Target ratcheting and effort reduction

Jan Bouwens
a,n
, Peter Kroos
1,b
a
Tilburg University, Department of Accountancy, P.O. Box 90153, 5000 LE Tilburg, The Netherlands
b
VU University Amsterdam, Department of Accounting, De Boelelaan 1105, 1081HV Amsterdam, The Netherlands
a r t i c l e i n f o
Article history:
Received 7 March 2008
Received in revised form
25 May 2010
Accepted 2 July 2010
Available online 13 July 2010
JEL classication:
J33
M40
Keywords:
Target setting
Ratchet effect
Manipulating real economic activities
a b s t r a c t
In this paper, we examine how retail store managers reduce their sales activity in
response to target ratcheting. We nd that managers with favorable sales performance
in the rst three quarters reduce their sales activity in the nal quarter. We also
document that managers who engage in sales reducing activities enhance their
likelihood of meeting their next-year sales target, which is based on their current sales.
That is, managers who reduce their sales activity in the nal quarter are more likely to
beat their next-year sales targets than managers who refrain from reducing their nal-
quarter sales.
& 2010 Elsevier B.V. All rights reserved.
1. Introduction
We examine how target ratcheting impacts the sales activity of a particular rms retail store managers over four
accounting years. To set sales targets for the next scal year, our sample rm uses the current years sales information; that
is, the rm ratchets their targets (Weitzman, 1980). We argue that target ratcheting incentivizes store managers to reduce
the sales they make in the nal quarter of the year in order to make their next-year sales target more achievable. Because
our sample rm is unable to determine when store managers reduce their sales activity, managers who engaged in sales
reduction were more likely to achieve their next-year sales targets than were managers who did not reduce their sales
activity.
Our sample rm is uncertain about the sales potential of each of its retail stores. Firm management believes that
current sales provide an indication of a stores sales potential. Accordingly, to set each stores next-period sales
target the rm uses their current sales. Weitzman (1980), however, argues that target ratcheting induces managers
to make a trade-off between the current rewards derived from favorable performance and the future losses derived
from the assignment of more ambitious sales targets. Indeed, Milgrom and Roberts (1992, p. 233) argue that
target ratcheting can be unproductive in that managers may refuse to cooperate with efforts to improve productivity.
As such, we empirically examine whether the store managers, following favorable year-to-date sales performance, are
inclined to reduce their end-of-year sales performance in an attempt to mitigate the increase in their next-year sales
target.
Contents lists available at ScienceDirect
journal homepage: www.elsevier.com/locate/jae
Journal of Accounting and Economics
0165-4101/$ - see front matter & 2010 Elsevier B.V. All rights reserved.
doi:10.1016/j.jacceco.2010.07.002
n
Corresponding author. Tel.: +31 13 4668288; fax: +31 13 4668001.
E-mail address: j.bouwens@uvt.nl (J. Bouwens).
1
Tel.: +31 20 5988405; fax: +31 20 5989870.
Journal of Accounting and Economics 51 (2011) 171185
The unique characteristics of our data enable us to clarify four relatively unexplored issues regarding the potential
adverse consequences of target ratcheting wherein well-performing managers reduce their current performance to
mitigate the increase in their next-period target.
First, we document that target ratcheting impacts a store managers real economic activities. Leone and Rock (2002)
demonstrate that managers use accruals to manipulate their reported earnings downward. Murphy (2000) demonstrates
that in rms that use ratcheted targets, managers with favorable year-to-date performance tend to manipulate their
net income downward later in the accounting year. Murphy does not nd that managers similarly manipulate their
sales performance, a discrepancy Murphy explains by the greater discretion managers have over accruals relative to
cash ows (p. 262). We, on the other hand, study target ratcheting in a setting wherein reducing performance
via accounting manipulation is virtually impossible. We therefore attribute any reduction in a managers performance
to the real economic decision making of store managers. Prior literature suggests that managers can reduce their
real performance by allowing for price discounts (Roychowdhury, 2006) or reducing their investment levels (Eldenburg
et al., 2007). The store managers in our setting, however, do not have the decision rights to offer price discounts or
reduce investment levels. Store managers can essentially reduce their stores sales levels by no other means
than expending less effort in servicing their customers. Accordingly, we demonstrate how managers with favorable
year-to-date performance reduce their sales efforts in an attempt to mitigate the increase in their next-year sales
target.
Second, we examine the extent to which job rotation can offset the adverse consequences of target ratcheting. The
detailed HR information we collect from our sample rms archives enables us to distinguish between managers who
continue to manage the same store and managers who leave the store. Brickley et al. (2004) propose job rotation as one
means of mitigating the adverse consequences of target ratcheting. Unlike well-performing store managers who continue
to manage the same store and thus may benet from manipulating their performance, managers who leave their store will
not face the ratcheted sales target the following year. In our setting, however, we nd no evidence to suggest that job
rotation can be used to mitigate the costs of target ratcheting.
Third, our sample rms detailed nancial information enables us to determine which managers might be inclined to
engage in such performance reduction. Prior research has identied, ex-post, at the rm level (e.g., Roychowdhury, 2006;
Eldenburg et al., 2007) and at the divisional level (Leone and Rock, 2002) the conditions under which rm or business-
unit managers may have beneted from manipulating their performance. By collecting monthly sales-target and
target-achievement data at the store level, we are able to establish, ex-ante, whether managers have incentives to
manipulate their performance, and, ex-post, whether these managers have actually engaged in performance manipulation.
Thus, our setting enables us to identify the degree of each managers interest in engaging in performance-reducing
activities.
Fourth, we examine the extent to which a managers reduced performance actually increases their likelihood of
achieving their next-period sales target. Our study has the potential to clarify how managers are able to meet their target
over consecutive accounting years (Indjejikian and Nanda, 2002). Indjejikian and Nanda propose that, since targets should
reect all available information, the likelihood of achieving the next-period target should be independent of whether the
current target is achieved. They, however, nd that target achievements are positively associated over time. We likewise
nd that target achievement persists over time, but only for a specic group of managers, that is, the store managers who
engage in sales reduction. This stands to reason as these managers benet from their performance reductions by enhancing
their likelihood of achieving their next-period target compared with their non-manipulating colleagues.
The remainder of our paper is structured as follows: Section 2 reviews the literature on target ratcheting and presents
our hypotheses; Section 3 describes our research setting and data collection; Section 4 presents our results; and Section 5
discusses our ndings and concludes.
2. Theory
The target against which a managers performance is evaluated can be established based on technical studies, the
performance of the managers peers, and/or the managers actual prior performance (Milgrom and Roberts, 1992; Murphy,
2000). Firms often use prior performance to establish future targets (Murphy, 2000; Leone and Rock, 2002; Leone et al.,
2006). In our sample rm, senior management assumes that, on average, each store performs 20% below its sales capacity.
The rms CFO stated this assumption as follows:
On average all stores are working at 80% of capacity. Therefore it is difcult for me to accept any sales drop.
In addition, the rms senior management believes that with the introduction of new products, each stores sales
capacity increases each year. It therefore follows that the slack will likewise increase if store managers fail to take
advantage of the new products and increase their sales. Senior management explicitly stated that a retail stores sales
performance plays an important role in target setting. That is, the rm uses each stores annual deviation from its current
sales target to set next years sales target. Weitzman (1980) coined the term ratchet principle to refer to the tendency
for performance standards to increase after a period of good performance.
J. Bouwens, P. Kroos / Journal of Accounting and Economics 51 (2011) 171185 172
2.1. The ratchet effect
A given stores sales target deviation provides the rm with a signal of a retail stores economic capacity, and therefore
this deviation can be used to establish the stores next-period target. According to Weitzman (1980), using ratcheted
targets introduces the dynamic incentive problem wherein agents make a trade-off between the current rewards derived
from favorable performance and the future losses derived from the assignment of higher targets. If an agent becomes
convinced that manipulating future targetsfor example, by reducing their current performancewill increase the total
wealth they stand to gain from current and (expected) future performance, they will do so. Holthausen et al. (1995) and
Murphy (2000) dub this mechanism the perverse incentive effect of target ratcheting.
Whether or not agents decide to reduce their performance will depend on whether they believe they can maintain their
current performance level in the face of increasing targets over subsequent periods. Leone and Rock (2002) distinguish in
that respect between permanent innovations and transitory innovations. Permanent innovations refer to measures
managers take that have a permanent effect on performance levels, for example, making the production process more
efcient. Such performance increases can be sustained without further increases in effort in subsequent periods. Transitory
innovations, on the other hand, refer to positive performance effects that can only be sustained by agents continuing to
increase their effort in subsequent periods. To the extent that agents are uncertain of whether they can sustain high levels
of performance in the future, they have strong incentives to reduce their current performance levels.
