Balancing difficulty of performance targets: theory and evidence

We examine how firms balance difficulty of performance targets in their annual bonus plans. We present an analytical model showing that managerial allocation of effort is a function of not only relative incentive weights but also the difficulty of performance targets. We find that relative incentive weights and target difficulty can either be complements or substitutes in motivating effort depending on the extent to which managers have alternative employment opportunities. To test the predictions of our model, we use survey data on performance targets in annual bonus plans. Our sample of 877 survey respondents consists primarily of financial executives in small- and medium-size private companies where annual bonuses are important both for motivation and retention. Consistent with our model, we find that relative incentive weights are negatively (positively) associated with perceived target difficulty when concerns about managerial retention are high (low). It follows that performance measures included in annual bonus plans have sometimes easy and other times challenging targets depending on their relative incentive weights and retention concerns.