Ratcheting Effect and the Role of Relative Target Setting

Managers use a variety of information sources to set performance targets. This paper examines the use of information from comparable responsibility centers. Using data from 376 branches of a large travel retailer over five years, we find that performance of comparable responsibility centers (relative target setting) is associated with target setting after controlling for past performance (ratcheting). Our findings also indicate that relative target setting (RTS) is relevant to assess the information quality of past performance. Specifically, we find that the magnitude of ratcheting decreases (increases) with RTS for favorable (unfavorable) performance variances, and that the asymmetry of ratcheting (different ratcheting coefficients for unfavorable than for favorable variances) is significant for large magnitudes of RTS. Managers use the flexibility associated with the subjectivity of the target setting process (in contrast to the stickiness of contracting and the use of relative performance evaluation) to weigh RTS and past performance differently across different responsibility centers.

This seminar is organised by the Erasmus Accounting Research Group.