This section examines how companies set earnings targets as well as other financial and nonfinancial targets. The sample includes all companies and business units (private and public) where performance target data is available, except for nonprofit entities. Thus, the findings are not specific just to CFO bonus plans as in the previous section. We start out by examining earnings targets.
Figure 1 shows the trend in earnings targets between 2008 and 2013. Following the 2008– 2009 recession, there was a steady trend upwards from the low of 4.57% targeted return on sales in 2009 to 6.25% in 2012. Average actual return on sales of 6.33% in 2012 slightly
Figure 1. 2008–2013 Earnings Targets
5.45% 4.57% 5.00% 6.00% 6.25% 7.50% 4.00% 5.00% 6.33% 3% 4% 5% 6% 7% 8% 2008 2009 2010 2011 2012 2013 Earnings Targets Actual Earnings
Note: Median earnings targets (return on sales) are marked in blue and median actual earnings are marked in red. 2012– 2013 earnings targets and 2012 actual earnings are from the current 2013 survey (about 1,485 entities included), 2010– 2011 earnings targets and 2010 actual earnings are from the 2011 survey (about 570 entities included), and 2008–2009 earnings targets and 2008 actual earnings are from the 2009 survey (about 830 entities included).
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exceeded the target. The following increase in earnings targets from 6.25% in 2012 to 7.5% in 2013 was the highest among the six years on record.
Figures 2 shows a detailed distribution of 2013 earnings targets. The striking feature, which was also apparent in prior years, is that there were very few earnings targets set just below zero. Instead, there was a high frequency of earnings targets at or just above zero. For example, there were only 11 cases of earnings equal or greater than -1% of sales and smaller than 0% but 135 cases of earnings in the next range where earnings were equal or greater than zero and smaller than 1% of sales. Of the 135 cases in the range “at or just above zero,” 66 were exactly equal to zero. Apparently, instead of a negative earnings target many companies preferred to set a zero or a small positive target.
Panel A of Table 13 compares earnings target difficulty over time. Target difficulty is measured in two ways. First, as a proportion of companies that actually met their target (i.e., the 2012 target in the current survey). Second, as survey respondents’ perception of the likelihood that they are going to meet the target set for the current period (i.e., the 2013 target in the current survey).
Using the first measure of target difficulty, we find that targets were abnormally difficult to achieve in 2008 and became a lot more achievable in 2010 and 2012. In 2012, 62% of
Figure 2. Frequency of 2013 Earnings Targets
Note: Sample includes 1,205 private and public entities (corporate and BU level), excluding nonprofit organizations, with 2013 earnings targets between -20% and 20% of sales. The x-axis plots return on sales divided into 1% wide ranges. For example, 0% marks the range where targeted return on sales was equal or greater than 0% and smaller than 1%. The y-axis counts the number of entities with targeted earnings in each of the ranges. In case of the 0–1% range, the darker shade represents the number of entities with 2013 earnings targets equal to zero (66) and the lighter shades represents (69) entities with targeted earnings greater than 0% and smaller than 1%.
0 50 100 150
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companies met their targets and 38% failed to meet the target, essentially the same proportions as in 2010. In contrast, only 46% companies met their earnings target in 2008. Using the second measure of target difficulty, we obtain similar results. The estimated likelihood of achieving current earnings target was only 48% in 2009 but increased to 66% in 2011 and 69% in 2013 even though both 2011 and 2013 saw considerable target increases relative to prior years. Other financial targets (e.g., sales targets) were on average more difficult to achieve than earnings targets but showed a similar trend in that achievability was increasing over time.
Interestingly, whereas financial targets became easier to achieve since the recession, there was hardly any change in the perceived difficulty of nonfinancial targets. The estimated
Table 13. Difficulty of Performance Targets in Annual Bonus Plans
Note: Sample includes all private and public entities (corporate and BU level), excluding nonprofit organizations, with available data on target difficulty. The sample in Panel B is smaller because only a subset of survey respondents provided information about specific nonfinancial measures used.
