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Incentives for Efficient Inventory Management: The Role of Historical Cost

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This paper examines inventory management from an incentive and control perspective. We demonstrate that the residual income performance measure based on historical cost accounting provides managers with incentives to make optimal production and inventory depletion decisions. The lower-of-cost-or-market rule is shown to be effective in situations where inventory may become obsolete due to unexpected demand shocks. Our analysis also considers settings in which the unit variable cost of production can be lowered by initial investments. Proper incentives require that the depreciation charges for these initial fixed costs are independent of the actual production and sales quantities. Therefore, a variable costing format, rather than an absorption costing format, is essential for the purpose of managerial performance evaluation.

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... In a similar way, a sensitivity analysis of the optimal cycle time T * is performed in the next corollary by using the closed expression (21). Corollary 3. Let T * be optimal cycle time given by (21). ...
... In a similar way, a sensitivity analysis of the optimal cycle time T * is performed in the next corollary by using the closed expression (21). Corollary 3. Let T * be optimal cycle time given by (21). Then: ...
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This paper presents the optimal policy for an inventory model where the demand rate potentially depends on both selling price and stock level. The goal is the maximization of the profitability index, defined as the ratio income/expense. A numerical algorithm is proposed to calculate the optimal selling price. The optimal values for the depletion time, the cycle time, the maximum profitability index, and the lot size are evaluated from the selling price. The solution shows that the inventory must be replenished when the stock is depleted, i.e., the depletion time is always equal to the cycle time. The optimal policy is obtained with a suitable balance between ordering cost and holding cost. A condition that ensures the profitability of the financial investment in the inventory is established from the initial parameters. Profitability thresholds for several parameters, including the scale and the non-centrality parameters, keeping all the others fixed, are evaluated. The model with an isoelastic price-dependent demand is solved as a particular case. In this last model, all the optimal values are given in a closed form, and a sensitivity analysis is performed for several parameters, including the scale parameter. The results are illustrated with numerical examples.
... Such performance measures are often based on accounting data because these outperform cash-flow data when it comes to intertemporal matching of costs and revenues. In search of a performance metric that yields an inventory cost charge equal to the relevant costs, Baldenius and Reichelstein (2005) analytically show that use of a particular residual income performance metric results in efficient delegation. Their residual income measure deducts from income an interest charge for the value of all operating assets including inventory based on compounded historical cost, which ensures that the manager is charged the real production cost when inventory is sold, and based on the LIFO inventory flow rule, which first expenses the most recently produced inventory units. ...
... managers take their inventory management decisions by further advancing in the spirit of Baldenius and Reichelstein (2005), considering inventory management decisions from an incentive and control perspective. This implies that (1) the inventory management decision is delegated to an operations manager who has superior information and (2) the operations manager is evaluated by means of particular performance measures. ...
... Such performance measures are often based on accounting data because these outperform cash-flow data when it comes to intertemporal matching of costs and revenues. In search of a performance metric that yields an inventory cost charge equal to the relevant costs, Baldenius and Reichelstein (2005) analytically show that use of a particular residual income performance metric results in efficient delegation. Their residual income measure deducts from income an interest charge for the value of all operating assets including inventory based on compounded historical cost, which ensures that the manager is charged the real production cost when inventory is sold, and based on the LIFO inventory flow rule, which first expenses the most recently produced inventory units. ...
... managers take their inventory management decisions by further advancing in the spirit of Baldenius and Reichelstein (2005), considering inventory management decisions from an incentive and control perspective. This implies that (1) the inventory management decision is delegated to an operations manager who has superior information and (2) the operations manager is evaluated by means of particular performance measures. ...
Article
This monograph introduces Management Accounting to Operations Management researchers and illustrates how unleashing this accounting information perspective into the world of Operations Management can improve our understanding of topics of interest to Operations Management researchers and practitioners. We start by offering a crash course in accounting terminology and then introduce the three important properties of accounting information (i.e. imperfect nature, endogenously determined, and multi-purpose). Next, we address four different areas in Operations Management: capacity acquisition and allocation, inventory management, production scheduling, and product design. For each of these areas, we describe the approaches used in Operations Management and Management Accounting and spend considerable attention on how using an accounting approach can spur progress in Operations Management.
