Subjective bonuses and target setting in budget-based incentive contracts

Abstract

"Subjective bonuses can reflect implicit contracts entered at the beginning of the period when certain employees commit to more difficult targets and managers use subjective bonuses at the end of the period to reward this commitment. We examine this prediction in a budget-based incentive systems’ setting. We argue that the presence of these implicit contracts allows managers to adapt targets to the individual characteristics of employees and their units with the purpose of enhancing the motivational structure of budget-based contracts. Using data from 414 branches of a large travel retailer during a four-year period, we find that managers use their discretion to set targets at different levels of difficulty across branches and subjective bonuses are sensitive to the difficulty of these targets. Branches with more difficult targets relative to their peers receive larger subjective bonuses. We also test the motivational effect of larger subjective bonuses and find that they have a positive effect on future performance. In particular, larger target increases (relative to peers) from current to the next period result in larger performance increase (relative to peers) when the branch is rewarded with higher subjective bonuses in the current period. The evidence indicates that subjective bonuses can fulfill roles beyond addressing performance measurement systems’ limitations. Managers use them to reward employees’ commitment to target difficulty and to motivate future performance."