Organizations dramatically increase the incentives for gaming when they link compensation to budgeted performance. This is powerfully illustrated by Harvard Business School Professor Michael Jensen's diagram of how budget-based incentives lead managers to manipulate results to maximize their bonus payouts (see exhibit 2). When managers are in the targeted bonus zone, they do everything they can to maximize results. But if they have not reached the payout zone, they delay activities and push out results to increase their chance of getting a bonus in the next year and to reduce the starting point for the next year's budget negotiations. Likewise, if managers reach the top of their payout range, they pull back rather than optimize performance.

The key to breaking this chain is to separate rewards from the planning process. The Beyond Budgeting model separates its rolling forecasts from performance evaluations. It holds that ethical organizations can still pay incentive compensation, but they do not tie it to negotiated targets. Rather, they base incentive payouts on relative performance metrics -- measures that evaluate results only in comparison with the performance of other business units. Relative measures usually evaluate results against leading industry indicators, competitors' performance, and benchmarks of similar functions within the same company and at other companies. They sometimes also include comparisons with prior-year performance, but the focus is on how well the business unit did relative to other groups.

To see what a difference relative metrics can make, consider the telecommunications industry in the late '90s. Suppose that a telecom company which used traditional budgeting set a sales growth goal of 15 percent. Its actual performance reached 20 percent, so its traditional incentive plan tied to budgets generously rewarded this performance. But if executives had looked at their market with hindsight, they would have seen that the industry grew by more than 30 percent. The traditional incentive system paid high rewards for sales performance that actually eroded market share.

Compensating based on relative performance accounts for the external environment and motivates teams to always strive for improvement. Even if your performance is up substantially from the year before, you still must work to reach the top of your peer group. Relative measures make success more challenging because the target moves up or down depending on how well others are performing. However, they eliminate the crystal-ball tactics required by traditional budgeting.

One useful tool for performance comparisons is the league table, which provides rankings of various internal units from best to worst. By themselves, league tables can identify best practices and motivate divisional managers through peer pressure. When tied to incentive pay, they are even more effective. Although companies determine in advance the metrics by which an individual's performance will be evaluated, the scoring is viewed in hindsight, so compensation is based on what the business unit achieved relative to others operating in the same environment.

Handelsbanken uses league tables to rank branch managers on the key company metric, cost-to-income ratio. Each branch's performance is ranked against that of other branches in its region; branch results combine into a regional total, with which each bank is compared. The regions combine into the bank's overall results, which it compares with results of other leading banks in the Nordic region. This system has helped Handelsbanken consistently rank as the top-performing bank in Scandinavia.

Nordic building products distributor Ahlsell uses similar divisional league tables, which group performance into two classes. Ahlsell's key metric is return on sales. Branches at or below the hurdle rate are grouped into what the company calls its "qualifiers' league." These business units must focus on improving returns. Branches above the hurdle are considered to be in the "premier league;" they focus on both the return percentage and growth.

The way Handelsbanken and Ahlsell judge divisional performance demonstrates how an organization can use one critical metric to provide employees at all levels with guidance on what is considered winning performance. Companies can clearly shape managers' incentives -- and performance -- without resorting to the traditional budgeting process. And executives can be comfortable delegating a tremendous amount of responsibility to field operations if they are confident that local managers understand and have incentive to achieve what is expected of them in terms of performance.