The effort and risk-taking effects of budget-based contracts

We investigate how the budget levels embedded in budget-based contracts affect individual effort and risk-taking. We show that, from a wealth maximization perspective, a tradeoff exists between motivating effort and encouraging risk-taking. We illustrate an inverted-U relation between budget levels and effort. Budget levels and effort are positively correlated until budgets become very difficult, at which point individuals “give up.” We illustrate an opposing, U-shaped, relation between budget levels and risk-taking. Low budgets provide the flexibility to take greater risks, whereas high budgets induce individuals to “play it safe” to ensure budget attainment. Risky projects provide the greatest probability of reaching very high (stretch) budgets. We conduct a laboratory experiment to empirically test this economic proposition vis-à-vis extant psychology research. Consistent with security-potential/aspiration theory, we find that individuals are willing to sacrifice expected wealth to either meet the budget or increase their potential payoffs. Our results suggest that the effort-risk tradeoff is mitigated at low budget levels, thereby increasing firm welfare, but is exacerbated at high budget levels, reducing firm welfare. Collectively, our results highlight the importance of understanding how managerial accounting practices such as budgets affect the various determinants of performance and not just performance per se. Our results also help reconcile conflicting evidence regarding where budget difficulty levels should be set.