Agents can reduce their current performance by manipulating either their accounting (e.g., discretionary accruals) or
their real economic activities (e.g., pricing, allocation of effort). Murphy (2000) and Leone and Rock (2002) document
evidence of managers engaging in accounting manipulation to lower their performance. Agents who are unable to engage
in accounting manipulation must resort to manipulating their real economic performance. The earnings management
literature provides evidence that managers, for example, offer price discounts (Oyer, 1998; Roychowdhury, 2006) or reduce
investment levels (Eldenburg et al., 2007) to manage their performance. An agents ability to reduce performance becomes
rather limited when he has no inuence over accounting decisions, pricing policies, or investment levels. To reduce their
current performance, such agents have few options other than simply expending less effort. Indeed, agents with limited
decision rights may have even stronger incentives to prevent principals from ratcheting their targets following
performance improvements, since to meet or beat the next-period targets, they will have to expend greater amounts of
effort in subsequent periods.
While the above arguments suggest that agents will attempt to reduce their current performance to mitigate the next-
period target increase, just when they do so remains unclear. Murphy (2000) nds that income smoothing occurs at the
end of, rather than early in, the accounting year. This makes sense given that agents become increasingly certain of their
performance as the year proceeds. We therefore predict that agents who intend to reduce their performance will primarily
attempt to do so at the end of the accounting year.
To summarize, agents facing transitory performance innovations will have strong incentives to reduce their
performance as a means of mitigating the next-period target increase. Given their limited decision rights, to achieve
this performance reduction, such agents must resort to real economic decision making, that is, they must decide to expend
less effort in servicing customers.
We therefore propose the following hypothesis:
Hypothesis 1. Agents with favorable year-to-date performance will reduce their end-of-year performance.
2.2. Consequences of effort reduction
As Indjejikian and Nanda (2002) argue, a rational rm benets if it uses past performance information in revising the
compensation arrangement. This argument assumes that the information reected in current performance is fully
incorporated into the next-period target such that the probability of an agent of achieving their future target is
independent of their current target achievement. Milgrom and Roberts (1992, p. 235), however, argue that agents can
successfully hide their true performance potential over successive accounting periods. That is, by expending less than their
optimal effort, agents can produce a lower level of performance that does not reect the focal units true economic
potential. The target based on this lower performance will, on average, be easier to achieve than would have been the case
had the agent expended optimal effort. Thus, if agents face dynamic incentive problems that encourage them to reduce
their current effort and if the agents supervisors are unable to observe when and by how much agents have reduced their
effort, we expect that agents who reduce their performance will have an advantage in terms of achieving future targets,
compared with agents who do not engage in performance reduction (Milgrom and Roberts, 1992). Indeed, Indjejikian and
Nanda (2002) document a serial correlation between consecutive target achievements.
In conclusion, in the absence of performance reduction, we would expect to nd no serial correlation between
consecutive target achievements (Indjejikian and Nanda, 2002). However, to the extent that agents are able to reduce their
performance without being detected by their supervisors, we expect to nd a serial correlation between consecutive target
achievements. Thus, we propose the following null hypothesis:
Hypothesis 2. Consecutive target achievements will be unrelated.
J. Bouwens, P. Kroos / Journal of Accounting and Economics 51 (2011) 171185 173
3. Research setting
3.1. The research site
Our research site comprises a business unit of a privately held retail rm (aka The Free Record Shop) based in the
Netherlands. The rm sells games, CDs, DVDs, and a range of goods and services associated with entertainment. The rms
strategy is two-fold: to maintain its market leadership within the Netherlands and to strengthen its position as a major
retailer in its industry in NorthWest Europe. In 2005, the rm comprised approximately 400 retail stores, employed 2500
people, and generated h400 million in revenue. The business unit we examine represents the rms main store formula
located in the Netherlands. The business unit comprises three geographical regions, each region consists of several clusters,
and each cluster contains between seven and nine stores. We conduct empirical analyses using data from nearly 200 retail
stores, which collectively make approximately 50% of the rms total sales. Most stores are located in primarily urban areas
in or near shopping centers, and each outlet sells essentially the same merchandise. The rms accounting year differs from
the calendar year, starting in October and ending the following September.
3.2. The decision rights of store managers
The top-level management team of the rm believes that they are best informed about how to improve the sales
performance of retail stores. Thus, decision rights with regard to pricing and advertising rests with the management team
only, and store managers are instead primarily responsible for the day-to-day operations within the stores. The
management team decides what products to offer now and what to offer in the future. New offerings arrive in stores
complete with instructions on how to sell them. The management team also decides what marketing efforts are
appropriate for increasing sales. Directives relating to How to approach the market are developed at the rm level and
are specically laid out with the expectation that store managers and employees will comply with them. These directives
include: providing timely and clear feedback to sales assistants; focusing on meeting customer needs and not engaging in
hard-selling; and improving cost awareness.
While such directives are established by the management team at the rm level, store managers do enjoy some
inuence over sales levels. For example, store managers can increase sales through deploying their sales force effectively,
by encouraging customers to buy product complements, and by increasing the number of products sold to each customer.
3.3. The target-setting process
Our sample rm sets the years formal targets in October, the start of its accounting year. About three months prior, the
rm determines an initial sales target based on its current sales gures and its nancial goals for the following year. This
initial sales target yields a preliminary sales target for each retail store. In October, at the beginning of the next accounting
year, the actual sales gures for the nal quarter are used to calculate fourth-quarter bonuses and to determine each retail
stores formal sales target for the new accounting year. As such, developments in each stores sales over the fourth quarter
lead to revisions of both the annual sales target at the rm level and the allocation of that sales target over the various
regions, clusters, and stores. This allocation of the rm-level target occurs in a top-down fashion. At this stage, each stores
budgeted labor hours are determined based on its formal sales target. The nancial targets are considered xed for the
whole accounting year. To monitor the performance of store managers, the rm divides its annual sales target into monthly
sales targets. When determining each monthly sales target, the rm adjusts for seasonal patterns, for example, the
Christmas season. Since bonuses are awarded on a quarterly basis, these monthly sales targets are combined to establish
quarterly sales targets.
2
3.4. The incentive system
The rms incentive system has two main components, namely, quarterly bonuses and salary increases. Store managers
earn a quarterly bonus if they exceed their sales target for that quarter. Bonus payments increase in proportion to the
2
Given that our rms retail stores face similar economic conditions, are proximate to one another, and sell similar product lines, we consider
seasonal patterns to be uniform across stores. To test whether seasonal patterns are uniform across stores, we regress, for each store, actual sales in the
current month on actual sales in the previous month while including year dummies and adjusting for clustered standard errors. Our results substantiate
senior managements intuition regarding the homogeneity of seasonal patterns across stores. The 12 regressions of current monthly sales on prior
monthly sales yield a mean (median) t-statistic of 64.51 (50.17) (untabulated). Senior management believes that this target-setting process produces
more or less equally accurate sales targets for all months. As such, we test whether the target accuracy systematically varies between months. We dene
target accuracy as the inverse of monthly absolute target deviations calculated as the absolute value of the difference between actual monthly sales and
the monthly sales target divided by the monthly sales target (i.e., 9Sales
i,t,m
Target
i,t,m
9/Target
i,t,m
, where t denotes the accounting year t, and m denotes
monthly periods in the respective accounting year t with m=(1, y, 12) for store i). Next, we perform one-sided paired t-tests for each of the 12 individual
months to determine whether the mean difference between the target accuracy for each individual month and the average target accuracy for the
remaining 11 months is signicantly less than 0. For the majority of the months, the results do not reveal signicantly lower target accuracy. Overall, we
conclude that the rms adjustments of targets based on seasonal patterns are fairly accurate.
J. Bouwens, P. Kroos / Journal of Accounting and Economics 51 (2011) 171185 174
degree that stores sales exceed the quarterly sales target and decrease in proportion to the degree that managers exceed
their budgeted labor hours for that quarter, with a lower bound of zero bonus.
3
Under this system, managers may receive
bonuses in no quarters or up to and including all four quarters of the accounting year. On average, 10% of a store managers
total pay comes from the bonus(es) they receive.
