Setting Financial Performance Thresholds, Targets and Maximums in Bonus Plans

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 placement of the thresholds and maximums vary significantly across the organizational entities. We identify five factors that provide partial explanations of where and why these standards are set where they are: desire for cross-equity equity, need for performance, planning uncertainty, trade-offs in gaining manager commitment to the standards, and manager operating style.