[Banker and Hughes (1994) demonstrate the economic sufficiency of normal activity-based unit cost for optimal pricing decisions. This paper provides an agency parallel to their analysis by examining how, in the presence of capacity costs, the desirable tradeoff between risk-sharing and incentives can be achieved through modification of the performance measures on which the contract is based. Similar to Banker and Hughes (1994), I find that the optimal capacity cost allocation is a function only of budgeted volume when capacity can be used to produce a single product. Analysis of a joint production setting, however, reveals the optimal allocation to be based on the joint products' estimated net realizable values.]

Examines the allocation of sunk capacity costs and joint costs. Trade-off between risk-sharing and incentives; Optimal capacity cost allocation as a function of budgeted volume; Previous research on capacity cost allocation; Insights from principal-agent theory.

This paper examines the exercise of employee stock options (ESOs) by executive officers. We document a positive relation between the variance of ESO returns and the remaining life of the option at exercise, and show that the strength of the relation is reduced by the extent the firm hedges the returns on the ESO. We thus provide empirical evidence of a link between an ESO's expected term and its investment risk to the executive, and document that some firms provide a hedge against option risk.