Managers are also eligible for salary increases. Supervisors of store managers base salary increases on annual subjective
performance assessments conducted at the end of the accounting year. The subjective assessment is based on the extent to
which the store manager met their annual sales target and complied with rm directives. The outcome of the subjective
evaluation determines not only whether a salary increase is awarded, but also the size of the increase. Specically, an
outstanding (good) {mediocre} subjective performance assessment is associated with, approximately, a 5% (3.5%) {2%}
increase in salary.
3.5. Impediments to affecting measured results
In our research setting, the rm provides managers with very limited decision rights, which makes it difcult for store
managers to manipulate their performance. First, the rm does not allow store managers to create discretionary accruals.
Store managers operate cash registers wherein sales are made and recorded instantly and are not involved in bookkeeping.
Second, store managers have no decision rights with respect to pricing, purchasing decisions, advertising, and the like, and
stock replenishment is entirely centralized. Therefore, the only viable way for store managers to reduce sales is to reduce
real sales activities. That said, the rm even has ways of curbing sales-reducing activities. Store managers could, for
instance, decelerate the number of clients served per unit of time or expend less effort in cross-selling. However,
supervisors regularly drop by their stores unannounced and closely monitor their managers. Moreover, sales are tracked
and compared with the respective sales target at the store level on a monthly basis. In combination, these measures make
it difcult for managers to manipulate their performance during the course of the year.
3.6. Data collection
We collected monthly sales data and quarterly labor-hour data over a period of 48 months (i.e., 16 quarters),
representing four accounting years from October 2000 through September 2004. We obtained our data on sales and labor
hours electronically from the corporate headquarters general ledgers. While each accounting year features almost 200
individual store observations, limitations posed by data requirements and availability forced us to conduct our analyses
with fewer annual observations. For instance, we omitted from our sample any incomplete observations, such as
observations wherein a given year had 10 monthly observations for actual sales. For each analysis we conduct, we provide
details on the number of observations used. In addition, we manually collected stafng data from HR records that
represented three accounting years from October 2001 through September 2004. Therein, we excluded any observations
where stores experienced store management turnover during the course of the accounting year. Documents regarding
general strategy, incentive compensation, and performance evaluation, as well as our meetings with senior management
and corporate staff, supplement our inquiry with qualitative data.
4
3.7. Descriptive statistics
Table 1 presents descriptive statistics on yearly data for our main variables. Actual sales and target sales amount to
approximately h845 K. While the mean sales-target deviation is about zero, the standard deviation of the sales-target
deviation is approximately h96 K, and 46% of store managers show an adverse deviation from the sales target. The mean
(median) adjustment in the sales target is h54 K (h52 K), and in only 17% of cases is the sales target adjusted downward.
This nding is consistent with our sample rms assumption that, on average, the retail stores sales contain some slack.
The mean (median) change in sales is h51 K (h45 K), and 16% of store managers exhibit decreases in sales. The vast majority
of store managers (i.e., 70%) stay within their budgeted labor hours, and the mean negative deviation from the labor-hour
target is 218 hours. Finally, about 28% of the store managers leave their store the following year.
Table 2 provides detailed data on the bonus payments. We nd that the number of quarters in which a store manager
meets or beats their sales target varies between managers and that the percentage of store managers receiving a bonus
decreases as the year proceeds. For example, in the rst, second, and third quarters, 58%, 50%, and 48% of store managers,
respectively, receive a bonus, while only 35% of store managers receive a bonus in the fourth quarter. We nd that 21% of
store managers receive a bonus in only one quarter, 17% receive a bonus in three quarters, and 77% of store managers
receive a bonus in at least one quarter of the year.
3
Bonuses are paid according to the following formula: if sales sales target40; h46n[(quarter salessales target)/sales target]+1%n(quarter sales
sales target). The bonus is discounted for labor-hour overruns: h22n(actual hoursbudgeted hours)/budgeted hours. The calculation of bonuses is not
permitted to deviate from this formula.
4
We were only able to inspect these documents at the research site.
J. Bouwens, P. Kroos / Journal of Accounting and Economics 51 (2011) 171185 175
4. Results
4.1. Evidence of target ratcheting
To identify each stores sales potential, the rm uses past sales performance and sets sales targets accordingly. Once a
store has achieved a store record, the rm re-establishes this record as the minimum level of sales that the store should
make (Murphy, 2000; Leone et al., 2006). Moreover, the rm sets sales targets asymmetrically: below-target performance
prompts management to decrease the next-year sales target to a lesser extent than above-target performance would
prompt management to increase the next-year sales target.
5
To empirically examine this asymmetry, we estimate the
following regression model
6
:
TARGET_UPDATE
i,t
b
0
b
1
DEV_TARGET
i,t
b
2
DEV_TARGET
i,t
*D_ADV
i,t
b
3
D_ADV
i,t
u
i,t
, 1
where TARGET_UPDATE
i,t
denotes the change in sales target for store i from year t to year t+1 (i.e., sales target
i,t +1
sales
target
i,t
), DEV_TARGET
i,t
denotes the sales performance for store i in period t compared with the sales target (i.e., actual
sales
i,t
sales target
i,t
), and D_ADV
i,t
is an indicator variable equal to 1 if actual salesotarget sales for store i in year t and is
0 otherwise. The impact of positive sales target deviations on subsequent sales targets is indicated by the coefcient b
1
.
Table 1
Descriptive statistics.
Sales target deviation denotes the actual sales minus target sales; % managers with negative sales target deviation denotes the fraction of store managers
with a sales target deviationo0; sales target adjustment denotes the sales target in period t+1 minus the sales target in period t; % managers with negative
sales target adjustment denotes the fraction of store managers with a sales target adjustmento0; sales change denotes the actual sales in period t minus
the actual sales in period t1; % managers with negative sales change denotes the fraction of store managers with a sales changeo0; labor hours target
deviation denotes the actual labor hours minus the target labor hours; % managers who exceed maximum labor hours denotes the fraction of store managers
with a labor hours target deviation40; bonus payout denotes the fraction of managers with bonuses40; bonus (% salary) denotes the mean bonus
expressed as a percentage of the annual salary (excl. bonus); salary increase (% salary) denotes the career-specic increase in salary; and % managerial
turnover denotes the percentage of store managers who leave the store in the following year. Our sample comprises 200 stores and spans 4 accounting
years.
Measure Mean Median Std. dev. Min. Max.
Target sales (h) 844,968 760,000 398,835 183,120 3,565,980
Actual sales (h) 844,939 763,731 394,689 226,890 3,000,000
Target labor hours 5,925 5,415 1,800 2,879 16,466
Actual labor hours 5,712 5,146 1,886 3,378 16,358
Sales target deviation (h) 29 5,127 96,956 707,769 565,980
% managers with negative sales target deviation 46
Sales target adjustment (h) 54,212 52,000 113,059 430,071 1,500,000
% managers with negative sales target adjustment 17
Sales change 51,296 45,132 114,079 713,241 1,601,860
% managers with negative sales change 16
Labor hours target deviation 218 223 676 2,611 5,560
% managers who exceed maximum labor hours (%) 30
Bonus payout (%) 78
Bonus (% salary) 10 7 12 0 138
Salary increase (% salary) 2 0 5
% managerial turnover 28
Table 2
Quarterly bonus-payout descriptives.
This table reports the bonuses paid to store managers over the respective quarters. The two columns on the left report the percentage of managers who
achieved their quarterly target and earned a bonus in the rst, second, third, and fourth quarters, respectively. The two columns on the right report the
percentage of managers who earned a bonus in one, two, three, or four quarters.
Quarter Percentage of managers earning a
bonus in respective quarter
Number of quarters in which a
bonus was earned
Percentage of managers earning a
bonus for the number of quarters
1st 58 1 21
2nd 50 2 20
3rd 48 3 17
4th 35 4 20
5
The rm sets store-level targets and does not disaggregate targets any further.
6
Given that rm policies in terms of pricing, advertising, and so on are common to all stores, growth is assumed to be relatively constant across
stores, that is, the intercept of the corresponding regression models account for general growth. Random variation in sales growth across stores is
reected in the respective error terms.
J. Bouwens, P. Kroos / Journal of Accounting and Economics 51 (2011) 171185 176
The impact of adverse sales target deviations on the subsequent sales target is indicated by the sum of coefcients b
1
and
b
2
. Therefore, our empirical tests for the asymmetry of target ratcheting essentially amount to testing for a statistically
signicant coefcient b
2
. We also repeat our analyses using a scaled model in which we divide both TARGET_UPDATE and
DEV_TARGET by the sales target in period t.