... Ohlson, 1989 Ohlson, , 1995 Peasnell, 1981 Peasnell, , 1982 Martin, Petty and Rich, 2003; Magni, 2003), so we will make interchangeable use of the terms " excess profit " and " residual income " . In recent years residual income has given a renewed interest by several authors working in such different fields as accounting finance (Peasnell, 1981Peasnell, , 1982 Ohlson, 1995; O'Hanlon and Peasnell, 2002), applied finance (Stewart, 1991; Young and O'Byrne, 2001; Martin, Petty and Rich, 2003); management accounting (Rogerson, 1997; Baldenius and Reichelstein, 2005; Pfeiffer, 2004), financial mathematics (Peccati, 1989; Magni, 2000; Ghiselli Ricci and Magni, 2006), economic modelling (Magni, 2005). The notion has proved significant in its relations with the notion of value and the net-present-value concept: by summing the discounted value of the residual incomes of an economic activity one gets the net present value (NPV) (see Preinreich, 1938; Edwards and Bell, 1961; Lücke, 1955; Bodenhorn, 1964; Miller and Modigliani, 1961; Peasnell, 1981 Peasnell, , 1982 Peccati, 1987 Peccati, , 1989), which implies that the economic value of the asset itself may be computed with no recourse to cash flows, but only to excess profits. ...
... This NPV-consistency (aka conservation property) has been extensively used for constructing performance measures signalling wealth creation or wealth destruction in an economic activity, such as a company or a project. A performance measure is often used to reduce agency problems (Jensen, 1986; Meckling and Jensen, 1976), so residual income has been widely adopted as a key concept for devising management compensation plans aimed at inducing managers' optimal behaviour (see Rogerson, 1997; Mohnen, 2003; Pfeiffer, 2000; Baldenius and Reichelstein, 2005; Mohnen and Bareket, 2007). The use of this notion has also been advocated for tax policies: under the allowance-for-corporate-equity (also known as the imputed income method ) only excess profits are taxed, whereas normal returns to capital are exempt from corporate taxes (Boadway and Bruce, 1984; Rose and Wiswesser, 1998; Andersson et al., 1998. ...
Article
This paper presents an axiomatization of residual income, aka excess profit, and illustrates how it may univocally engenders fixed-income or variable-income assets. In the first part it is shown that, depending on the relations between excess profit and the investor's excess wealth, a well-specified theory of residual income is generated: one is the standard theory, which historically traces back to Hamilton (1777) and Marshall (1890) and is a deep-rooted notion in economic theory, finance, and accounting. Another one is the systemic value added or lost-capital paradigm: introduced in Magni (2000, 2003), the theory is enfolded in Keynes's (1936) notion of user cost and is naturally generated by an arbitrage-theory perspective. In the second part, the paper reverts the usual analysis: instead of computing residual incomes profits from a pattern of cash flows, residual incomes are fixed first to derive vectors of cash flows. It is shown that variable- or fixed-income assets may be constructed on the basis of either theory starting from pre-determined growth rates for excess profit. In particular, zero-coupon bonds and coupon bonds traded in a capital market are shown to be deducted as equilibrium vectors of residual-income-based assets.
... Suppose that net-revenues attainable from current capacity K T are given by some 30 As noted above, the omission of variable costs is without loss of generality. 31 Similar arguments apply in the inventory model of Baldenius and Reichelstein (2005), where a manager can store parts of the output produced in inventory. It is then incentive compatible to charge the manager for the historic cost of the units sold from inventory, even though those costs are sunk at the date of sale. ...
... They consider the traditional case of exponential depreciation and assume that the environment is completely stationary so that a stationary equilibrium level of capital stock exists in the sense that, if the firm begins at the stationary level of capital stock, then the firm optimally See Rogerson (1992) for an earlier, related, result. Papers that have generalized 7 Rogerson's(1997) result and applied it in a number of different settings include Baldenius and Reichelstein (2005), Baldenius and Ziv (2003), Reichelstein (1999, 2002), and Reichelstein (1997 Reichelstein ( , 2000). 7 maintains a constant capital stock by incurring a constant level of investment. ...
Article
This paper considers the profit-maximization problem of a firm that must make sunk investments in long-lived assets to produce output. It is shown that if per-period accounting income is calculated using a simple and natural allocation rule for investment, called the relative replacement cost (RRC) rule, under a broad range of plausible circumstances, the firm can choose the fully optimal sequence of investments over time simply by choosing a level of investment each period in order to maximize the next period's accounting income. Furthermore, in a model in which shareholders delegate the investment decision to a better-informed manager, it is shown that if accounting income based on the RRC allocation rule is used as a performance measure for the manager, robust incentives are created for the manager to choose the profit-maximizing sequence of investments, regardless of the manager's own personal discount rate or other aspects of the manager's personal preferences. (c) 2008 by The University of Chicago. All rights reserved..
