[Cost allocation is a pervasive practice in accounting. Horngren and Foster (1987, 411) define it as "the assignment and reassignment of a cost or group of costs to one or more cost objectives." An important form of cost allocation is the apportionment of corporate-level costs to various decentralized profit centers. The reason usually given for this procedure is that it is "a major means of getting subordinates to behave as desired by top managers" (1987, 422). Although such allocations have been criticized in the agency literature (Demski 1981) as being irrelevant for motivating managers in the presence of compensation contracts, this article identifies a precise role for indirect cost allocations, in conjunction with other instruments such as participative budgets, in settings with multiple divisions. A survey by Fremgen and Liao (1981) showed that 84 percent of firms allocated at least part of their indirect costs to their profit centers, and 80 percent did so for the purpose of evaluating the performance of profit center managers. The major aim was to remind managers that indirect costs exist and that at least a portion of these costs had to be covered by profit center earnings. Further, Atkinson's (1987) poll reported that the primary objectives of allocating indirect costs were the motivation of employees and the provision of signals for resource allocation. There has been little analytical work, however, on the economic role played by cost allocation systems. Demski (1981) claims that allocation mechanisms are useful only if they provide additional information that can be contracted upon. Similarly, Baiman and Noel (1985) show that in certain multiperiod settings, it is optimal to compensate an agent on the basis of prior periods' realizations of costs that were not in the agent's control, provided these costs affect the principal's capacity decisions. Magee (1988) identifies conditions under which an agent is compensated according to the usage of some resource, in addition to output. The agency studies described above cannot address cost allocations across operating units since they do not model multiple productive divisions among which common costs are to be allocated. Further, because they model single-agent settings, the second-best incentive schemes they derive suffice to motivate managers efficiently; thus, there is no role for allocations unless they provide additional information to the owner. With multiple divisions, however, simple compensation contracts do not provide adequate incentives to guarantee the owner's desired outcome. The role for allocations, over and above that of second-best contracts, in providing assurance to the owner is demonstrated here with a one-period model of an entrepreneur who incurs fixed costs in the production of different products by two workers. When the workers have correlated private information about the productivity of a common, central resource, the entrepreneur may fail to recover the fixed costs because the optimal payment schedules encourage the workers to misreport the productivity of the resource. By asking each worker to submit a budget to determine overhead rates, and by evaluating managers on their divisional profit after allocation of overhead costs, the entrepreneur can obtain the second-best return on the fixed investment. This mechanism is then compared to allocation systems observed empirically and to those recommended in the accounting literature. The mechanism design approach pursued in this paper, with the game itself a variable, enables the study of procedures by which accounting numbers are derived for purposes of performance evaluation. The accounting system is not imposed as a monitor or source of information; its value arises from its procedures, which enable the owner to play off the managers' private information against each other to guarantee a second-best return on investment. In the absence of such a system, the division managers would gain from implicitly colluding in their use of the central resource. The allocation scheme coordinates their actions and induces them to act in the manner desired by the owner. This positive role for the allocation of indirect costs in conjunction with the budgetary process emphasizes the value of a cost allocation system as a set of linked motivational devices.]

[This paper explores a possible explanation for the observed use of bonus pool arrangements. Under fairly general conditions, the use of a bonus pool arrangement results in a strict Pareto improvement by enabling an owner to exploit non-contractible information, that might otherwise not be used, to motivate agents. We characterize the optimal bonus pool arrangement and analyze the interdependencies which it induces between agents. Our results demonstrate the manner in which the use of non-contractible information via bonus pool schemes distorts the payoffs to agents relative to the case in which the non-contractible information is not used.]

[In the usual agency analysis of moral hazard, the principal is endowed with a production process and must hire an agent to manage it. Output depends on the agent's effort, the production process supplied by the principal, and some random state realization. A common assumption is that the output of the production process is costlessly observable and sufficiently informative about the agent's effort to warrant using it for contracting. However, this assumption may not be descriptive of a large number of settings. In fact, it is hard to conceive of many production settings in which the gathering and reporting of any information is totally free and independent of costly design decisions. For example, if the agent produces some product, it is not costless to monitor the number or the quality of the units produced; someone must be paid or a machine must be purchased to do so. In addition, some opportunity cost may have to be incurred to rearrange the production process to facilitate the assessment of the agent's work. In this article, we consider the implications of relaxing the assumption that output is costlessly observable and contractible, by analyzing the optimal design of a costly unconditional monitoring system. We characterize the monitoring system in terms of the Type I error associated with the obedient action and the Type II errors associated with the disobedient actions. We find that it is always optimal to design the monitoring system such that the Type I error is smaller than the Type II error for any disobedient action. Further, we find that as the costliness of the monitoring system increases, the Type I error increases monotonically, while the Type II error initially decreases and then increases.]

