Effective utility functions induced by organizational target‐based incentives

Abstract

Abstract Many companies set performance targets for their divisions to decentralize the decision‐making process and communicate with outside investors. This paper analyzes the effects of performance targets on the decision‐making behavior of the divisions. We introduce the notion of an ‘effective utility function’—a function that a division should use in its selection of projects if it wishes to maximize the probability of achieving its targets. We show that many target‐based incentives induce S‐shaped utility functions and discuss the organizational problems they may pose. We then show how an organization can set targets that induce expected utility maximization. Copyright © 2008 John Wiley & Sons, Ltd.