... Good inventory management has hence become crucial to businesses as they seek to continually improve their customer service and profit margins, in the heat of global competition and demand variability. Baldenius and Reichelstein [4] offered perhaps the most convincing study of the contribution of good inventory management to profitability. They studied inventories of publicly traded American manufacturing companies between 1981 and 2000, and they concluded that "Firms with abnormally high inventories have abnormally poor long-term stock returns. ...
Article
Full-text available
We propose a robust optimization approach to address a multiperiod inventory control problem under ambiguous demands, that is, only limited information of the demand distributions such as mean, support, and some measures of deviations. Our framework extends to correlated demands and is developed around a factor-based model, which has the ability to incorporate business factors as well as time-series forecast effects of trend, seasonality, and cyclic variations. We can obtain the parameters of the replenishment policies by solving a tractable deterministic optimization problem in the form of a second-order cone optimization problem (SOCP), with solution time; unlike dynamic programming approaches, it is polynomial and independent on parameters such as replenishment lead time, demand variability, and correlations. The proposed truncated linear replenishment policy (TLRP), which is piecewise linear with respect to demand history, improves upon static and linear policies, and achieves objective values that are reasonably close to optimal.
... While the focus on investment decisions is predominant in the literature, recent contributions have dealt with several different kinds of decisions. As regards operations management, a significant contribution is Baldenius and Reichelstein (2005), where the authors examine efficient inventory management from an incentive and control perspective: the firm delegates decision-making to a manager who has superior information and affects sales revenues with his productive efforts. They propose to value inventory with a compounded historical cost valuation rule that capitalizes production costs and periodic holding costs and, in addition, treats inventory as an interest-accruing asset (i.e. the value of each unit remaining in ending inventory in a given period increases at the cost of capital i). ...
Article
This paper deals with the notion of residual income, which may be defined as the surplus profit that residues after a capital charge (opportunity cost) has been covered. While the origins of the notion trace back to the 19th century, in-depth theoretical investigations and widespread real-life applications are relatively recent and concern an interdisciplinary field connecting management accounting, corporate finance and financial mathematics (Peasnell, 1981, 1982; Peccati, 1987, 1989, 1991; Stewart, 1991; Ohlson, 1995; Arnold and Davies, 2000; Young and O’Byrne, 2001; Martin, Petty and Rich, 2003). This paper presents both a historical outline of its birth and development and an overview of the main recent contributions regarding capital budgeting decisions, production and sales decisions, implementation of optimal portfolios, forecasts of asset prices and calculation of intrinsic values. A most recent theory, the systemic-value-added approach (also named lost-capital paradigm), provides a different definition of residual income, consistent with arbitrage theory. Enfolded in Keynes’s (1936) notion of user cost and forerun by Pressacco and Stucchi (1997), the theory has been formally introduced in Magni (2000a,b,c; 2001a,b; 2003), where its properties are thoroughly investigated as well as its relations with the standard theory; two different lost-capital metrics have been considered, for value-based management purposes, by Drukarczyk and Schueler (2000) and Young and O’Byrne (2001). This work illustrates the main properties of the two theories and their relations, and provides a minimal guide to construction of performance metrics in the two approaches.
... In case productivity is constant, this allocation rule boils down to 1/ T k=1 1 (1+i) k which corresponds to the instalment of a T -year annuity whose present value is equal to one. In this operations management context, a significant contribution is Baldenius and Reichelstein (2005), who examine efficient inventory management from an incentive and control perspective: the firm delegates decisions on production to a manager who has superior information and affects sales revenues with his productive efforts. They propose to value inventory with a compounded historical cost valuation rule that capitalizes production costs and periodic holding costs and, in addition, treats inventory as an interest-accruing asset (the value of each unit remaining in ending inventory in a given period increases at the cost of capital i). ...
Article
This paper presents a new way of measuring residual income, originally introduced by Magni (2000a,b,c, 2001a,b, 2003). Contrary to the standard residual income, the capital charge is equal to the capital lost by investors multiplied by the cost of capital. The lost capital may be viewed as (a) the foregone capital, (b) the capital implicitly infused into the business, (c) the outstanding capital of a shadow project, (d) the claimholders’ credit. Relations of the lost capital with book values and market values are studied, as well as relations of the lost capital residual income with the classical standard paradigm; many appealing properties are derived, among which an aggregation property. Different concepts and results, provided by different authors in such different fields as economic theory, management accounting and corporate finance, are considered: O’Hanlon and Peasnell’s (2002) unrecovered capital and Excess Value Created; Ohlson’s (2005) Abnormal Earnings Growth; O’Byrne’s (1997) EVA improvement; Miller and Modigliani’s (1961) investment opportunities approach to valuation; Young and O’Byrne’s (2001) Adjusted EVA; Keynes’s (1936) user cost; Drukarczyk and Schueler’s (2000) Net Economic Income; Fernández’s (2002) Created Shareholder Value; Anthony’s (1975) profit. They are all conveniently reinterpreted within the theoretical domain of the lost-capital paradigm and conjoined in a unified view. The results found make this new theoretical approach a good candidate for firm valuation, capital budgeting decision-making, managerial incentives and control.