Management control system, Internal control, Performance evaluation models, Contracting

[In certain circumstances, insider trades such as private transactions between executives and their firms could be disclosed after the end of the firm's fiscal year, on a Form-5 filing. We find that insider sales disclosed in such a delayed manner for large firms are predictive of negative future returns (-6 to -8 percent), as well as lower future annual earnings relative to analyst forecasts. These results stand in contrast to existing findings on the uninformativeness of quickly disclosed open-market insider sales. The Sarbanes-Oxley Act curtailed the use of Form 5 under the presumption that managers used this vehicle opportunistically. Our systematic evidence supports this presumption.]

This study uses the introduction of second-generation antitakeover legislation as a natural experimental setting to infer the value that managers place on the control rights conferred by stock ownership. We conjecture that managers will reduce their stockholdings in the post-legislation period because they can ensure their prior level of control while holding fewer risky shares. Using a variety of specifications, we find robust evidence consistent with this "revealed preference" hypothesis. Further demonstrating the key role played by control considerations in managers' stockholding decisions, the reductions in ownership are concentrated in management teams with higher levels of initial ownership and in firms without poison pills.

Cost allocation is a pervasive practice in accounting. Horngren and Foster (1987, 411) define it as "the assignment and reassignment of a cost or group of costs to one or more cost objectives." An important form of cost allocation is the apportionment of corporate-level costs to various decentralized profit centers. The reason usually given for this procedure is that it is "a major means of getting subordinates to behave as desired by top managers" (1987, 422). Although such allocations have been criticized in the agency literature (Demski 1981) as being irrelevant for motivating managers in the presence of compensation contracts, this article identifies a precise role for indirect cost allocations, in conjunction with other instruments such as participative budgets, in settings with multiple divisions. A survey by Fremgen and Liao (1981) showed that 84 percent of firms allocated at least part of their indirect costs to their profit centers, and 80 percent did so for the purpose of evaluating the performance of profit center managers. The major aim was to remind managers that indirect costs exist and that at least a portion of these costs had to be covered by profit center earnings. Further, Atkinson's (1987) poll reported that the primary objectives of allocating indirect costs were the motivation of employees and the provision of signals for resource allocation. There has been little analytical work, however, on the economic role played by cost allocation systems. Demski (1981) claims that allocation mechanisms are useful only if they provide additional information that can be contracted upon. Similarly, Baiman and Noel (1985) show that in certain multiperiod settings, it is optimal to compensate an agent on the basis of prior periods' realizations of costs that were not in the agent's control, provided these costs affect the principal's capacity decisions. Magee (1988) identifies conditions under which an agent is compensated according to the usage of some resource, in addition to output. The agency studies described above cannot address cost allocations across operating units since they do not model multiple productive divisions among which common costs are to be allocated. Further, because they model single-agent settings, the second-best incentive schemes they derive suffice to motivate managers efficiently; thus, there is no role for allocations unless they provide additional information to the owner. With multiple divisions, however, simple compensation contracts do not provide adequate incentives to guarantee the owner's desired outcome. The role for allocations, over and above that of second-best contracts, in providing assurance to the owner is demonstrated here with a one-period model of an entrepreneur who incurs fixed costs in the production of different products by two workers. When the workers have correlated private information about the productivity 01: a common, central resource, the entrepreneur may fail to recover the fixed costs because the optimal payment schedules encourage the workers to misreport the productivity of the resource. By asking each worker to submit a budget to determine overhead rates, and by evaluating managers on their divisional profit after allocation of overhead costs, the entrepreneur can obtain the second-best return on the fixed investment. This mechanism is then compared to allocation systems observed empirically and to those recommended in the accounting literature. The mechanism design approach pursued in this paper, with the game itself a variable, enables the study of procedures by which accounting numbers are derived for purposes of performance evaluation. The accounting system is not imposed as a monitor or source of information; its value arises from its procedures, which enable the owner to play off the managers' private information against each other to guarantee a second-best return on investment. In the absence of such a system, the division managers would gain from implicitly colluding in their use of the central resource. The allocation scheme coordinates their actions and induces them to act in the manner desired by the owner. This positive role for the allocation of indirect costs in conjunction with the budgetary process emphasizes the value of a cost allocation system as a set of linked motivational devices.

The reported cost of a product frequently contains historical cost components that reflect past investments in productive capacity. We examine a setting wherein a firm makes a sequence of overlapping capacity investments. Earlier research has identified particular accrual accounting (depreciation) rules with the property that, on a per unit basis, the historical cost of a product captures precisely its marginal cost. Relative to this benchmark, we investigate and characterize the direction and magnitude of the bias in reported historical cost that results from alternative depreciation rules, including in particular straight‐line depreciation in conjunction with partial direct expensing. In addition, we demonstrate that for a reasonable range of parameter specifications the resulting bias is rather small. Finally, we apply our framework to two specific settings. First, in a regulatory context, we establish the extent to which the accounting profit margin is indicative of a firm's pricing power in the product market. Second, we model an internal control scenario in which a manager's performance is evaluated using residual income, and identify the distortions in investment levels that result from the use of alternative depreciation rules.