The Value of Distorting Overhead Cost Allocations in an Agency Setting

This paper shows a strict demand for a suitably chosen inaccurate overhead cost allocations in an agency model in which a profit center manager is in charge for production cost containment and pricing decisions. Given exogenous restrictions on the compensation scheme, the use of distorted overhead costs by transforming the performance measure into an quot;accounting profitquot;, helps calibrate incentives for the manager. The paper derives conditions for under- or overallocation of overhead costs to products. Generally, underallocation is preferable if the riskiness of quantity is not strongly positively related with price and unit cost of a product, or if the product is relatively more price-sensitive