... The literature analyses accounting rules regarding their ability to achieve strong goal congruence (e.g. Baldenius and Reichelstein, 2005;Dutta and Reichelstein, 1999, 2002, 2005Dutta and Zhang 2002;Mohnen and Bareket, 2007;Pfeiffer and Schneider, 2007;Reichelstein, 1997Reichelstein, , 2000Rogerson, 1997;Wagenhofer, 2003). As a result, special accounting rules such as the relative benefit depreciation-scheme are required to achieve strong goal congruence. ...
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Purpose – The purpose of this paper is to outline the link between value creation, performance measurement and goodwill accounting according to the International Financial Reporting Standards (IFRS) and United States Generally Accepted Accounting Principles (US-GAAP). Since economic goodwill is identical to the present value of future residual income, the paper examines how accounting information gathered for impairment testing of goodwill according to International Accounting Standard (IAS) 36 and Financial Accounting Standard (FAS) 142 can be used for internal control purposes. Design/methodology/approach – The paper adopts common assumptions in the literature of residual income-based valuation and analytically derives a periodic performance measure of both value creation and its realization based on information available from impairment testing. Findings – This paper demonstrates that information required by IFRS and US-GAAP to evaluate a firm's goodwill can be used to design a performance measurement system which provides information about both value creation and realization of value. Practical implications – From a practical perspective, the paper shows that appropriate adjustments of data used in impairment testing result in information which ideally fits the requirements of an optimal performance measurement system. Originality/value – The paper presents a performance measure which provides information about the actual creation of value as well as its realization in a period and is superior to traditional residual income-based performance measures.
... As a consequence, the principal can use the accounting profit in the first period to performance measures (e.g. Baldenius and Reichelstein 2005, Dutta and Reichelstein 2005, Dutta and Zhang 2000, Mohnen and Bareket 2006, and Pfeiffer and Schneider 2006. Dutta and Reichelstein (2002) show that compensation contracts based on so-called goal congruent performance measures lead to first-best investment decisions if investment decisions are not associated with private costs to the manager. ...
Article
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This paper studies the impact of tightening accounting standards on an impatient manager's long-term investment decisions under earnings based performance evaluation. We analyze how the manager's possibility to influence current earnings will affect his investment decision-making. We examine a two-period agency model in which the manager's efforts during the first period have short- and long-term consequences. We find that tighter accounting regulation intensifies underinvestment problems. Tighter accounting standards increase the manager's personal costs of bringing forward investment project benefits, which results in reduced incentives for the manager to supply effort on investment activities. In turn, discretion in accounting standards allows managers to anticipate the future benefits of their investment decisions in their current performance measure. This result holds valid even when compensation contracts additionally include other performance measures than regulated accounting numbers.
... Good inventory management has hence become crucial to businesses as they seek to continually improve their customer service and profit margins, in the heat of global competition and demand variability. Baldenius and Reichelstein [4] offered perhaps the most convincing study of the contribution of good inventory management to profitability. They studied inventories of publicly traded American manufacturing companies between 1981 and 2000, and they concluded that " Firms with abnormally high inventories have abnormally poor long-term stock returns. ...
Article
Full-text available
We propose a robust optimization approach to address a multi-period, inventory control problem under ambiguous demands, that is, only limited information of the demand distributions such as mean, support and some measures of deviations. Our framework extends to correlated demands and is developed around a factor-based model, which has the ability to incorporate business factors as well as time series forecast effects of trend, seasonality and cyclic variations. We can obtain the parameters of the replenishment policies by solving a tractable deterministic optimization problem in the form of second order cone optimization problem (SOCP), with solution time, unlike dynamic programming approaches, is polynomial and independent on parameters such as replenishment lead time, demand variability, correlations, among others. The proposed truncated linear replenishment policy (TLRP), which is piecewise linear with respect to demand history, improves upon static and linear policies. Our computational studies also suggest that it performs better than simple heuristics derived from dynamic programming.
