Setting Financial Performance Thresholds, Targets, and Maximums in Bonus Plans

ABSTRACT This study uses both archival and field evidence from one multidivisional firm to examine how the three commonly used financial performance standards used to calibrate short-term bonus payouts—thresholds, targets, and maximums—are set. The setting of the standards results from complex negotiating processes. Consistent with prior research, we find that performance targets—the middle parameter—are set to be exceeded by most organizational entities. Contrary to some existing normative theory, actual performance is often outside the incentive zone, which is defined by the range between the maximum and threshold. The reasons for this include desires to raise managers' aspiration levels, concerns about bonus payment affordability, and trade-offs in gaining manager commitment to the standards. Often the target is not in the middle of the incentive zone. We identify three additional factors that provide partial explanations of where and why these standards are set where they are: employee risk mitigation, desire for cross-entity equity, and manager operating style. Data Availability: Confidentiality agreements prevent the authors from distributing the data.