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 article info Article history: Received 7 March 2008 Received in revised form 25 May 2010 Accepted 2 July 2010 Available online 13 July 2010 JEL classification: J33 M40 Keywords: Target setting Ratchet effect Manipulating real economic activities abstract In this paper, we examine how retail store managers reduce their sales activity in response to target ratcheting. We find that managers with favorable sales performance in the first three quarters reduce their sales activity in the final 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 final quarter are more likely to beat their next-year sales targets than managers who refrain from reducing their final- quarter sales. & 2010 Elsevier B.V. All rights reserved. 1. Introduction We examine how target ratcheting impacts the sales activity of a particular firm’s retail store managers over four accounting years. To set sales targets for the next fiscal year, our sample firm uses the current year’s sales information; that is, the firm ratchets their targets (Weitzman, 1980). We argue that target ratcheting incentivizes store managers to reduce the sales they make in the final quarter of the year in order to make their next-year sales target more achievable. Because our sample firm 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 firm is uncertain about the sales potential of each of its retail stores. Firm management believes that current sales provide an indication of a store’s sales potential. Accordingly, to set each store’s next-period sales target the firm 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) 171–185