The consequences of improper managerial incentives in the Former Soviet Union

by Michael Estok, May, 1999

 

Capitalism and markets have never held much ground in Russia. After a short introduction in the early twentieth century, the Communist party conquered and commanded Russia’s economy for over seventy years, injecting anti-capitalistic and anti-profit propaganda into the mainstream of the nation’s managers and civilians. Throughout the Communist regime, the planners’ philosophies conflicted with the managers of the state-owned, goods-producing industries due to an incentive system that was not aligned with the state’s interests, causing poor managerial performance and operational inefficiencies. Some of these damaging business practices have remained in Russia’s systems, making the recent transition to a market economy more difficult than expected.

The inherent conflict in any business organization involves the managers and the owners (or in the USSR, the state). A manager’s main focus is on building a healthy and long-living institution that will keep them employed. In contrast, owners want a quick return on their investment, whether they are shareholders clamoring for capital gains or government officials hoping for higher inflows to spend on programs. Thus, the balancing act between the managers and owners, between long-run stability and short-run profitability, is the internal driving engine of a corporation (1).

What then happens if the owners do not desire profit? One might propose a similarity between Soviet firms and non-profit corporations. However, this likeness does not hold, as the two institutions have different goals. Any Western business student would be quick to note that non-profit companies, despite their name, work toward earning enough income to balance operating expenses and to accumulate earnings to fund future growth. The managers of these companies work not to maximize, but to maintain these "profit" levels, as any organization must to have an effective and extensive life.

The Communist party does not encourage profit seeking. Managers had little reason to work toward "profit" anyhow, since their firm did not keep it. Whereas a capitalistic board of directors would stress profits to their managers, the Soviet leaders stressed output to theirs. However, since it was in the ultimate interest of the Soviet party to produce goods at a certain degree of profitability (every organization requires profitability to operate), the wrong objectives were being communicated. This led to structural business problems, and as a modern managerial accounting textbook notes, "[a] lack of goal congruence ordinarily can be seen in the form of dysfunctional behavior on the part of…managers, i.e., behavior that is not in the best interests of the organization as a whole" (2). Since managers were only encouraged to work on maximizing output, the interests and goals of the managers and owners were not aligned, causing undesirable side effects.

Generally, to align the interests of the two parties of an organization, the owners offer incentives to lead the management to act in a certain fashion. These incentives ensure that a manager, in order to enrich him or herself, will make decisions that are good for the organization overall (3). Today, a popular incentive technique gives a manager partial ownership through shares of the company or stock options that will increase in value based on the value of the company. Thus, the managers will gain by acting according to the owners’ interests (increased profits), in addition to performing the normal managerial tasks of extending the life of the company to sustain employment (4).

At first the Soviets considered such incentives to be contradictory to socialist ideology. Incentives, some argued, should be based not on personal gain, but on enthusiasm for executing an important task and on enthusiasm for the communist objective. For example, incentive for Western non-profit managers beyond breaking even often comes from pride and feelings of self-worth, not from monetary rewards. However, non-profits perform services that are for important causes and are beneficial to the community, whereas Soviet firms produce goods, such as steel and textiles. Such activities do not have enough moral value to motivate a manager to improve performance, and the argument for communist advancement did not convince enough people. Indeed, economist Joseph S. Berliner notes, "we are…reminded that while enthusiasm is well and good, communism, as Lenin used to say, must be built ‘not directly on enthusiasm but with the aid of enthusiasm born out of the great revolution; [communism must be built] on private interest, on personal incentive, on businesslike accounting" (5).

