How New Evidence Can Help Us Understand Effective Performance Targets and Incentives

"Organisational control is about getting employees and managers to be aligned towards the achievement of organisational objectives"

For any firm to achieve its objectives, the performance of its employees is crucial. Across a series of research projects, Wim Van der Stede demonstrates that our understanding about designing effective performance management systems, including targets and employee rewards, is ever subject to new insights from research in interesting contexts.

There are several questions for a firm to answer when it designs a performance management system: How does it measure employee performance? What information does a company use to set targets? And what incentives are effective in motivating employees to reach these targets?

“Organisational control is about getting employees and managers to be aligned towards the achievement of organisational objectives,” explains Professor Van der Stede.

“Accounting comes into this picture because one way in which we can do this is by means of ‘financial results controls’, meaning that we set expectations through targets in financial terms – such as profits for a division, sales for a retail outlet, or costs for a production plant – which we expect employees to achieve. We also typically attach incentives to that.”

We can keep improving our understanding of what works under which circumstances in the several steps of this process by examining interesting settings, but access to firms’ internal data can be limited. Across two separate pieces of research, Van der Stede and colleagues show how novel evidence can modify some of the stylised assumptions in the areas of target setting, performance measurement, evaluation, and incentives, and provide more nuanced insights for practitioners.

Setting targets: ratcheting revisited

When firms set targets for managers, it is often said they create an unintended incentive for them not to over-achieve, because it will only lead to higher targets the following year, in a process known as “target ratcheting”.

As Van der Stede explains: “There is this general perception that you better not overshoot your targets because the next thing you know, through ratcheting, your next year’s targets will be higher, because this year was ‘easy’, so that becomes the new expectation – plus some more.”

Earlier research had shown that this can take place, but given that firms will not want to penalise their most well-regarded managers over the long term, Van der Stede and colleagues (Indjejikian, Matějka, Merchant, Van der  Stede; 2014) set out to examine how firms design their targets “dynamically over time” in practice.

They surveyed senior industry executives from 666 firms about their performance targets, past sales, earnings and bonuses, expected bonuses, and how difficult they thought their targets are, by asking them to report the likelihood of meeting next year’s goals.

The researchers found significant differences in how target setting operated in firms, depending on previous performance. In high-profitability entities, targets are less likely to be increased for managers of these entities if they reach them one year, so they are more likely to achieve them in subsequent years – they are not ratcheted up.

However, a ratcheting effect does still apply to less well-performing managers, so that if managers achieve their targets, a higher bar is set for them the following year. They also find that firms tend not to set “negative performance” targets, so for loss-making firms, the targets cluster at zero, even if these will be hard to achieve.

Van der Stede explains: “If you are generally a well-performing manager who generally achieves targets, then you are less subject to this ratcheting effect, and you should fear it less. In a sense, you know the boss knows that you’re a good manager, that your targets are not easy, but they are achievable and – guess what? – if you do achieve them, they are happy to reward you for it, and won’t penalise you by making them ever-more challenging.… But if you are a poorly performing manager then achieving your target is when you are ‘only’ delivering what everyone wanted you to deliver.”

The relationship between targets met and targets set is not automatic, as sometimes assumed, and good managers can be confident they will not lose out on bonuses. This suggests they can be presumed to have an incentive to stay and to perform well over the longer term.

Whereas this research looked at the target-setting aspect of a financial results control system, there is also the incentives aspect – that is, how do organisations reward performance achievement by way of bonuses?

Designing performance incentives: penalties versus bonuses

When it comes to financial incentives, a common assumption is that bonuses work better than penalties, and, in fact, penalties are rarely observed in practice in organisations. “The general belief is that employees should not be ‘made to pay’ for poor performance. A ‘penalty’ is often perceived to exist already when ‘not earning’ a bonus, if bonuses are expected, so you don’t have to ‘take money’ from employees for them to feel penalised,” Van der Stede notes. “Think of it as ‘implicit’ penalties.” However, evidence about whether and when penalties are used is limited.

In research from 2020, Van der Stede, together with Anne Wu and Steve Yu-Ching Wu, looked into this by using data from 543 production line workers in an electronic chip manufacturing plant in China, and their monthly earnings over a period of around two years. Unusually, total renumeration included both bonuses for good performance (number of tasks completed above a set target) and penalties for slow speeds and poor-quality work.

They found that the effect of a penalty in one month is initially more significant for the employees’ performance the next month. While both bonuses and penalties led to an increase in productivity, for each RMB1 of penalty a worker received, they increased their work rate by over half again as much as for the same amount of bonus.

There is, however, a diminishing sensitivity for both penalties and bonuses as the amounts increase, but this occurs faster for penalties, creating a tipping point when bonuses become more effective. Specifically, when a bonus reaches about 12 per cent of a worker’s base salary, they have a greater effect on performance than penalties of the same amount.

Thus, even though penalties can be an effective means to improve subsequent performance within a certain range, there are nonetheless several reasons why employers should be wary of imposing penalties. As Van der Stede and his co-authors found in this study, penalties also had an effect on employee turnover, with high-skilled workers especially more likely to leave after having received a penalty. Clearly, whereas penalties may be an effective stimulus for immediate productivity improvements up to a point, employees don’t like them. And the workers a firm least wants to lose may respond to them most adversely.

This research indicates that, at least in a certain set of circumstances and up to a certain point, penalties can operate as an incentive, more than just “bonuses withheld”. However, the effect of a penalty has longer-term consequences for motivation, employee retention, and the quality of the workforce. There is room for further research to hone our understanding of what works best, where, and when. 

Conclusions: beware unintended consequences

These two pieces of research together have significant implications for thinking about the assumptions firms make when they devise financial control systems. Though the two studies involve different settings and types of employees – senior managers and manufacturing workers – they both indicate there are important trade-offs involved in designing effective financial control mechanisms.

Poor calibration of these trade-offs produces unintended consequences, ranging from demotivating your best performing managers (such as by continually ratcheting their targets) to losing your most highly valued employees when they face unexpected penalties. But firms also do not want to leave achievable performance “unearned” through slack targets, nor low efficiency and poor-quality work to persist. How then to “optimally” motivate employees and managers remains a tall order, but one that no organisation can afford to ignore. 

Professor Wim Van der Stede - LSE Profile


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This research profile is based on the following publications: 

Indjejikian, R.J., Matějka, M., Merchant, K.A., and Van der Stede, W.A. (2014), “Earnings Targets and Annual Bonus Incentives”, The Accounting Review, July; 89 (4): 1227–1258

Van der Stede, W.A., Wu, A., and Wu, S. (2020), “An Empirical Analysis of Employee Responses to Bonuses and Penalties”, The Accounting Review, November; 95 (6): 395–412.