reporting,
incentives-setting, and individual performance appraisal. Now, things are
changing: Those practices, usually combined under brands such as Management by Objectives, Merit Pay, or Pay-for-Performance have recently come
under fire. If markets and work are becoming ever more dynamic, how can static,
annual rituals remain effective and appropriate to improve or even control
performance?

Look at companies large and small, and everywhere in the world,
and you will find that performance management practices these days are
remarkably alike, almost everywhere. That bundle of management practices was
popularized between the 1950s and the 1980s, starting with the idea of
Management by Objectives, proposed by Peter Drucker in his 1954 book, and into
the late 1970s, when Michael Porter elevated the idea of competitive advantage,
or strategy, to a quasi-science. Since then, “fixed performance contracts”
have become almost omnipresent and are until this day considered the standard
for managing performance, and for controlling businesses and people.

Starting with the Beyond Budgeting movement in the late 1990s,
some have started to question the idea of the static performance contract: the
philosophy of budgeting and setting fixed targets in advance, and then
measuring and judging actual performance against those pre-defined objectives.
Fixed performance contracts, the critics say, are not only inefficient today.
They can only be counter-productive in times when uncertainty and surprise
become the norm, and when value-creation becomes more complex, instead of
remaining just complicated.

The side effects of “fixed performance contracts” are
wide-ranging and dramatic. They range from internal stakeholders gaming
performance systems and controls (in reaction to target-setting and bonus
compensation), to external stakeholders and CFOs rigging the financial markets
(in reaction to earnings guidance and expectation management).

Performance Management: Are we riding a dead horse?

In other words: The performance management practices from the
past are broken, and we know it. Uncertainty and complexity have long
invalidated planning, forecasting, fixed targets, plan-actual reporting (see
illustration 1), and bonus systems. We have outsourced control to markets a
long time ago. But instead of letting go of all practices that assume stable,
slow-moving, and indeed dull markets, we have continued to optimize and perfect
these practices. We have tried to improve a way of managing that has long been
straight jackets, or “dead horses.” The very same Peter Drucker once wrote that
“90% of what we call management today actually consists of practices that make
it hard for people to do their work.” 
Today, the challenge for us is not just to recognize that, and its
consequences. It is to get off the dead horse.

In dynamic markets and value creation, absolute targets weaken
control and create misleading incentives (left), while relative measurement
enables transparency and adaptive control rooted in self-organization
principles (right).

Illustration 1: How we fool ourselves, using fixed performance contracts: Example of a financial performance indicator

The good news is that the solution, or the alternative to fixed
performance contracts, has already been around for quite a while, albeit in a
relatively small number of startlingly successful “pioneering” organizations.
Even though they may seem new and indeed counter-intuitive to many companies
and managers today that have been used to the notion of controlling through
fixed performance contacts, some larger companies have used relative
performance contracts, exclusively, for a few decades,. As we learned during
the case study research journey of the Beyond Budgeting Round Table (of which I
was a director for a few years), that started in 1998: There is a whole world
beyond budgeting, beyond fixed targets, incentives and variance reporting. We
began labeling this alternative “relative performance contracts” in the early
2000s.

Relative performance contracts are based on the assumption that
it is unwise to set fixed targets for managers and teams and then to control
their behavior and activities in terms of these targets. The implicit agreement
is that management’s task is to provide a challenging and open work climate
within which employee teams agree to aim for continuous performance
improvements: managers and employees must use their knowledge and their own
common sense to adapt to changing conditions and environments.

Towards the emerging “relative” performance contracts:

Under this performance contract, decisions are not made at the
top. Instead, they are distributed, decentralized, and devolved as far out as
possible. This type of performance contract increases, not erodes, mutual
trust. Increased transparency and higher expectations (compared to competitors
or their equivalent) provide a permanent challenge, which either has to be
matched to or whose failure will lead to equally transparent consequences.
Responsibility for performance and decision-making are gradually shifted away
from the center of the organization towards the periphery. Decentralization
thus is key to relative performance contracts.

Illustration 2: How to move from fixed to relative performance contacts

Variations of this kind of relative measurement have been used
by a few larger companies for decades. An example: In 1971, after severe
internal crisis, Swedish bank Handelsbanken
began to transform its organizational units into self-managed profit centers
with clearly defined customer relationships and highly devolved responsibility
for the results. Budgets, fixed targets, quotas, incentives and bonus systems,
and indeed also the org chart, and central departments like marketing, product
management and risk were abolished. Handelsbanken now has over 10,000 employees
and it has consistently been Europe´s most successful bank for more than 42
years, in pretty much any performance indicator you can imagine. This bank´s
branch network now consists of more than 700 subsidiaries, legally independent
regional banks, and service departments. Autonomy of the bank’s branches has
been extended continuously since the 1970s. The company’s main focus is on
branch effectiveness, not on the profitability of individual products.

To monitor performance, Handelsbanken developed a compellingly
simple control system within which teams work on the basis of relative
performance measurement based on “real world,” not planned, performance data.
Success is no longer measured according to negotiated, planned data, but
relative improvement as measured using a limited number of key figures. To do
this, the bank as a whole compares itself with its closest rivals. Similarly,
regional banks assess their performance monthly and in comparison with other
regions, and branches are compared with other branches. All targets,
performance assessments and reporting systems are thus based on internal or
external competition and continuous improvement.

Illustration 3: Ways of measuring, without actual-plan-variances, fixed targets, or plans

This 3-layer continuous ranking system has proved to be highly
self-regulating and has required only minor modifications over the course of
decades. It does not depend on any annual adjustment, hierarchically integrated
planning, or internal negotiation. At the same time, it has dramatically
increased internal transparency and responsibility of teams to act as if “the
branch is the bank.” Employees are driven not by individual targets or group
incentives; rather, the system appeals to employees’ need to be valued and
recognized for their role in helping the organization succeed.

Other larger, successful companies such as Southwest Airlines,
Toyota, W.L. Gore, Guardian Industries, Aldi, dm-drogerie markt, or Egon
Zehnder International have developed models similar to the Handelsbanken
approach. There are enough examples of pioneering companies to give us the
courage to overcome traditional thinking and ways of dealing with performance,
Now that competitive benchmark date is becoming widely available, and to
organizations of all kinds and sizes, at much lower cost than ever before, we
have ever more reasons to search for new ways to measure and improve
performance more effectively: using real data, not invented numbers.

Niels Pflaeging is
an entrepreneur, management advisor, influencer and speaker. He is founder of
the international BetaCodex Network and author of the business bestseller Organize for Complexity, published in 2014.
For five years, he was a Director of the Beyond Budgeting Round Table
BBRT.  You can download Niels´ white
paper “Making Performance Work” here. Get in touch with him through: @NielsPflaeging, www.nielspflaeging.com or www.betacodex.org

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  • In the last sentence, “date” should be “data”. Otherwise it’s an interesting perspective. Thank you.