Thus, by the 30s, managers in Soviet firms were receiving monetary bonuses as an incentive to boost performance. Some firms gave bonuses based on such measures as fuel conservation, labor productivity, spoilage reduction, and even profit. However, "[if] the special bonuses are small, they will not be very effective" (6). Thus the vast majority of bonuses, or so-called premia, were based on the successful fulfillment of the Soviet output plan. This system allowed managers each month to earn bonuses of 30 to 100 per cent of his or her base salary for properly fulfilling the factory’s given plan. In addition, the manager can earn an additional bonus of 2 to 10 per cent of base salary for each percentage of plan "overfulfillment" (7). This system clearly offers drastic incentive to produce according to the plan, but the targets were set challengingly high, and they would be raised even higher after successful fulfillment. Thus, despite each manager’s efforts, about a third of managers did not achieve their target plans in the mid-50s (8).

Though the premia gave managers incentive to work hard, there was a lack goal congruence between the managers and the state. Although the state wanted their production plans accomplished, the over-emphasis on the quantity produced caused managers to take questionable measures to achieve targets. These actions, although they helped achieve targeted plans, were generally poor business practice and proved to be destructive for the economy as a whole. Some of the results of the premia include:

Ochkovtiratel’stvo, literally "rubbing-in someone’s eyeglasses" or paraphrased, "pulling the wool over someone’s eyes" (9). These were deceptive tricks to have output appear to be at the target level, when in reality it was below. Changing product mix was one way of simulating budget accomplishment. For example, in a metals factory, the manager would be required to produce so many tons in a month. However, if in the last days the target appeared unattainable, the manager would switch production to only the heaviest metals, even though the state wanted production of all metals (10).

Since the difference in salary for a manger between producing 99 and 100 percent of the plan was so dramatic, managers also stretched accounting rules to meet the target. The USSR did not comply with International Accounting Standards; rather, they had a complex and somewhat anarchical system. Each firm’s Chief Economist had great degrees of flexibility in preparing statements, which allowed exaggerating output. An important Generally Accepted Accounting Principle is the matching principal in which related expenses and revenues must be recorded in the same, appropriate time period (11). Using accounting tricks, Soviet managers would "borrow" nonexistent output from the next month to meet present targets (12). Without strict rules, the accounting system in general was used more for smoke screens than for measurement and control, and as an expert in Russian accounting reported, "Nobody in a plant ever believes anything that is published by the economics [Accounting] dept. but they recognize the game, the necessity of the activity, and the skills involved with some respect" (13).

Managers further abused the system by purposely underreporting their firms’ capacity, in hopes for a lower production target. Since, in general, their main goal was earning premia, they were lying about their resources, leading to more false information and poor communication (14). Also, managers were inefficient in managing their firms, often making up to 70-90 per cent of their monthly production the last ten days. The extremity of the reward pushed them to work above capacity like this. Though they might have received the bonus, the industry suffered due to increased spoilage in storming periods, idleness in the early month, excessive overtime wages, and customer dissatisfaction with delivery schedules (15).

An obvious and often-practiced method of extending production was to reduce the quality of the goods. By making available resources stretch further, budget plans could be met, but only at an enormous cost to the society later on (16).

Strakhovka, or a "safety factor," arose during operating. Due to the urgent need of full production, managers wanted to ensure that their materials supply was sufficient. Since the government occasionally gave managers insufficient supplies and it was illegal to trade with other factories to obtain these, each manager would ask for extras to "hoard" inventory. The same phenomenon occurred with equipment and capital ordering, and managers snatched up as much as they could, even if they did not need it, as the state supplied the firms free of charge with no interest payments due. A manager working toward profit knows that "every surplus machine slows down the turnover of his capital and reduces his profit," but this is not a problem to the Soviet manager, although his nation is weakened as a result (17).

Expressly to obtain the aforementioned "safety factors" from the government, a practice called Blat became "an essential thread in the fabric of Soviet society" (18). Blat is the endless network of personal acquaintances and connections that managers use to hoard capital. Berliner notes, "Blat may be used to obtain everything from a new apartment to a carload of coal" (19). To increase blat, managers hired a full-time employee called tolkach, or supply expediter, to schmooze with government officials and secure reception of more capital. This undue influence caused a misallocation of resources because popular and respected firms got more supplies than needed, while introverted firms did not get enough to meet their target plans. In addition, the many tolkach around the nation caused yet another superfluous and crippling expense for the nation (though hidden in the books).

