Martin P. Loeb
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Deloitte & Touche Faculty Fellow
Van Munching Hall 3351
Robert H. Smith School of Business
The University of Maryland
College Park, MD 20742, USA
Phone: (301) 405-2209

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Book

Managing Cybersecurity Resources: A Cost-Benefit Analysis

BUDGET-BASED CONTRACTING,

CAPITAL BUDGETING,

PROCUREMENT CONTRACTING,

AND ASYMMETRIC INFORMATION

This paper demonstrates that performance measures proposed by Ijiri, Kinard, and Putney (1968) may actually encourage dysfunctional behavior. One performance measure designed to evaluate a responsibility (profit) center is shown to penalize the center for taking certain profit-maximizing decisions. A second performance measure designed for use in negotiated procurement contracts is shown to reward the contractor for poor forecasts. Alternative performance measures are given which are consistent with the motivation of accurate forecasting and operating efficiency.

  • Loeb, Martin and Wesley A. Magat, ¡§Soviet Success Indicators and the Evaluation of Divisional Management,¡¨ Journal of Accounting Research, Spring 1978, pp. 103-121.

The paper aims at integrating the research on Soviet success indicators with the study of budget-based performance metrics in the accounting literature, and suggesting a new indicator for use in properly motivating enterprise or divisional management. It shows that, unfortunately, the Soviet success indicators motivate biased forecasts when these forecasts are used by central planners (corporate headquarters) to allocate capital among enterprises (divisions). The paper presents an alternative success indicator which motivates both accurate forecasts and efficient operating behavior. With the profit-sharing indicator, a manager's evaluation depends both on all other divisions' forecasts and on their realized profits; with the alternative indicator a manager's evaluation is independent of other divisions' realized profits. The paper also shows that no indicator truly ¡§solves¡¨ the problem of fully allocating total firm profits while also motivating divisions to report truthful forecasts, regardless of the forecasts of other divisions.

Conventional wisdom related to capital budgeting suggests that providing a project sponsor with an improved cash flow forecasting system should lead to higher firm value. Recent agent theoretic work related to the value of an information system makes such wisdom suspect. However, such work has implicitly assumed that, where communication between the subordinate and superior is allowed, it is used by the superior for control purposes only. We show that the value of providing a subordinate (e.g., project sponsor) with a new information and communication system is unclear even in a case where a superior (e.g., central management) uses communication for planning as well as control purposes. We also identify necessary and sufficient circumstances under which it is not beneficial to the superior to provide the subordinate with a new information and communication system under previous agency theoretic work, but is beneficial under our expanded analysis.

This paper focuses on the optimality of a purchaser using ex-post costs in compensating a supplier in the context of sole source procurement. Traditional agency work has shown that, under certain conditions, it may be optimal for an agent to be held responsible for uncontrollable outcomes. In this paper, limiting conditions are examined under which it would not be optimal for the purchasing firm to base the payment to the supplier on perfectly observable actual costs, even though the supplier has considerable control over these costs. It is also shown that the relative severity of the moral hazard and adverse selection issues leads to the relative domination of the fixed price contract and the cost-plus contract and that the optimal linear procurement contract approaches a fixed price (cost-plus) contract as the adverse selection problem decreases (increases) relative to the moral hazard problem..

Considered is a monopolist selling one product to a commercial market and a related, but distinct, product to the government. In the absence of sales to the government, the usual welfare loss associated with too little quantity being sold at too high a price arises. Using an agency model, the welfare consequences of using a cost-plus contract for procurement are examined. We show that such a contract exacerbates the welfare loss in the commercial market due to cost shifting motivated by cost allocation. We then turn attention to the use of a payment ceiling in connection with a cost-plus contract. Here we show that the payment ceiling reduces the welfare loss in the commercial market by motivating the monopolist both to increase commercial output and to lower the price. Additionally, the use of a payment ceiling is seen to reduce the moral hazard problem associated with cost-plus contracts.

Cost-plus procurement contracts are widely used by the government. Although prior studies have recognized that payment ceilings are a common element in cost-plus procurement contracts, these studies have not examined the endogenous determination or the welfare effects of such ceilings. In this paper, a simple agency model is used to examine the optimal level of a payment ceiling in the context of cost-plus contracting in sole source procurement. It is demonstrated that the optimal cost-plus contract with payment ceiling dominates the optimal cost-plus contract without ceiling. This is because the use of a payment ceiling has two benefits. First, the payment ceiling serves as a de facto means of delegating the decision as to whether or not the project should proceed. Thus, the contract with payment ceiling takes advantage of the supplier's private information. Second, the payment ceiling, along with the optimal choice of the fixed fee, helps to mitigate moral hazard problems associated with cost-plus contracting.

Although payment ceilings are a common feature of cost-based procurement contracting, literature examining the role of such ceilings is quite limited. This paper investigates the interaction among the optimal levels of a cost sharing parameter, a fixed payment parameter, and a ceiling parameter of a linear procurement contract with payment ceiling. The introduction of a payment ceiling to a linear contract generally has a number of effects on decision-making of a risk-neutral purchaser and a risk-neutral supplier. The introduction of the payment ceiling provides the purchaser with an additional tool to handle the adverse selection problem arising from the private information on cost held by the supplier. A measure of the variance of a zero-mean shock term now affects the decisions of the purchaser and supplier, as the payment ceiling makes the risk-neutral supplier's expected payoff concave. It is also shown that the purchaser may optimally set the ceiling at a level that may be more or less than the exogenously specified level of expected benefits from the project. Examples are provided in which the purchaser is strictly better off with the payment ceiling, although the ceiling may not always bind. The additional benefits to the purchaser of having a ceiling can exceed the information rents earned by the supplier in the model without the ceiling.

  • Gordon, Lawrence A., Martin P. Loeb, and Chih-Yang Tseng, "Capital Budgeting and Informational Impediments: A Managerial Accounting Perspective.¡¨ Chapter in Contemporary Issues in Management Accounting (Oxford University Press), A. Bhimini (ed.), 2006, pp. 146-165.

This paper reviews the capital budgeting literature around the theme of information impediments and discuses directions for future research. Three related streams in the capital budgeting literature, (1) the use of sophisticated methods for selecting capital investments (2) asymmetric information, and (3) post-auditing of capital investments, are viewed through the information impediments lens.

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