CVP under uncertainty and the manager's utility function

Cost-volume-profit analysis has focused on the firm's short-run output decision assuming that the manager maximizes the firm's objective function rather than his or her own. This study argues that the decision problem facing the manager is to determine not only the level of output, but also the level of investment in risky assets in such a way that the expected utility of the manager's own end-of-period wealth can be maximized when the manager's wealth function is dependent on vested interests both within and outside of the firm, possibly in competition with the firm. Through analytical work, it is demonstrated that a change in fixed costs of the firm affects not only the production decision of a manager, but also his orher decision to invest in risky assets. The direction of this fixed cost effect depends on the particular type of risk aversion displayed by the manager. From the analytical work, five propositions are developed for empirical investigation in the future.The most helpful comments of Professor Cheng-few Lee are greatly acknowledged. We wish to thank anonymous referees who's comments have improved the paper. Furthermore, participants at the seminar at the University of Massachusetts Lowell also provided helpful comments.     

Cost-System Choice and Incentives—Traditional vs. Activity-Based Costing

We incorporate information and managerial incentives into the analysis of a common cost-management tool—activity-based costing (ABC). We study the choice of a costing system in a firm where the owners contract with a manager to use either a traditional or an ABC system and make production decisions. We show that, as commonly argued in managerial-accounting literature, in a first-best setting with no informational asymmetries the ABC system is always preferred to the traditional costing one. However, when the firm's manager has relevant private information, the owners' choice of a costing system is not as clear. We demonstrate that the firm earns higher expected profits under the ABC system when the uncertainty about the manager's private information is high. Conversely, the firm's expected profit is higher under the traditional costing system when the uncertainty surrounding the manager's private information is low because the gross benefits of better information provided by ABC are exceeded by the additional informational rents the owners must pay the manager under this system. Our results provide a formal explanation of the coexistence of traditional and ABC systems in practice.     

A Note on Deductible Insurance and Production

This paper examines the optimal production decision of a firm facing revenue risk. We show that the purchase of actuarially fair deductible insurance unambiguously induces the firm to produce more if the firm is not only risk averse but also prudent. If the firm's perferences satisfy constant absolute risk aversion, buying actuarially unfair deductible insurance unambiguously enhances production should the positive loading factor be sufficiently small. When there are moral hazard problems in that the firm's output cannot be contracted upon, we show that the purchase of actuarially fair deductible insurance unambiguously induces the firm to produce more if the firm's utility function is quadratic.     

The disclosure policy of the firm in an efficient market

This study analyzes the information content of the financial reports of the management-controlled firm in an efficient market. The firm's disclosure fulfills two roles: it is the basis of the principal-agent contract—stewardship role, and it is an input to the market price informativeness (decision making) role. Optimal disclosure is derived as the outcome of the firm's owner-manager-potential buyer game. The seller and the buyer maintain principal-agent relationships with the manager, who alone observes verifiable and unverifiable information on the value of the firm. The market's price of the firm, as well as the manager's compensation, depend on the firm's reports. The firm's owner directs the manager to report verifiable information, at least, (due to the threat of coalition forming) and stewardship information, at most. The market's reaction to the financial reports depends on the information available to the market prior to their release.     

Controlling Risk in Accounts Receivable Management

In granting trade credit, the credit manager must weigh the expected profit from a sale against the risk of customer default. A common procedure is to sell on credit only to those customers whose risk of default is below some critical level. This procedure does not effectively control a firm's ratio of bad debt to sales. In this paper, formulas are derived for the variance of this ratio under various assumptions regarding the number and size distribution of customers. Knowledge of this variance enables the credit manager to more accurately control his credit losses.     

A Generalisation of the Mean-Variance Analysis

In this paper we consider a decision maker whose utility function has a kink at the reference point with different functions below and above this reference point. We also suppose that the decision maker generally distorts the objective probabilities. First we show that the expected utility function of this decision maker can be approximated by a function of mean and partial moments of distribution. This 'mean-partial moments' utility generalises not only mean-variance utility of Tobin and Markowitz, but also mean-semivariance utility of Markowitz. Then, in the spirit of Arrow and Pratt, we derive an expression for a risk premium when risk is small. Our analysis shows that a decision maker in this framework exhibits three types of aversions: aversion to loss, aversion to uncertainty in gains, and aversion to uncertainty in losses. Finally we present a solution to the optimal capital allocation problem and derive an expression for a portfolio performance measure which generalises the Sharpe and Sortino ratios. We demonstrate that in this framework the decision maker's skewness preferences have first-order impact on risk measurement even when the risk is small.     

Dynamic preferences for popular investment strategies in pension funds

In this paper, we characterize dynamic investment strategies that are consistent with the expected utility setting and more generally with the forward utility setting. Two popular dynamic strategies in the pension funds industry are used to illustrate our results: a constant proportion portfolio insurance (CPPI) strategy and a life-cycle strategy. For the CPPI strategy, we are able to infer preferences of the pension fund’s manager from her investment strategy, and to exhibit the specific expected utility maximization that makes this strategy optimal at any given time horizon. In the Black–Scholes market with deterministic parameters, we are able to show that traditional life-cycle funds are not optimal to any expected utility maximizers. We also prove that a CPPI strategy is optimal for a fund manager with HARA utility function, while an investor with a SAHARA utility function will choose a time-decreasing allocation to risky assets in the same spirit as the life-cycle funds strategy. Finally, we suggest how to modify these strategies if the financial market follows a more general diffusion process than in the Black–Scholes market.     

Regulated Managerial Insider Trading as a Mechanism to Facilitate Shareholder Control

This paper shows that managerial insider trading, suitably regulated, reduces information asymmetry and helps shareholders better screen corporate decisions. In a setting where a firm's manager has private information about potential projects and his preferences differ from those of shareholders, I derive a unique perfect-sequential equilibrium (Grossman and Perry, 1986) where the manager's inside information is partially revealed through his voluntary purchase of the firm's stock, and shareholders screen investment proposals based on the revealed information. However, to make information revelation credible, the manager should be required to report his trading publicly and be prohibited from making a short-term reversal of his position.     

Revenue Recognition in a Multiperiod Agency Setting

This paper examines how various revenue recognition rules affect the incentive properties of accounting information in a stewardship setting. Our analysis demonstrates that if revenues are recognized according to the realization principle, a single performance measure based on aggregated accounting information can be used to provide desirable production and effort incentives to the manager. In contrast, mark-to-market accounting does not provide efficient aggregation of raw information to solve the stewardship problem. Mark-to-market accounting, though sensible from a valuation perspective, fails to provide desirable incentives because it relies on the anticipated, rather than the actual, performance of the manager. We also consider a setting in which the manager can control the timing of the firm's sales. It then becomes desirable to modify the realization principle and apply the lower-of-cost-or-market valuation rule. The desirable accounting thus exhibits a conservative bias.     

Managerial Ownership and Corporate Hedging

Abstract:  Using information on 443 UK non-financial companies, this work provides evidence supporting the hypothesis that managerial risk aversion is an incentive to deviate from the optimal hedging position. Conflicts of interest between shareholders and managers are at the centre of the decision about the firm's risk profile but are not relevant as determinants of the decision to hedge. This is rather associated with factors enhancing the firm's expected value (underinvestment, scale economies, tax savings).