We estimate our regression equations with OLS and use actual-sales and sales-target data collected over four account-
ing years starting in October 2000. The t-statistics are based on clustered standard errors adjusted for heteroskedasticity
and autocorrelation (Petersen, 2009).
7
The use of two store-years for each observation yields a maximum of 600 store-year
observations. The estimation of the regression equation requires that stores be in operation for the entire accounting year.
Because some stores temporarily closed down (i.e., due to renovations), others closed permanently, and still others opened
for the rst time, our sample comprises 496 store-year observations.
Table 3, Panel A reports our results.
8
The coefcient b
1
, which denotes positive target deviations, is positive and
signicant (po0.01). Moreover, the coefcient b
2
, which denotes the asymmetry in target ratcheting, is negative and
signicant (po0.05). We also run an F-test to assess the signicance of the sum of the coefcients (i.e., b
1
+b
2
), which
denotes the relation between negative target deviations and the corresponding change in the next-period target. This
relationship is signicant at the po0.01 level. Our results conrm the presence of asymmetric target ratcheting. A positive
sales target deviation of 100 is associated with a next-year target increase of about 117, whereas a negative sales target
deviation of 100 is associated with a next-year target decrease of approximately 92. The F-value indicates that our models
are highly signicant (po0.01).
9
4.1.1. Variation in target ratcheting coefcients
Table 3, Panel B presents the results of our regression model for ve portfolios partitioned according to the magnitude
of their deviations from the sales target. The ve portfolios range from the smallest deviations (both positive and negative)
from the sales target to the largest deviations (both positive and negative) from the sales target. We observe variation in
the degree of ratcheting across the various sizes of sales target deviation. That is, while both high and low positive target
deviations result in upward adjustments of the next-year sales target, only large negative target deviations result in
downward adjustments of the next-year sales target. Given that the sum of the coefcients b
1
and b
2
denotes the
association between negative target deviations and changes in the next-year target, we nd that the coefcients are
positive and signicant only for those portfolios containing observations with a deviation460%, that is, the 6080%
portfolio (0.87; i.e., 1.750.88) and the 80100% portfolio (0.94; i.e., 1.150.21). Thus, low negative deviations from the
sales target do not result in downward adjustments of the next-year sales target. This nding is consistent with Leone et al.
(2006), who argue that while rms adjust targets upward following above-target performance that is the result of both
controllable factors (i.e., effort) and uncontrollable factors (i.e., exogenous shocks), rms only adjust targets downward
following below-target performance when that performance can be attributed to uncontrollable factors. In our sample, we
consider small negative target deviations to result from substandard managerial effort while large negative deviations
result from factors beyond the managers control. We nd that the b
2
coefcient, which represents asymmetry in target
ratcheting, is signicant in all analyses.
4.2. Test of Hypothesis 1: do store managers engage in sales reduction?
Hypothesis 1 predicts that well-performing managers reduce their end-of-year performance to make the next-year
target more achievable. To empirically test this hypothesis, we examine two equations. Eq. (2a) compares the end-of-year
sales of managers with favorable year-to-date performance to those of managers with unfavorable year-to-date
performance without taking into consideration the next-year employment of managers. Eq. (2b) takes into account
managerial turnover, given that managers who leave the store have no incentive to inuence the next-year target. For
managers who continue to manage the same store, Eq. (2b) allows us to compare the end-of-year sales of managers with
favorable year-to-date performance to those of managers with unfavorable year-to-date performance. In addition, for
managers with favorable year-to-date performance, Eq. (2b) allows us to compare the end-of-year sales of managers who
continue to manage the same store to those of managers who leave their store.
7
Standard errors of observations from the same retail store may not be completely independent, that is, the residuals may be correlated across years
(time-series dependence) for a given retail store. In all of our analyses, we use unbiased clustered standard errors because they account for residual
dependence created by the panel data structure (Petersen, 2009). Clustered standard errors also account for general forms of heteroskedasticity.
8
For both models, one inuential observation (Cooks D41) is excluded from the regression analyses.
9
It may be argued that given that managers differ in terms of their ability to achieve sales growth, the rm bases target updates on sales growth
rather than on target deviations. We test a model similar to Eq. (1): TARGET_UPDATE
i,t
=b
0
+b
1
DEV_SALES
i,t
+b
2
ADV
i,t
nDEV_SALES
i,t
+b
3
ADV
i,t
+u
i,t
, where
DEV_SALES
i,t
equals (Sales
i,t
Sales
i,t1
) and ADV
i,t
is an indicator variable equal to 1 if Sales
i,t
oSales
i,t1
in year t for store i and is 0 otherwise. The results
show that positive sales changes of 100 lead to upward adjustments of 94, while negative sales changes of 100 lead to downward adjustments of 117 (not
tabulated). Both positive and negative sales changes ultimately lead to sales targets that do not exceed prior sales. Consistent with interviews with rm
management establishing that deviations from the sales target are used as the basis for target setting, the explanatory power (R
2
) of this model is
considerably lower than that of the model specied in Eq. (1).
J. Bouwens, P. Kroos / Journal of Accounting and Economics 51 (2011) 171185 177
4.2.1. Effort reduction
We examine whether managers reduce their sales activity at the end of the year when they have achieved favorable
sales performance earlier in the year. We empirically test whether managers reduce their sales activity using the following
model:
X
12
m 10,11,12
SALES
i,t,m
TARGET
i,t,m
g
0
g
1
X
9,10,11
m 1
SALES
i,t,m
TARGET
i,t,m
g
2
X
9,10,11
m 1
SALES
i,t,m
TARGET
i,t,m
*DGYTD
i,t
g
3
DGYTD
i,t
u
i,t
, 2a
where
P
12
m 10,11,12
SALES
i,t,m
=TARGET
i,t,m
denotes the ratio of actual sales to target sales in the nal three, two, and one
month(s) of the accounting year t for store i,
P
9,10,11
m 1
SALES
i,t,m
=TARGET
i,t,m
denotes the ratio of actual sales to target sales
in the rst nine, ten, or eleven months of the accounting year t for store i, and DGYTD
i,t
is an indicator variable equal to 1 if
actual sales exceed the sales target over the rst nine, ten, or eleven months of the accounting year t, that is,
if
P
9,10,11
m 1
SALES
i,t,m

P
9,10,11
m 1
TARGET
i,t,m
40 for store i in year t and is 0 otherwise. We predict that managers with
Table 3
Asymmetric target ratcheting for full sample/subsamples.
This table reports the regression estimates from a pooled OLS regression of the following model:
TARGET_UPDATE
t
b
0
b
1
DEV_TARGET
t
b
2
DEV_TARGET
t
*D_ADV
t
b
3
D_ADV
t
u
t
1
First, we estimate this model over the full sample and then again over ve portfolios of equal size ranging, in terms of magnitude, from the smallest
(positive and negative) deviations from the sales target to the largest (positive and negative) deviations from the sales target, wherein each portfolio
comprises a similar fraction of positive and negative deviations from the sales target. For the unscaled model, TARGET_UPDATE
t
denotes the change in the
sales target in period t+1 relative to period t; DEV_TARGET
t
denotes the deviation from the sales target in period t; and D_ADV is an indicator variable
equal to 1 if the sales target deviationo0 in period t and is 0 otherwise. For the scaled model, both TARGET_UPDATE
t
and DEV_TARGET
t
are deated by the
sales target in period t. T-statistics based on clustered standard errors that account for heteroskedasticity and autocorrelation are reported in parentheses.
