Forced Ranking of Performance scores
During the nineties it was common practice for companies paying bonuses to doctor the performance scores to make sure they didn't spend over budget. It was also argued that a "smoothing" was required to account for the fact that some Managers tended to score highly and some were "hard" scorers. Rather than try to improve scoring behaviour so that Managers understood precisely what, for example, a "superior" performance rating was and how it should be scored, most companies, in the interests of empowerment, preferred to let them go and adjust the outcome later. Although the budgeting objective was (sometimes) achieved, the practice made a mockery of the performance management process because it diminished the integrity of the exercise in the eyes of the recipient employees. It didn't smooth for the "hard" and "soft" marker effect either - the differential still remained.
In a recent telephone survey of a dozen large companies, we were surprised to discover that the practice is still alive and well and living in corporate Australia. Of the 12 surveyed companies, 10 still used some form of performance score adjustment for bonus budgeting purposes. The most common manifestation (7 of the 10) is the "forced ranking" of performance scores prior to the application of a formula to calculate individual bonuses. The performance ratings are forced into a normal distribution - sometimes before the performance management process begins and sometimes after it has been completed. In the before scenario, using the example of a 1 to 5 performance scale, each Manager is told precisely how many 1's, 2's, 3's, 4's and 5's they are allowed to award. In the post scenario, the rating is adjusted from that which has been conveyed by the Manager to the employee for the purposes of calculating the bonus (some increased and some decreased to fit into the normal distribution). The changes are usually not conveyed to either the Manager or the employee.
This surreptitious method encourages Managers to abdicate responsibility for the bonus outcome when it does not correspond with the performance conversation they had with the employee some weeks before. Basically, when questioned about the paucity of the bonus, they can (quite legitimately) blame someone else, usually HR. The other three companies did pretty much the same thing except that they used a two dimensional performance matrix instead of a rating scale. They still tried to apply the normal distribution to the matrix performance outcomes. Arithmetically, this simply extends the scale to nine, 12 or 16, depending on the parameters of the matrix. Only two of the surveyed companies retained the integrity of the performance management scores - one by using an allocated budget and the other by over budgeting.
Hard Dying Habits
Remuneration systems design is, more often than not, an exercise in change management. Any change management practitioner will tell you that the initial and fundamental human behavioural response to change is resistence. This is particularly the case where the pre-existing practices have become habitual.
The fact is that forced ranking is an unecessary anachronism that brings more negatives to the table than (albeit, dubious) positives.The Kapitis Top/Down Allocation methodology dispenses with the need to force rank performance scores, avoids the use of rigid individual bonus calculation formula and allows for precise budgetery control. The only thing it forces is management decision making - something the shareholder is already paying for anyway. In addition to these advantages, Top/Down Allocation compels Managers to consider and assess the performance of teams - from entire Business Units down to the smallest functional groups. Forced ranking, which exists primarily because companies still use individual formula to calculate bonuses, has great difficulty incorporating a team result in the absence of a structured Balanced Score card mechanism, or similar. Even where this does exist beyond the Business Unit level, it's application complicates the formula.
Top/Down Allocation - How does it work?
The Kapitis Top-down Allocation, Bottom-up Distribution methodology is a proven approach developed over many years. It has achieved a strong correlation to share price appreciation and profit improvement in a diverse range of businesses across many industries. The allocation and distribution process balances manager responsibility with accountability. It is designed to reward superior performance within the confines of a performance determined total spend. The first step is the determination of the total amount of the bonus pool. The determination of this amount must be predictable based on group results to facilitate transparency and confidence in the program.
Once the bonus pool amount has been determined it is then allocated by the Chief Executive to the Business Units based on their relative performance. An amount is also put aside for later distribution to the Direct Reports to the chief executive. The amount allocated to a Business Unit is then allocated, by the Business Unit leader, to the Divisions of that Business Unit. Again, an amount is set aside for the Direct Reports (the Managers of those Divisions). See Illustration 1 : Pool Allocation.
This allocation step is then repeated throughout the organisation down to the smallest group or department.
Once the allocation has been completed it is submitted for approval by the Manager at each level. All lower level decisions are visible higher up the organisational hierarchy ensuring transparency and consistency.
Distribution
The distribution stage of the process requires managers to determine how much of the amount allocated will go to each individual. This is based on their performance, the budgeted bonus percentage, and the amount previously allocated to this department. See Illustration 2: Distribution to Manufacturing executives
Once the distribution has been completed it is submitted for approval by the Manager. Again, all lower level decisions are visible to all managers above, thereby increasing the transparency and consistency of distribution decisions both down and across the organisation.Once individuals understand that the goals of the group and the Business Unit, plus their individual goals need to be met in order to maximise the potential bonus amount, they are much more likely to ensure they understand the goals, and their role in achieving them.
The methodology requires performance assessment at various levels - Group wide, Business Unit, Team and Individual. Since all decisions are open to scrutiny from management above them, it also increases the need to ensure all decisions are supportable based on the evidence.
The straightforward nature of the decisions that need to be made under this methodology facilitate a more streamlined process. The Top-Down allocation approach ensures that Managers at all levels know their leaders have completed this exercise before them, and thereby assigned it significant priority. The separation of the allocation and distribution decisions helps Managers focus on Business Unit performance initially, and then individual performance. The Top-Down approach also ensures the entire exercise is completed to the original budget - you cannot allocate or distribute beyond your pool.
This methodology enables organisations to optimise the inherent benefits in performance based pay. The days of contaminating the performance management process with forced ranking are over.
Author: Greg Brogan
Date: 27 Sept 2006