The effect of unstable budget difficulty on performance over time

Abstract

Firms generally seek to set budget targets with similar levels of expected difficulty each period. However, variability in realized budget difficulty across periods can occur, resulting in unstable budget difficulty. Although variability in budget difficulty arguably reduces the value of preset fixed budget targets for performance evaluation, we develop theory that predicts unstable (relative to stable) budget difficulty will increase employee performance over time. Specifically, we predict that unstable budget difficulty incentivizes greater attempts at ability improvement to prepare for future periods of potentially higher difficulty. Our experimental results support this theory. We also find evidence that suggests the ability improvement from unstable settings is greater for moderate, relative to low, typical difficulty levels. These results significantly improve our understanding of the effect of fixed budgets when budget difficulty is likely unstable.