Panel A: Full sample regression model
Dependent variable TARGET_UPDATE
t
Model Unscaled Scaled
Intercept Prediction 228.14
nnn
(6.43)
4.09
nnn
(7.49)
DEV_TARGET
t
+ 1.17
nnn
(21.61)
1.16
nnn
(21.65)
DEV_TARGET
t
nD_ADV
t
0.25
nnn
(3.08)
0.24
nn
(1.90)
D_ADV
t
468
(0.12)
0.97
(1.22)
Year dummies Yes Yes
F-test (b
1
+b
2
=0) 406.80
nnn
65.02
nnn
Number of obs. 496 496
R
2
0.83 0.87
F-statistic 644.42
nnn
810.54
nnn
Panel B: Portfolio regression model
Dependent variable TARGET_UPDATE
t
Portfolios Portfolios partitioned on magnitude of deviation from sales target
120% 2140% 4160% 6180% 81100%
Prediction
Intercept 976
(0.10)
15,727
nn
(2.26)
502
(0.04)
4,632
(0.54)
28,994
n
(1.72)
DEV_TARGET
t
+ 3.49
nnn
(3.01)
2.70
nnn
(9.44)
1.61
nnn
(7.07)
1.75
nnn
(6.66)
1.15
nnn
(12.76)
DEV_TARGET
t
nD_ADV
t
3.47
nnn
(2.76)
3.05
nnn
(9.74)
1.84
nnn
(6.17)
0.88
nnn
(3.46)
0.21
nn
(1.87)
D_ADV
t
12,798
(1.31)
4,952
(0.60)
35,590
nn
(2.26)
21,430
(1.50)
5,902
(0.38)
Year dummies Yes Yes Yes Yes Yes
F-test (b
1
+b
2
=0) 0.00 4.42
nn
1.12 85.93
nnn
203.73
nnn
R
2
0.35 0.82 0.78 0.89 0.94
F-statistic 9.98
nnn
62.81
nnn
92.43
nnn
284.49
nnn
541.23
nnn
n
Indicates signicance at the 10% level (one-tailed when the coefcient sign is predicted, two-tailed otherwise).
nn
Indicates signicance at the 5% level (one-tailed when the coefcient sign is predicted, two-tailed otherwise).
nnn
Indicates signicance at the 1% level (one-tailed when the coefcient sign is predicted, two-tailed otherwise).
J. Bouwens, P. Kroos / Journal of Accounting and Economics 51 (2011) 171185 178
favorable year-to-date sales will be more inclined to reduce their sales activity in the nal months of the year than
managers with unfavorable year-to-date sales. We expect that g
2
o0 for Eq. (2a).
4.2.2. Effort reduction and managerial turnover
Milgrom and Roberts (1992) and Brickley et al. (2004) contend that the adverse consequences of target ratcheting could
be mitigated through job rotation, given that managers who report a favorable year-to-date performance and transfer to a
different store will not confront the upwardly ratcheted sales target in the subsequent year. To control for the potential
inuence of managerial turnover, we distinguish between: (a) store managers who continue to manage the same store in
the next period and (b) store managers who leave the rm or go on to manage a different store in the next period. Taking
managerial turnover into consideration, we empirically examine the adverse consequences of target ratcheting using the
following regression equation:
X
12
m 10,11,12
SALES
i,t,m
TARGET
i,t,m
g
0
g
1
X
9,10,11
m 1
SALES
i,t,m
TARGET
i,t,m
g
2
X
9,10,11
m 1
SALES
i,t,m
TARGET
i,t,m
*DGYTD
i,t
g
3
DGYTD
i,t
g
4
X
9,10,11
m 1
SALES
i,t,m
TARGET
i,t,m
*DTRANSF
i,t
g
5
DTRANSF
i,t
g
6
X
9,10,11
m 1
SALES
i,t,m
TARGET
i,t,m
*DGYTD
i,t
*DTRANSF
i,t
u
i,t
, 2b
where
P
12
m 10,11,12
SALES
i,t,m
=TARGET
i,t,m
,
P
9,10,11
m 1
SALES
i,t,m
=TARGET
i,t,m
, and DGYTD
i,t
are dened as specied in Eq. (2a), and
DTRANSF
i,t
is an indicator variable equal to 1 if the manager leaves store i at the end of year t and is 0 otherwise. Through
Eq. (2b), we distinguish between four different groups of managers, each of which is summarized in Table 4, Panel A.
Our examination of Eq. (2b) is twofold. First, we examine the adverse consequences of target ratcheting for managers
who continue to manage the same store. For these managers, we examine their end-of-year sales performance based on
whether they had favorable year-to-date performance (Case 2, Table 4, Panel A) or unfavorable year-to-date performance
(Case 1, Table 4, Panel A). We expect that managers with a favorable year-to-date performance who continue to manage
the same store (Case 2, represented by the sum of coefcients (g
1
+g
2
)) will be more likely to reduce their sales activities in
the nal quarter, compared with the category of managers who continue to manage the same retail store and have
unfavorable year-to-date performance (Case 1, represented by g
1
). Thus, we expect that g
2
o0 for Eq. (2b). Second, we
examine whether managerial turnover mitigates the adverse consequences of ratcheting. Among managers with favorable
year-to-date performance, we examine whether managers who continue to manage the same store (Case 2, Table 4, Panel
A) are more likely to engage in sales reducing activities than managers who leave their store (Case 4, Table 4, Panel A). We
expect that managers with favorable year-to-date performance who leave their store (Case 4, represented by the sum of
coefcients (g
1
+g
2
+g
4
+g
6
)) will be less likely to reduce their sales activity than managers who continue to manage the
store and have favorable year-to-date performance (Case 2, represented by the sum of coefcients (g
1
+g
2
)). Therefore, we
expect that the sum of coefcients (g
4
+g
6
)40 for Eq. (2b).
10
4.2.3. Estimation of regression equations
We estimate Eqs. (2a) and (2b) with OLS and use 3 years of actual-sales and sales-target data, as well as manager-
stafng data from October 2001. This analysis compares each stores end-of-year sales target deviation with its year-to-
date target deviation. Because the accuracy of a given stores sales target may vary across the months and because this
variation may differ from store to store, we employ a xed-effects model to control for any time-invariant unobserved
heterogeneity across stores. Given that our analysis takes into account the next-year employment of retail-store managers,
we base our estimation on two years of store observations.
11
We also require that stores operate continuously and have the
same manager throughout the year. Ultimately, our sample comprises 311 store-year observations.
Table 4, Panel B presents our regression results for the nal three, two, and one month(s) of the accounting year. For
each of the three months, the left columns (Eq. (2a)) do not take into account store-manager turnover, while the right
columns (Eq. (2b)) do.
4.2.4. Empirical evidence on effort reduction
In our estimation of Eq. (2a), we nd that managers with favorable year-to-date performance signicantly reduce their
sales activities in the nal quarter of the year. The coefcient g
2
on
P
12
m 10,11,12
SALES
i,t,m
=TARGET
i,t,m
*DGYTD
i,t
is negative
and signicant for the nal three, two, and one month(s) (po0.1). Thus, consistent with the ratchet effect, we nd that
managers with favorable year-to-date performance exhibit poorer performance at the end of the year than managers with
unfavorable year-to-date performance. We also nd that managers with a favorable year-to-date performance exhibit
poorer end-of-year performance compared with their year-to-date performance. That is, we nd that the sum of
coefcients (g
1
+g
2
) according to an F-test is signicantly greater than zero (po0.01), but smaller than one for the nal
three and two months (po0.01), as well as for the nal month (po0.05) of the accounting year (not tabulated).
12
10
Table 4, Panel A distinguishes four cases whereas only three cases are actually used in our analyses. That is, Case 3 is not compared with the other
cases. Case 3 managers do not continue to manage the same store and have unfavorable year-to-date sales performance.
11
Note that we have four years of accounting data from the general ledgers and three years of data from HR records.
12
For Eq. (2a), the coefcient g
1
is not signicantly greater than 1 for each of the three months evaluated at a 10% signicance level.
J. Bouwens, P. Kroos / Journal of Accounting and Economics 51 (2011) 171185 179
Table 4
Managerial effort reduction following target ratcheting.
This table reports the regression estimates from a Least Squares regression of the following two regression models:
X
12
m 10,11,12
SALES
t,m
TARGET
t,m
g
0
g
1
X
9,10,11
m 1
SALES
t,m
TARGET
t,m
g
2
X
9,10,11
m 1
SALES
t,m
TARGET
t,m
*DGYTD
t
g
3
DGYTD
t
u
t
; 2a
X
12
m 10,11,12
SALES
t,m
TARGET
t,m
g
0
g
1
X
9,10,11
m 1
SALES
t,m
TARGET
t,m
g
2
X
9,10,11
m 1
SALES
t,m
TARGET
t,m
*DGYTD
t
g
3
DGYTD
t
g
4
X
9,10,11
m 1
SALES
t,m
TARGET
t,m
*DTRANSF
t
g
5
DTRANSF
t
g
6
X
9,10,11
m 1
SALES
t,m
TARGET
t,m
*DGYTD
t
*DTRANSF
t
u
t
: 2b
P
12
m 10,11,12
SALES
t,m
=TARGET
t,m
denotes the ratio of actual sales to target sales in the nal three, two, or one month(s) of period t;
P
9,10,11
m 1
SALES
t,m
=TARGET
t,m
denotes the ratio of actual sales to target sales in
the rst nine, ten, or eleven months of period t; DGYTD
t
is an indicator variable equal to 1 if the cumulative sales target deviation over the rst nine, ten, or eleven months (formally described as
P
9,10,11
m 1
SALES
t,m
TARGET
t,m
) of period t40 and is 0 otherwise; and DTRANSF
t
is an indicator variable equal to 1 if the store manager transfers to another store, job, or rm in the year subsequent to period t and
is 0 otherwise. T-statistics are reported in parentheses. Panel A summarizes the interpretation of coefcients for each of the possible groups of managers distinguished in Eq. (2b). Panel B reports the regression
results.