Finally, monthly production targets set the stage for a dangerously short-run perspective on business. Plus, the central planners moved managers around to different firms every few years to prevent employee ties and camaraderie. Consequently, the managers had little or no incentive to consider long-run management, and investment was not rationally evaluated and technology advancement was neglected. Working on the creation of new technology required risks, expenditures, and time, and even if better technology was introduced, the manager would be worse off, because target plans would have been raised, lowering the manager’s chances of receiving premia (20).

All of these abnormal business practices were in conflict of the interests of the state and played a role in the crumbling of the communist economy. It is important to note that these practices are not merely inherent to the communist system and absent everywhere else. For example, we see a cousin form of blat in the United States with many corporations hiring bureaucratic lobbyists to persuade government officials into helping the company, through many different means. However, the problems discussed above in the communist system were unavoidable with the premia output-plan incentive system, as managers, in general, will take whatever means necessary to enrich themselves.

Russia has since abolished communism and instituted a market system. Many of the questionable business practices discussed above still flourish now, some to an even greater extent, and Russia is in a terrible recession. Why have these destructive actions not disappeared or receded since the introduction of a market economy? Two possible answers follow.

It takes a long time to lose bad habits. Many of the managers today were managers for their entire lives in the communist era, and they must learn the necessary skills to operate in a market economy. Accounting has just recently undergone the process of standardization, which is critical for management control and investor information. Also, technology needs to catch up with the rest of the world, as the short-run attitude of Soviet managers inhibited its growth. Firms are just beginning to use the Internet and e-mail, and accounting is finally being done on software programs (instead of paper) to perform better analyses (21). These activities have been long performed in the successful market economies.

Russia still has not instituted a clear market system. Managers are still focusing strictly on output, and are unable to make educated decisions without the rules of the game. A Russian consultant stated that they are "forced (by regulations, taxation, and ignorance) to play baseball with soccer rules" (22).

To strengthen the economy, the new managers and owners of the private companies need to create the same internal engine present in successful Western companies by aligning their respective goals with the overall goals and needs of the company. In addition, Russia needs to complete the infrastructure (through laws, technology, and institutions) to successfully make the transition. And they have a lot of catching up to do.

Footnotes:

(1) Beatty, 837    (2) Young, 111   (3)Young, 171   (4)Berliner, 69
(5) Ibid  (6) Berliner, 81  (7) Berliner, 50  (8) Berliner, 51
(9) Berliner, 32  (10) Berliner, 72  (11) Horngren, 594  (12) Berliner, 54
(13) Web page: Prices...  (14) Berliner, 27  (15) Berliner 48-49
(16) Berliner, 33  (17) Berliner 31, 79  (18) Berliner, 36  (19) Berliner, 94
(20) Berliner, 79  (21) Web page: Prices...  (22) Ibid

Bibliography:

  • Beatty, Jeffrey F. and Samuelson, Susan S., "Business Law For A New Century." Little, Brown and Company: Boston, 1996.

  • Young, David W., "Primer on Management Accounting." The Crimson Group, Inc.: Cambridge, MA, 1998.

  • Berliner, Joseph S., "Soviet Industry from Stalin to Gorbachev: Essays on Management and Innovation." Cornell University Press: Ithaca, New York, 1988. pp. 1-97.

  • Horngren, Sundem, and Elliott, "Introduction to Financial Accounting." Prentice Hall: Upper Saddle River, NJ, 1999.

  • http://www.geocities.com/WallStreet/1280/price_accounting.htm. Prices vs. Accounting Practices in Former Soviet Union, May 1, 1999.

  • Owen, Thomas C., "Russian Corporate Capitalism from Peter the Great to Perestroika." Oxford University Press: New York, 1995. pp. 3-15.

 

 

 

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