... Because carrying an excess amount of product is costly, most retailers strive to streamline their inventories (Eroglu and Hofer, 2011). Managers are incentivized to develop efficient inventory management (Baldenius and Reichelstein, 2005) and engage in lean inventory practices (Eroglu and Hofer, 2011). Efficient inventory management can help retailers obtain targeted levels of inventory turnover (Achabal et al., 2000), which measures how fast a retailer sells its inventory. ...
This research investigates the performance implications for retailers of having a chief stores officer (CSO) in the top management team (TMT). Using a matched sample consisting of 120 public retailers, we find that CSO presence is positively associated with 3 different performance metrics, namely, comparable store sales, profit per store, and Tobin's q. We also identify a partial mediating mechanism and find that CSO presence improves retailer performance through enhanced inventory turnover. Our results are robust to controlling for a series of TMT characteristics (such as chief marketing officer presence, chief operating officer presence, and TMT diversity), time-invariant unobservables at the retailer level, different measures of key variables, and alternate model specifications. As the first study that explores the phenomenon of CSO presence, our findings have important implications for public retailers on how to leverage marketing expertise in the TMT to improve performance.
... Good inventory management has hence become crucial to businesses as they seek to continually improve their customer service and profit margins, in the heat of global competition and demand variability. Baldenius and Reichelstein [3] offered perhaps the most convincing study of the contribution of good inventory management to profitability. They studied inventories of publicly traded American manufacturing companies between 1981 and 2000, and they concluded that " Firms with abnormally high inventories have abnormally poor long-term stock returns. ...
Article
Full-text available
We propose tractable replenishment policies for a multi-period, single product inventory control problem under ambiguous demands, that is, only limited information of the demand distributions such as mean, support and deviation measures are available. We obtain the parameters of the tractable replenishment policies by solving a deterministic optimization problem in the form of second order cone optimization problem (SOCP). Our framework extends to correlated demands and is developed around a factor-based model, which has the ability to incorporate business factors as well as time series forecast effects of trend, seasonality and cyclic variations. Computational results show that with correlated demands, our model outperforms a state independent base-stock policy derived from dynamic programming and an adaptive myopic policy.
... In contrast they point out that mark-to-market accounting generally does not provide efficient aggregation of raw information for the principal to solve the stewardship problem. Baldenius and Reichelstein (2005) examine inventory management from an incentive perspective. ...
Article
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The discussion on value-based performance measures is centered around the concept of residual income. The main property of residual income is its connection to capital budgeting and the net-present-value-rule. This property is, however, not sufficient to guarantee strong goal congruence between management decisions and the firm's objectives. So far, the literature suggests compensa-tion schemes based on modified accounting rules in order to induce the manager to make optimal investment decisions. In contrast, we show that strong goal congruence is also attainable by mod-ifying the compensation function. We develop an incentive scheme based on a bonus bank, which can be interpreted as a nonlinear contract. Within this concept, we provide a link between the incentive system and the actual creation of value, measured by a performance measure derived from Excess Value Created. European Business School Oestrich-Winkel, the 30th EAA (European Accounting Association) Annual Congress in Lisbon (2007), and the 4th EIASM (European Institute for Advanced Studies in Management) Workshop on Performance Measurement and Management Control in Nice (2007).
... While specific results on allocated customer consideration amounts are missing, analytical models on stewardship find cost accounting superior to fair value accounting under most circumstances ( Dutta and Zhang, 2002;Baldenius and Reichelstein, 2005). Kwon (2005) even suggests conservative accounting is superior since it motivates the manager to increase effort. ...
Article
Accounting scandals and deficiencies in standards have persuaded international accounting standard-setters to rethink revenue recognition. The proposals of the joint IASB/FASB-project Revenue Recognition feature an asset-liability approach relying on measurement at fair values or at allocated customer consideration amounts. This paper chooses construction contracts to illustrate and to evaluate the far reaching changes implied by the proposals in a multi period context. Main results suggest that the proposals are ambivalent in terms of relevance but critical in terms of reliability compared to the recent IAS 11. A pure fair value approach which yields irritating patterns of revenue recognition, is inappropriate for stewardship purposes, and unlikely to be adopted because of regulatory incompatibilities. Measuring performance obligations at allocated consideration amounts partly mitigates these concerns.
... One of the most important recommendations of the study is to abolish the accounting uniformity applied to the public business sector In the Arab Republic of Egypt for the different internal and external economic conditions surrounding it. Baldenius and Reichelstein (2005) aimed to examine the management of commodity inventory from an incentive perspective. The study showed that the manager obtains special information about the revenues that can be to achieve in the future, the entry for the remaining performed on the basis of historical cost, can to achieve optimal incentives taking into account management efforts as well as production decisions and selling. ...
