Ratee Influence in Targe-Setting and Target Achievability: An Empirical Analysis of Objective Performance Measures

Empirical research in performance-based compensation has been silent on the performance target, which generates important incentives whenever the subordinates can influence the target-setting process. Moreover, research overlooks the effect of simultaneous use of different types of participative target- setting methods on the subordinates’ strategic response. In the ratcheting literature, target performance is generally treated as a threshold performance level that triggers bonus compensation. This target performance provides the subordinates with a constructive incentive to exert at least the threshold level of effort. On the other hand, because better performance can result in a less attainable future target performance via target ratcheting, the subordinates can also have a destructive incentive not to give the best level of effort for maximal performance. Most prior studies have not illuminate various destructive incentives of the subordinates in the target-setting process while assuming that the superior can discern the proper target performance easily and quickly. Practically, the superior has difficulty in identifying proper performance because output performance is affected not only by input resources (e.g. subordinates efforts) but also by market conditions and production functions that are complicated and/or obscure to the superior. In order to promote the accuracy of target performance, the superior try to engage the subordinates in the target-setting process. The superior is likely to seek for communication with the subordinates in circumstances that adversely affect the accuracy of discerning the proper target performance. Participative target- setting, however, may not work as expected. The subordinates can also have another destructive incentive to derive more achievable target performance by exerting their influence through the target-setting process. This study investigates how the subordinates exert influence on targets through negotiations with the superior by focusing on the ratchet parameters. This study is built on the findings documented in Choi and Hwang (2012), which suggest that when the subordinates succeed (fail) in meeting target performance, the probability of achieving target performance in the following period decreases (increases) with how sensitively target performance ratchets in response to actual performance in the current period. I find that the slope of the ratchet principle is smaller (larger) when the subordinates beat (miss) targets as they exert greater influence in the target-setting process. This implies that the more difficult-to-achieve target performance are set when the subordinates have less influence on the target-setting process. I also find that the serial correlation of target achievability, documented in Indjejikian and Nanda (2002), is reinforced as the subordinates have more influence. My findings mention that, from a perspective of the level of targets, the participative target-setting may produce an adverse effect as the subordinates exercise more influence. As opposed to tight and challenging targets recommended by prior studies, targets set by an active interaction between the superior and the subordinates tend to be loose and achievable. The subordinates’ strategic response to the ratcheting slope may be concrete evidence on the creation of slack documented in prior studies. However, I do not argue that the superior should stop involving the subordinates in the target-setting process. There are several purposes using the participative target-setting. Especially, it is important that participation can provide the subordinates with higher satisfaction and motivate them for better performance. Since the subordinates’ true capabilities are unobservable, it is inevitable for the superior to depend on the subordinates’ cooperation in target-setting. My findings suggest that, in order to successfully design or implement performance-evaluation system in terms of motivational purpose, the superior should understand how the subordinates try to decrease target-level through the target-setting process. In addition, the accounting profession is to develop sound performance-evaluation system that provides the superior with means to induce positive net benefit from the trade-off between motivational effect of performance-improvement and adverse effect of target-decrease, accompanied by the active participation of the subordinates.