Panel A: Groups of managers distinguished in Eq. (2b)
Year-to-date performance Turnover Association between year-to-date performance
and end-of-year performance
Case 1: Year-to-date salesrtarget No turnover g
1
Case 2: Year-to-date sales4target No turnover g
1
+g
2
Case 3: Year-to-date salesrtarget Turnover g
1
+g
4
Case 4: Year-to-date sales4target Turnover g
1
+g
2
+g
4
+g
6
Panel B: Regression model
Dependent variable
P
12
m 10,11,12
SALESt,m=TARGETt,m
Model Final 3 months Final 2 months Final month
Prediction Eq. (2a) Eq. (2b) Eq. (2a) Eq. (2b) Eq. (2a) Eq. (2b)
Intercept 0.286
(1.30)
0.240
(1.05)
0.263
(1.23)
0.302
(1.31)
0.107
(0.46)
0.125
(0.50)
P
9,10,11
m 1
SALESt,m=TARGETt,m
1.346
nnn
(5.73)
1.296
nnn
(5.29)
1.332
nnn
(5.82)
1.372
nnn
(5.57)
1.097
nnn
(4.39)
1.130
nnn
(4.24)
P
9,10,11
m 1
SALES
t,m
=TARGET
t,m
*DGYTG
t
0.735
nnn
(2.73)
0.738
nnn
(2.72)
0.806
nnn
(3.03)
0.799
nnn
(2.97)
0.418
n
(1.42)
0.362
y
(1.22)
DGYTG
t
0.696
nnn
(2.66)
0.701
nnn
(2.64)
0.769
nnn
(2.97)
0.756
nnn
(2.89)
0.387
(1.35)
0.307
(1.06)
P
9,10,11
m 1
SALES
t,m
=TARGET
t,m
*DTRANSF
t
0.167
(0.64)
0.141
(0.53)
0.258
(0.91)
DTRANSF
t
0.149
(0.61)
0.138
(0.55)
0.198
(0.75)
P
9,10,11
m 1
SALESt,m=TARGETt,m*DGYTGt *DTRANSFt
0.005
(0.11)
0.021
(0.45)
0.082
n
(1.57)
Year dummies Yes Yes Yes Yes Yes Yes
Store xed effects Yes Yes Yes Yes Yes Yes
F-test (g
1
+g
2
=0) 24.55
nnn
13.38
nnn
18.76
nnn
14.54
nnn
26.15
nnn
21.47
nnn
F-test (g
1
+g
2
+g
4
+g
6
=0) 15.26
nnn
5.76
nn
8.93
nnn
F-test (g
4
+g
6
=0) + 0.51 0.27 0.52
Number of observations 311 311 311 311 311 311
F-statistic 32.28
nnn
18.71
nnn
34.99
nnn
19.73
nnn
21.66
nnn
12.80
nnn
y
Indicates signicance at the 15% level (one-tailed when the coefcient sign is predicted, two-tailed otherwise).
n
Indicates signicance at the 10% level (one-tailed when the coefcient sign is predicted, two-tailed otherwise).
nn
Indicates signicance at the 5% level (one-tailed when the coefcient sign is predicted, two-tailed otherwise).
nnn
Indicates signicance at the 1% level (one-tailed when the coefcient sign is predicted, two-tailed otherwise).
J
.
B
o
u
w
e
n
s
,
P
.
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r
o
o
s
/
J
o
u
r
n
a
l
o
f
A
c
c
o
u
n
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i
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a
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c
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i
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s
5
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(
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)
1
7
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1
8
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4.2.5. Empirical evidence on effort reduction and managerial turnover
Our examination of Eq. (2b) is twofold. First, for managers who continue to manage the same store, we estimate
whether managers with favorable year-to-date performance (Case 2) have poorer sales in the nal quarter than store
managers with unfavorable year-to-date performance (Case 1). Consistent with our predictions, the coefcient g
2
on
P
12
m 10,11,12
SALES
i,t,m
=TARGET
i,t,m
*DGYTD
i,t
is negative and signicant for both the nal three months and the nal two
months of the year (po0.01). In addition, we show that managers with a favorable year-to-date sales performance exhibit
poorer end-of-year sales performance compared with their year-to-date performance. The sum of coefcients (g
1
+g
2
)
according to an F-test is signicantly greater than zero for the nal quarter (po0.01), but smaller than one for the nal
three and two months of the year (po0.01) (not tabulated).
13
Second, we examine the potential impact of store-manager
turnover. We predicted that the end-of-year performance of managers with favorable year-to-date performance who leave
the store (Case 4) will exceed that of managers with favorable year-to-date who continue to manage the same store
(Case 2). Our evidence does not support this prediction. The results of an F-test indicate that, for all three equations, the
sum of coefcients (g
4
+g
6
) is not signicantly different from zero.
To gain a greater understanding of how target ratcheting affects sales performance in the nal quarter, we ranked the
stores in our sample based on their year-to-date performance ranging from highly unfavorable to highly favorable. We nd
that the stores exhibiting small positive deviations from the sales target have the worst sales performance in the nal
quarter of the year (results not tabulated). This is consistent with our prior nding that small positive deviations from the
sales target yield the largest upward ratcheting of the next-period target.
In short, Eqs. (2a) and (2b) both suggest that target ratcheting has adverse consequences. Managers with favorable year-
to-date performance reduce their end-of-year performance to mitigate the next-year target increase. On the other hand,
we do not nd that store manager turnover mitigates the adverse consequences of target ratcheting. Indeed, the end-of-
year performance of store managers who leave the store is not statistically different from the end-of-year performance of
store managers who stay in the same store. This latter nding notwithstanding, we conclude that our ndings support
Hypothesis 1.
14,15
4.2.6. Do store managers also reduce sales earlier in the year?
Our analyses to this point have focused on managers sales performance at the end of the accounting year. For their part,
managers have two means of increasing their compensation: (a) earn each quarterly bonus, which is based on the
managers deviation from the sales target in that quarter; and (b) earn a favorable score on the annual subjective
performance appraisal, which is based on the managers annual sales target deviation and determines their increase in
salary for the following year. In the absence of target ratcheting, managers have incentives to maximize their effort across
all four quarters because doing so maximizes their likelihood of receiving bonuses in all four quarters as well as a salary
increase in the following year. Target ratcheting forces managers to make a trade-off between the current benets derived
from favorable performance and the future losses derived from the assignment of more ambitious sales targets. Table 4
suggests that some managers purposefully reduce their sales activities at the end of the year. Such a strategy allows these
managers to earn a relatively high annual bonus payout, earn a salary increase (i.e., having already achieved their targets
over the prior three quarters provides a safeguard for any sales reductions in the nal quarter with regard to achieving
their annual sales target), and mitigate the increase in the next-year sales target. Reducing their performance at, for
example, the beginning or the middle of the accounting year makes managers vulnerable to the possibility of not achieving
their sales target at all and therefore losing the attendant benets.
16
Nevertheless, as a robustness check, we investigate
whether managers also engage in sales reducing activities in the beginning and/or the middle of the year (not tabulated).
After performing an analysis similar to that of Eqs. (2a) and (2b), we nd no evidence to suggest that managers also reduce
their performance early in the year. That is, the coefcient g
2
on
P
1,2,::,8
m 1
SALES
i,t,m
=TARGET
i,t,m
*DGYTD
i,t
is in no case
negative and signicant.
17
13
An alternative explanation is that managers who report unfavorable year-to-date performance accelerate their sales in the nal months. However
only 12% of the managers who report unfavorable performance after 9 months and continue to manage the same store have a positive bonus payout in
the fourth quarter. This suggests that bonus and appraisal incentives are, for the majority of under-performing managers, out-of-the-money. Moreover,
for Eq. (2b), the coefcient g
1
is again not signicantly greater than 1 evaluated at a 10% level.
14
Interviews with senior management informed us of the probable means managers use to affect timing of sales. Such illustrations include cutting
back on the provision of information and advice concerning merchandise and merchandise maintenance, reduced selling of complementary products
(e.g., extended guarantees), and so on. As supplemental analysis, we examined whether retail stores that report favorable sales performance after nine
months use fewer labor hours in the nal three months. We did not nd any signicant results (not tabulated).