Article
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This study investigates methods of evaluation of Inventory in the Industrial Companies in Taiz city of Yemen during the period 2015-2016. 70 questionnaires were distributed to the CFOs and officials on the stores and some accountants in industrial companies. Data analysis through the Statistical Package for Social Sciences (SPSS) was the use of scientific statistical methods "Frequencies and percentages". The results findings indicate that the industrial companies are used the automated controls on the inventory, not facing difficulties in the selection of the appropriate methods in the accounting of inventory, used the periodic inventory system, the weighted average method is the most commonly method, used the method of cost or market and in the process of inventory in the presence of chartered accountant and form a special committee. Based on the findings the study suggested that for consistency and uniformity all firms within the Industry should value and report their inventory using FIFO method.
... Petty, 2000; Arnold and Davies, 2000;Pfeiffer, 2000;Young and O'Byrne, 2001;Mohnen, 2003;Baldenius and Reichelstein, 2005;Mohnen and Bareket, 2007;Pfeiffer and Schneider, 2007); on the other hand, it is used for project/firm valuation (Preinreich, 1936(Preinreich, , 1937(Preinreich, , 1938Peasnell, 1981Peasnell, , 1982aPeccati, 1987Peccati, , 1989Ohlson, 1989Ohlson, , 1995Feltham and Ohlson, 1995;Lundholm and O'Keefe, 2001;O'Hanlon and Peasnell, 2002;Penman, 2007) owing to its lifespan consistency with the NPV: the sum of discounted residual incomes is equal to NPV (see Preinreich, 1936Preinreich, , 1938Lücke, 1955;Edey, 1957;Edwards and Bell, 1961;Bodenhorn, 1964;Peasnell, 1981Peasnell, , 1982aEdwards, Kay, and Mayer 1987;Peccati, 1989;Brief and Peasnell, 1996;Martin and Petty, 2000;Fernàndez, 2002;Martin, Petty and Rich, 2003;Pfeiffer, 2004;Magni, 2009Magni, , 2010a; however, periodic consistency does not hold in general (Egginton, 1995. But see Anctil, 1996;Anctil, Jordan and Mukherji, 1998, for exceptions) and ranking projects with RI is not equivalent to NPV ranking. ...
Article
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The internal rate of return (IRR) is a widely used benchmark for assessing the reliability of the accounting rate of return (ROA) as a measure of economic profitability. We turn this reasoning process on its head by demonstrating that a suitable (weighted average) aggregation of ROAs better captures what is generally meant by economic profitability than does the IRR. We show that average ROA when compared with the cost of capital, will always correctly signal economic profitability in the sense that it will correspond exactly with what would be obtained from a net present value calculation. We also show that average ROA can be used to make meaningful inter-firm comparisons of profitability, when due allowance is made for differences in investment scale. Using this framework, we show how average ROA can be used to assess economic profitability for a truncated time series where the opening and closing capital stocks provided by the accounting system do not adequately represent the firm’s initial and ending endowments of resources. Finally, we suggest how this approach can be put to practical use in assessing profitability of firms on an on-going basis.
... The underlying interrelationship between corporate strategy and inventory (Hitt and Ireland, 1985;Li, 1992;Tamas, 2000) has induced much of existing research to examine its main usual suspects. Examples of these usual suspects include volume and structure of inventories (Chikan, 1996), incentives for efficient inventory management (Baldenius and Reichelstein, 2005), parameters that impact on inventory policy (Borgonovo, 2008), efficacy of inventory (Barker and Santos, 2010), and determinants of inventory turnover (Gaur et al., 2005;Kolias et al., 2011). ...
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It is hypothesized in this study that the relationship between institutional ownership and inventory management is more likely to be moderated by other internal corporate governance mechanisms (i.e., managerial ownership, board leadership structure and board size). This is more likely to happen as one weak governance mechanism in one area will be offset by a strong one in another area. Furthermore, the effectiveness of one corporate governance mechanism (i.e., institutional ownership) is more likely to be contingent on some contextual variables. Econometric analysis, using a sample of Egyptian listed firms, provides strong evidence for the applicability of this theme and demonstrates that institutional ownership affects inventory management positively (negatively) when managerial ownership is high (low), CEO duality (non-duality) is in place, or board size is large (small). This conclusion is robust to the use of different control variables and econometric models.
