Incentives for Efficient Inventory Management: The Role of Historical Cost
Posted: 10 Jul 2005
This paper examines inventory management from an incentive perspective. We show that when a manager has private information about future attainable revenues, the residual income performance measure based on historical cost can achieve optimal (second-best) incentives with regard to managerial effort as well as production and sales decisions. The LIFO (last-in-first-out) inventory flow rule is shown to be preferable to the FIFO (first-in-first-out) rule for the purpose of aligning incentives. Our analysis also finds support for the lower-of-cost-or-market inventory valuation rule in situations where the manager receives new information after the initial contracting stage.
Keywords: Inventory management, historical cost accounting, decentralization, agency theory
JEL Classification: D82, J33, M41, M43, M44
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