15
With respect to the magnitude of the incentive effects, we estimate what the effect would be if the adverse incentive effects were absent. This
would result in a 4% increase in earnings before taxes for the given business unit over the period 20012004 (h500,000). The decrease in the sales
performance in the nal month(s) for those managers with favorable year-to-date performance that continue to manage the same store would result in a
7% bonus increase for the given store managers.
16
That is, earlier in the accounting year, managers are less certain of the degree to which they can reduce their performance without simultaneously
jeopardizing their performance evaluation and, thereby, their salary increase, which is contingent on achieving their annual sales target.
17
On the contrary, the coefcient g
2
for two months is positive and signicant. For example, the coefcient g
2
is positive and signicant after two
months of favorable sales performance. However, this signicance does not persist in the months immediately following. This suggests that well-
performing managers increase their effort after two months to take full advantage of the busy Christmas season.
J. Bouwens, P. Kroos / Journal of Accounting and Economics 51 (2011) 171185 181
4.2.7. Do store managers expose themselves as sales reducers?
Previously, we found that managers with favorable year-to-date performance reduce their sales activities in the nal
months of the accounting year. Therefore, we next aim to establish the extent to which store managers who engage in sales
reducing activities actually expose themselves as sales reducers. Specically, we examine the extent to which store
managers who reduce their sales at the end of the year actually report negative sales target deviations. We test this
empirically using the following equations:
X
12
m 10,11,12
SALES
i,t,m
TARGET
i,t,m
l
0
l
1
DGYTD
i,t
v
i,t
, 3a
X
12
m 10,11,12
SALES
i,t,m
TARGET
i,t,m
l
0
l
1
DGYTD
i,t
l
2
DTRANSF
i,t
l
3
DGYTD
i,t
*DTRANSF
i,t
v
i,t
, 3b
where
P
12
m 10,11,12
SALES
i,t,m
TARGET
i,t,m
denotes the (cumulative) monthly deviations from the sales target for the nal
three, two, and one month(s), t indicates the accounting year t, and m indicates the monthly periods in the respective
accounting year t using m=(1, y, 12). In Eq. (3a), the coefcient l
0
denotes the end-of-year deviation from the sales target
for managers with unfavorable performance in the nal three, two, or one month(s), and the sum of coefcients (l
0
+l
1
)
denotes the end-of-year sales target deviation for managers with favorable sales performance in the nal months. For both
Eqs. (3a) and (3b), a signicant and negative sum of coefcients (l
0
+l
1
) implies that managers with favorable year-to-date
performance who engage in sales reducing activities do so to the extent that they actually report negative target
deviations, thereby exposing themselves as sales reducers. We estimate regression Eqs. (3a) and (3b) using a xed-
effects model. As before, we use three years of actual-sales and sales-target data, as well as manager-stafng data gathered
between October 2001 and September 2004, which yields 311 store-year observations.
The results of the above analysis (not tabulated) consistently suggest that store managers with favorable year-to-date
performance report higher end-of-year target deviations than do managers with unfavorable year-to-date performance, as
indicated by a positive and signicant coefcient for l
1
(po0.01). As indicated by a positive sum of coefcients (l
0
+l
1
),
managers with favorable year-to-date performance also exhibit favorable deviations from the sales target in the nal
months of the year. In Eq. (3b), only in the nal month of the year do we nd that store managers with favorable year-to-
date performance who continue to manage the same store reduce their sales activities to such an extent that they report
negative target deviations (po0.01), specically, of about h1K. However, because bonuses are calculated over the entire
nal quarter and not on a month-to-month basis, one could argue that even these managers only barely expose themselves
as sales reducers.
In conclusion, our evidence suggests that managers do engage in sales reducing activities. However, they typically do so
without producing negative sales target deviations.
4.3. Test of hypothesis 2: are sales reducers more likely to achieve subsequent targets?
We now examine whether there is an association between consecutive target achievements to infer whether managers
are successful at inuencing their next-period target increase. A store managers success at making future targets more
easily achievable depends on the rms ability to identify when managers are reducing their sales efforts.
First, we compare the actual sales targets assigned to managers with the theoretical targets that should be assigned
given past targets, past sales target deviations, and the ratcheting parameters reported in Table 3, Panel B. Next, we
compare the differences between the actual targets and the theoretical targets between, on the one hand, managers who
engage in sales reducing activities (i.e., store managers with favorable year-to-date performance who continue to manage
the same store) and, on the other hand, managers who do not (i.e., all remaining store managers). If the rm were able to
identify which managers engage in sales reducing activities and subsequently adjust managers next-period targets
accordingly, then we would expect the difference between the actual targets and the theoretical targets to be signicantly
higher for sales reducers than for all other managers. Table 5 presents the results of our analyses. The p-values that follow
from the one-sided test of mean differences indicate no signicant differences between the actual sales targets and the
theoretical sales targets across the two groups of managers. This suggests that the rm is not able to identify which store
managers engage in sales reduction. This nding is not surprising given the results discussed in the previous section,
namely, that store managers only reduce their sales to a moderate degree. Indeed, we found that even when store
managers do reduce their end-of-year sales, they typically keep reporting positive deviations from the monthly sales
targets.
4.3.1. Higher likelihood of achieving future sales targets
To the extent that store managers successfully inuence their next-period target, we should observe that managers who
engage in sales reducing activities are more likely to consistently perform well over consecutive periods. We univariately
assess the likelihood that a given store manager will achieve their sales target over consecutive periods. We nd that the
likelihood of achieving the yearly target over two (three) consecutive periods is 46% (22%). In addition, we nd that the
correlation between consecutive target achievements is insignicant (po0.32) (not tabulated).
J. Bouwens, P. Kroos / Journal of Accounting and Economics 51 (2011) 171185 182
While this suggests that all information about the sales capacity of stores is incorporated in the future targets
(Indjejikian and Nanda, 2002), it also suggests that store managers put in maximum effort and that rm management
updates targets accordingly. However, while the results presented in Table 4 indicate that managers do engage in sales
reduction, the results presented in Table 5 suggest that our sample rm fails to recognize this sales reduction. To address
this apparent discrepancy, we test whether store managers who reduce their sales at the end of the accounting year
actually affect their likelihood of achieving their next-year target. To distinguish between high-level performers, mid-level
performers, and low-level performers in the nal two months of the accounting year, we use two indicator variables.
18
We
use the following regression model to examine Hypothesis 2:
DEV_TARGET
i,t 1
d
0
d
1
DEV_TARGET
i,t
d
2
DEV_TARGET
i,t
*D_LOW
i,t
d
3
DEV_TARGET
i,t
*D_MED
i,t
d
4
D_LOW
i,t
d
5
D_MED
i,t
u
i,t
, 4
where DEV_TARGET
t
denotes the target deviation in year t (i.e., actual sales
t
target sales
t
); D_LOW
t
is an indicator variable
equal to 1 if the store managers share of yearly sales for the nal two months is in the lowest tercile of the total sample in
period t, ranked according to the nal two months share of yearly sales from low to high, and is 0 otherwise; and D_MED
t
is an indicator variable equal to 1 if the store managers share of yearly sales for the nal two months is in the middle
tercile of the sample in period t, ranked according to the nal two months share of yearly sales from low to high, and is 0
otherwise. In addition to this model, we employ a scaled model in which we divide DEV_TARGET
t +1
and DEV_TARGET
t
by
the corresponding sales target. We estimate Eq. (4) with OLS and use three years of actual-sales and target-sales data, as
well as manager-stafng data from October 2001. This analysis builds directly on the analysis performed using Eq. (2b) and
likewise has a maximum of 311 observations. We exclude all observations wherein managers left the store in the year
following the focal year. Our nal estimation is based on 221 observations. Table 6 reports our results.
The coefcient d
1
on DEV_TARGET
t
is not signicant, which suggests that consecutive sales target deviations are not
related for managers who most likely do not engage in sales reducing activities at the end of the year. The coefcient d
2
on
DEV_TARGET
t
nD_LOW
t
, however, is positive and signicant for both the unscaled and scaled models (po0.05 and po0.01,
respectively), which suggests that the decision to engage in sales reduction pays off. That is, given their positive sales target
deviation in the current year, managers who reduce their sales efforts have a greater likelihood of achieving a positive
target deviation in the next year, compared with the managers who do not reduce their sales.