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We examine a setting where the owner of a company delegates the authority to make overlapping capacity investments to an impatient manager. If the manager’s internal interest rate exceeds the owner’s cost of capital, a discrepancy arises between the owner’s and the manager’s perceived marginal cost of capacity, which is based on future cash flows associated with new capacity investments. This, however, leads the manager to capacity underinvestment. We argue that by using the performance measure residual income, in conjunction with particular depreciation rules, such as the relative practical capacity (RPC) depreciation rule, it is possible to avoid creating an underinvestment incentive for the manager. We begin by examining the effect direction of a deviation from the RPC depreciation rule on the manager’s perceived marginal cost of capacity, which is based on future cost charges associated with new capacity investments. We then analyze the magnitude of the distortion of the manager’s perceived marginal cost of capacity if the most convenient straight-line depreciation rule and the annuity depreciation rule are used. Thereby, we identify the bias in the manager’s perceived marginal cost of capacity between these depreciation rules. Finally, we analyze the effect of partial direct expensing on the manager’s perceived marginal cost of capacity and show that low levels of partial direct expensing can increase the objective congruence of the managerial performance measure residual income if the straight-line or the annuity depreciation rule is used.
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This paper considers the profit maximization problem of a firm that must make sunk investments in long-lived assets to produce output. It is shown that if per period accounting income is calculated by using a particular allocation rule for investment called the relative benefit and replacement cost (RBRC) rule, that, in a broad range of plausible circumstances, the fully optimal sequence of investments over time can be achieved simply by choosing a level of investment each period to maximize next period's accounting income. In the basic model, it is assumed that there is a single centralized decision maker so the role of the cost allocation rule is that it simplifies the seemingly-complex multi-period optimization problem by decomposing it into a series of simple single period problems. An extension to the basic model considers the case where shareholders delegate the investment decision to a better-informed manager. It is shown if accounting income based on the RBRC allocation rule is used as a performance measure for the manager, robust incentives are created for the manager to choose the profit maximizing level of investment regardless of the manager's own personal discount rate.
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Accounting measures are traditionally considered not significant from an economic point of view. In particular, accounting rates of return are often regarded economically meaningless or, at the very best, poor surrogates for the IRR, which is held to be “the” economic yield. Likewise, residual income does not enjoy, in general, periodic consistency with the project NPV, so residual income maximization is not equivalent to NPV maximization. This paper shows that the opposition accounting/economic is artificial and, taking a capital budgeting perspective, illustrates the strong (formal and conceptual) connections existing between economic measures and accounting measures. In particular, the average accounting rate of return is the correct economic yield of a project; the traditional IRR is (whenever it exists) only a particular case of it. The average accounting rate generates a decision rule which is logically equivalent to the NPV rule for both accept/reject decisions and project ranking. The paper also shows that maximization of the simple arithmetic mean of residual incomes is equivalent to NPV maximization, owing to its periodic consistency in the sense of Egginton (1995). Such an index may then be used for incentive compensation as well. Moreover, asset pricing may be interpreted in accounting terms as the process whereby the market determines the income impact on the assets’ value. As a result, the paper harmonizes the notions of accounting rate of return, internal rate of return, residual income, net present value: they are just different ways of cognizing the same notion. This conciliation stems in a rather natural way from three sources: (i) a fundamental accounting identity, which links income and cash flow in a comprehensive way, (ii) the definition of Chisini mean, (iii) a notion of residual income which takes account of the “real” (comprehensive) cost of capital.
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ABSTRACT 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. Copyright (c), University of Chicago on behalf of the Institute of Professional Accounting, 2009.
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This book explains why moral beliefs can and likely do play an important role in the development and operation of market economies. It shows why the maximization of general prosperity requires that people genuinely trust others - even those whom they know don't particularly care about them. It then identifies characteristics that moral beliefs must have for people to trust others even when there is no chance of detection and no possibility of harming anyone. It shows that when moral beliefs with these characteristics are held by a sufficiently high proportion of the population, a high trust society emerges that supports maximum cooperation and creativity while permitting honest competition at the same time. The required characteristics are not tied to any specific religious narrative and have nothing to do with the moral earnestness of individuals or the set of moral values. What really matters is how moral beliefs affect the way people think about morality. The required characteristics are based on abstract ideas that must be learned so they are matters of culture, not genes, and are therefore potentially capable of explaining differences in material success across human societies. This work has many theoretical and empirical implications including but not limited to social capital theory and trust-based economic experiments.