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likelihood of achieving nonfinancial targets was 69% in 2009, 75% in 2011, and 75% in 2013. Panel B of Table 13 makes this comparison in the subsample of companies with information about specific nonfinancial targets used. The likelihood of achieving targets ranged 74–80% for all type of nonfinancial measures and did not change much over time. Table 14 shows that the likelihood of achieving earnings targets varied considerably across companies, which is not reflected in the overall average reported in Table 13 (69%). In particular, we find that earnings targets in companies that performed well in the past were much easier to achieve than targets in poorly performing companies. Panels A–C of Table 14 measure past performance in three different ways as: (a) performance relative to last year’s target, (b) the absolute size of the earnings target, and (c) performance relative to peers.
Panel A of Table 14 shows that the estimated likelihood of achieving 2013 earnings targets ranged from 55% in companies where 2012 performance was well below the 2012 earnings target to 76% in companies where performance was well above the target. Similar variation can be found in 2011 with the likelihood ranging 50%–77% and even in 2009, when the likelihood was much lower and ranged 38%–61%, targets were again easier for companies that had met their prior year’s target.
Panel B shows that positive earnings targets were easier to achieve than negative earnings targets. Moreover, large positive targets were easier to achieve than smaller profits. For example, the estimated likelihood of achieving 2013 earnings targets was 72% in the group with highest earnings targets, 68% in companies with small positive targets, 49% in companies with zero earnings targets, 61% in companies targeting a relatively small loss, and 59% in companies targeting a large loss. It is noteworthy that of all target levels, zero earnings targets in 2013 were the most difficult to achieve. This is consistent with the finding in Figure 2 that many companies avoided loss targets and instead stretched their earnings target to zero even if it became less likely to be achieved.
Finally, Panel C divides companies into five groups depending on their performance relative to peers. The best performing companies estimated the likelihood of achieving 2013 earnings target at 78% whereas it was only 54% in the worst performing group.
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Table 14. Difficulty of Earnings Targets and Prior-Year Performance
Note: Same sample as in Table 13. Tabulated is the estimated likelihood of achieving next year’s earnings targets. “On Target” in Panel A means that earnings were the same as the target. Companies that failed to meet their target in the prior year were divided into two groups of similar size (“Below Target” and “Well Below Target”) depending on the target shortfall. Similarly, companies that met their target were divided into two groups of similar size (“Above Target” and “Well Above Target”). “Zero Earnings” in Panel B means that earnings were exactly equal to zero. Companies with targeted losses were divided into two groups of similar size (“Small Loss” and “Large Loss”) depending on the magnitude of the loss. Similarly, companies with targeted profits were divided into two groups of similar size (“Small Profit” and “Large Profit”). Performance groups in Panel C reflect answers to the question asking about “performance of your company relative to your closest industry peers.”
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In summary, an important choice companies face when designing bonus plans is how to calibrate the difficulty or achievability of various targets. We find that nonfinancial targets were easier to achieve on average than earnings or other financial targets. Moreover, the difficulty of nonfinancial targets remained relatively constant during and after the recession. In contrast, earnings targets were very difficult to achieve during the recession but became much more achievable in recent years despite the fact that earnings targets were steadily increasing.
Our results also highlight two persistent features of target-setting practices. First, companies are reluctant to set negative earnings targets; instead, they prefer zero or small positive targets even if such targets are less realistic and unlikely to be achieved. Second, companies are careful not to ratchet targets upwards too much following good past performance. Good performance in one period could be incorporated into targets for future periods and consequently targets could become harder to achieve following good performance in the past. Instead, companies make sure that the best performers have the easiest targets in the future and thus are reluctant to adjust targets upwards excessively. Both features above can have a positive effect on incentives in that they make executives more accountable for their past actions. Knowing that there will be no bonuses for losses, executives have strong incentives to minimize the impact of a recession on their company. Similarly, adjusting targets upwards only moderately following periods of good performance rewards executives for their current as well as past productive actions and motivates actions improving future performance.
Please contact me if you wish to share your experiences, make any comments or critical suggestions, or otherwise contribute to ongoing research on the role of CFOs and controllers in today's business environment.
Michal Matějka
W.P. Carey School of Business Arizona State University P.O. Box 873606
Tempe, AZ 85287-3606 Phone: 480-965-7984