19
Moreover, the sum of
coefcients (d
1
+d
2
) is positive and signicant according to the F-test (po0.05 and po0.01 for the unscaled and scaled
models, respectively), which implies that managers who reduce their sales activities are likely to achieve their next-year
sales target. The coefcients for the store managers in the middle tercile are insignicant.
We also repeated the analyses, this time categorizing managers into terciles based on their sales performance in the
nal three months and the nal month of the year (not tabulated). For the nal three months, the coefcient d
2
on
DEV_TARGET
t
nD_LOW
t
is positive and signicant for the scaled model, which suggests that sales reducers increase their
likelihood of achieving their next-year sales target. For the nal month, the coefcient d
2
on DEV_TARGET
t
nD_LOW
t
is
positive and signicant for both the unscaled and scaled models, which again suggests that sales reducers increase their
likelihood of achieving their next-year sales target. Furthermore, the coefcient d
3
on DEV_TARGET
t
nD_MED
t
is also positive
and signicant for both the unscaled and scaled models, which suggests that the managers in the middle tercile also
increased their likelihood of achieving their next-year sales target. In conclusion, we nd that managers who engage in
Table 5
Target differences for managers who do (do not) reduce sales.
This table reports the test results for the signicance of differences between, on the one hand, the actual sales targets assigned to managers, and, on the
other, the theoretical targets computed based on the actual deviations from the sales target in the prior period and the ratcheting parameters reported in
Table 3, Panel B for managers who engage in sales reducing activities (i.e., managers who have favorable year-to-date performance and continue to
manage the same store) and managers who do not engage in sales reducing activities (i.e., all remaining managers). Managers are classied as either
reducing or not reducing sales based on the results reported in Table 4. The reported p-value follows from an one-sided t-test for whether the target
difference (i.e., actual sales target theoretical sales target) for managers who reduce their sales4the target difference for managers who do not reduce
their sales.
Managers who reduce sales Managers who do not reduce sales Mean difference test (p-value)
Partitioning based on: N Mean N Mean
Final three months 150 17,735 161 17,162 0.44
Final two months 152 18,699 159 16,232 0.27
Final month 155 18,990 156 15,896 0.23
18
We rank stores on the basis of their share of yearly sales, formally dened as
P
12
m 10,11,12
SALES
i,t:m
=
P
12
m 1
SALES
i,t,m
. In this way, no potential bias
can be incorporated from using actual sales performance vis- a-vis the sales target, which may originate from the variation of target accuracy throughout
the year across retail stores.
19
Note that the prior results from Table 5 clearly indicated that, compared with managers with unfavorable year-to-date performance, store
managers with favorable year-to-date sales performance reduced their performance signicantly in the nal quarter. Furthermore, it is documented that
managers who reduce their sales typically continued to report positive sales target deviations.
J. Bouwens, P. Kroos / Journal of Accounting and Economics 51 (2011) 171185 183
sales reducing activities are more likely to achieve their next-period targets than managers who do not engage in sales
reducing activities. Hence, for the group of managers who reduce their sales efforts, we reject our null hypothesis (i.e.,
Hypothesis 2), which predicts that consecutive target achievements will be unrelated.
5. Discussion, limitations, and conclusions
Our results are consistent with our sample rm using current sales target deviations to set future sales targets, that is,
with the rm engaging in target ratcheting. We also nd that, to discriminate between managerial effort and general
economic conditions facing a given store (Weitzman, 1980; Leone and Rock, 2002; Leone et al., 2006), the rm ratchets
targets asymmetrically. Moreover, we demonstrate that such (asymmetric) target ratcheting prompts managers with
favorable year-to-date performance to reduce their performance in the nal quarter of the accounting year (e.g., Leone and
Rock, 2002). The conditions under which we establish these ndings include the rm withholding decision rights from
store managers, thereby leaving managers with few means of manipulating their performance. The managers in our setting
could scarcely affect their performance through either accounting manipulation (e.g., accruals) or real economic decisions
(e.g., through price discounts). Therefore, we conclude that the reductions in sales performance we observe can only be
achieved through reductions in sales effort, which suggests that the ratchet effect has a strong and adverse impact on the
rms incentive system. We did not nd support for the notion presented in Milgrom and Roberts (1992) that rms can
mitigate the adverse effects of target ratcheting through job rotation. This nding, however, may be caused by a lack of
statistical power due to a limited sample size.
We next investigate whether managers who try to mitigate their next-period target increase actually succeed in making
their next-period sales target more achievable. We nd that store managers who engage in sales reduction have an
advantage over other store managers in terms of achieving their next-period targets. That is, these managers are more
likely to achieve their next-period target than are managers who did not engage in sales reduction.
An important caveat to our study regards the generalizability of our ndings. The managers in our sample are drawn
from a single rm and are subject to a single incentive system. The rm in which we conduct our study allows its managers
very few decision rights, and our ndings are therefore specic in that respect. While this feature may limit the
Table 6
Multivariate analyses for consecutive target deviations.
This table reports regression estimates from a pooled OLS regression of the following model:
DEV_TARGET
t 1
d
0
d
1
DEV_TARGET
t
d
2
DEV_TARGET
t
*D_LOW
t
d
3
DEV_TARGET
t
*D_MED
t
d
4
D_LOW
t
d
5
D_MED
t
u
t
3
For the unscaled model, DEV_TARGET
t
denotes the deviation from the sales target in period t; D_LOW
t
is an indicator variable equal to 1 if the given
managers sales performance is in the lowest tercile of the total sample in period t, ranked according to the nal two months share of yearly sales from
low to high, and is 0 otherwise; and D_MED
t
is an indicator variable equal to 1 if the given managers sales performance is in the middle tercile of the
sample in period t, ranked according to the nal months share of yearly sales from low to high, and is 0 otherwise. For the scaled specication, we deate
DEV_TARGET by the sales target. T-statistics reported in parentheses are based on clustered standard errors that account for heteroskedasticity and
autocorrelation.
Dependent variable DEV_TARGET
t 1
Model Unscaled Scaled
Prediction
Intercept 43,175
nnn
6.20
nnn
(4.46) (4.44)
DEV_TARGET
t
0.17 0.16
(1.35) (1.33)
DEV_TARGET
t
*D_LOW
t
? 0.43
nn
(2.40)
0.44
nnn
(3.01)
DEV_TARGET
t
*D_MED
t
? 0.22
(1.15)
0.19
(0.97)
D_LOW
t
121,181
nnn
(6.61)
12.45
nnn
(6.73)
D_MED
t
59,244
nnn
(4.02)
6.60
nn
(3.63)
Year dummies Yes Yes
F-test (d
1
+d
2
=0) 4.03
nn
7.68
nnn
F-test (d
1
+d
3
=0) 0.12 0.03
Number of obs. 221 221
R
2
0.24 0.27
F-statistic 9.64
nnn
13.35
nnn
nn
Indicates signicance at the 5% level (two-tailed).
nnn
Indicates signicance at the 1% level (two-tailed).
J. Bouwens, P. Kroos / Journal of Accounting and Economics 51 (2011) 171185 184
generalizability of our results, it is also what enables us to conduct our tests in a controlled setting, which decreases the
likelihood that our ndings can be attributed to alternative explanations or that our results are disguised by omitted
variables. We can, for instance, control for managerial turnover. Our sample rm also focuses on one performance measure
only, that is, sales. Hence, it is almost impossible for our managers to make trade-offs with outcomes of other measures; if
this were not the case, then the phenomenon we intended to study might have been obscured. This feature of our research
settingthat is, being able to conduct our tests in a relatively controlled settingallows us to attribute our results to the
phenomenon under study with greater condence than would have been possible in a multi-measure setting. Certainly,
conducting our study in a different settingfor example, in a more decentralized setting or in a setting wherein bonuses
are based on achievements across several performance measures (rather than our rms single sales performance
measure)would increase our understanding of the ratchet effect.
The above limitations notwithstanding, we believe our ndings advance our understanding of how target ratcheting
affects our sample rms incentive system. Managers seem to respond to target ratcheting by engaging in sales reducing
activities at the end of the accounting year, and, thereby, managers seem to be able to increase their likelihood of achieving
their next-year targets.
Acknowledgement
We would like to acknowledge the helpful comments of Ross Watts (the editor) and Andrew Leone (the referee). The
paper has also beneted from discussions with Margaret Abernethy, Jasmijn Bol, Shane Dikolli, Peter Easton, Jennifer
Grafton, Chris Ittner, Laurence van Lent, Michal Matejka, Jeroen Suijs, the participants of the Global Management
Accounting Research conference 2007, and the participants of the AAA Management Accounting Section meeting 2008.
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