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More then just a textbook, A Theory of Incentives in Procurement and Regulation will guide economists' research on regulation for years to come. It makes a difficult and large literature of the new regulatory economics accessible to the average graduate student, while offering insights into the theoretical ideas and stratagems not available elsewhere. Based on their pathbreaking work in the application of principal-agent theory to questions of regulation, Laffont and Tirole develop a synthetic approach, with a particular, though not exclusive, focus on the regulation of natural monopolies such as military contractors, utility companies, and transportation authorities. The book's clear and logical organization begins with an introduction that summarizes regulatory practices, recounts the history of thought that led to the emergence of the new regulatory economics, sets up the basic structure of the model, and previews the economic questions tackled in the next seventeen chapters. The structure of the model developed in the introductory chapter remains the same throughout subsequent chapters, ensuring both stability and consistency. The concluding chapter discusses important areas for future work in regulatory economics. Each chapter opens with a discussion of the economic issues, an informal description of the applicable model, and an overview of the results and intuition. It then develops the formal analysis, including sufficient explanations for those with little training in information economics or game theory. Bibliographic notes provide a historical perspective of developments in the area and a description of complementary research. Detailed proofs are given of all major conclusions, making the book valuable as a source of modern research techniques. There is a large set of review problems at the end of the book.
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Stern Stewart's EVA framework for financial management and incentive compensation is the practical application of both modern financial theory and classical economics to the problems of running a business. It is a fundamental way of measuring and motivating corporate performance that encourages managers to make decisions that make economic sense, even when conventional accounting-based measures of performance tell them to do otherwise. Moreover, EVA provides a consistent basis for a comprehensive system of corporate financial management—one that is capable of guiding all corporate decisions, from annual operating budgets to capital budgeting, strategic planning, and acquisitions and divestitures. It also provides companies with a “language” for communicating their goals and achievements to investors—a language that the market is increasingly coming to interpret as a sign of superior future performance. The authors report that more than 300 companies have implemented Stern Stewart's EVA framework, including a growing number of converts in Europe, Asia, and Latin America. After describing significant behavioral changes at a number of EVA companies, the article focuses in detail on a single case history—that of auto parts manufacturer Federal-Mogul. Besides bringing about a dramatic change in the company's strategy and significant operating efficiencies, the adoption of EVA also led to an interesting change in Federal—Mogul's organizational structure—a combination of two large business units into a single profit center designed to achieve greater cooperation and synergies between the units.
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This paper provides a formal analysis of how managerial investment incentives are affected by alternative allocation rules when managerial compensation is based on accounting measures of income that include allocations for investment expenditures. The main result is that there exists a unique allocation rule that always induces the manager to choose the efficient investment level. The income measure created by this allocation rule is usually referred to as residual income or economic value added. Copyright 1997 by the University of Chicago.
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The paper studies the usefulness of accruals relative to cash flows for performance measurement in short-term contracts, if an agent undertakes activities with long-term and short-term consequences. It characterizes an optimal depreciation method for incentive purposes, and shows that it is not consistent with traditional depreciation methods. Rather, it aligns the performance measure with the expected long-term consequences of the investment, and shifts away compensation risk from the agent. The paper also identifies conditions under which accruals outperform cash flows as a performance measure even if the agent can manipulate the depreciation method.
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We consider a principal-agent model to examine the effectiveness of responsibility centers, in particular cost or profit centers. We show that rather than contracting with each agent directly, the principal can create equally powerful incentives by setting up a responsibility center structure. The principal contracts with only the ‘manager’ of the center and delegates contracting with other agents and coordinating their activities. The principal then must monitor some measure of financial performance such as the center's cost of profit. We also find that responsibility centers dominate direct contracting with the agents when communication is limited.
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This paper examines a multiperiod principal-agent model in which a divisional manager has superior information regarding the profitability of an investment project available to his division. The manager also contributes to the periodic operating cash flows of his division through personally costly effort. We demonstrate that it is optimal for the principal to delegate the investment decision and base the manager's compensation on the residual income performance measure. Our analysis points to a class of depreciation rules and to a particular capital charge rate which together ensure that a profitable (unprofitable) project makes a positive (negative) contribution to the residual income in every period. As a consequence, the compensation parameters for each period can be chosen freely so as to address the moral hazard problems without impacting the manager's investment incentives.
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this paper. In particular, I thank N. Melumad, D. Nissim, J. Ohlson, J. Panzar, W. Rogerson, X. Zhang and an anonymous referee for helpful suggestions.
The EVA revolution Corporate Finance <b>12</b&gt
  • A Ehrbar
  • B Stewart
EVA and Value-Based Management
  • D Young
  • S O Byrne
Inter-departmental cost allocation and investment incentives. Rev. Accounting Stud. <b>9&lt
  • D Wei