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

COST ALLOCATIONS AND INCENTIVE CONTRACTS

This paper addresses the simultaneous problems of determining input levels in a multidivisional firm and allocating the input costs to the divisions. A distinction analogous to that in economics between pure public goods and pure private goods is made between pure common inputs and pure private inputs. It is shown that for a pure common input, decentralization utilizing a full cost allocation can result in an efficient allocation of the input. Although efficient decentralization is possible in this case, the free-rider problem suggests that such an outcome is unlikely. In addition, it is shown that recently suggested allocation schemes base on game-theoretic concepts may not lead to an efficient allocation of pure common inputs.

This paper considers an intrafirm resource allocation model with a single principal and n agents. Each agent represents a division manager who uses a centrally provided input together with other inputs, including effort, to produce and sell final products. The principal represents an owner who is responsible for providing an input to the divisions. It is assumed that each agent (division manager) knows the local profit function for the division and has disutility for effort. The principal seeks to maximize firm-wide profits net of the costs of the centrally provided input and compensation to the agents. In this setting, which incorporates divergence of preferences and asymmetric information, it is shown that the principal and the n agents can strictly improve their welfare by moving from a set of compensation functions that do not include any allocation of costs to compensation functions that are based on cost allocation.

The question of why firms allocate costs for internal reporting has been brought to the forefront of accounting research. This cost allocation literature focuses on finding settings in which cost allocations arise as a part of optimal contracting, under conditions of asymmetric information and divergence of preferences. This paper presents a setting in which cost allocations are part of the optimal contract between the government and a firm supplying goods to the government. Conditions are provided under which an incentive contract (based on fully allocated costs) dominates a fixed-price contract (in which no allocation takes place) in the context of a bidding model for government procurement. It is shown that incentive contracts can dominate fixed-price contracts even when the government and potential suppliers are all risk-neutral, and thus when there are no benefits from risk-sharing per se. Thus, we provide an economic rationale for cost allocation.

The question of how, or even whether, indirect costs should be allocated for pricing decisions has been controversial and unresolved. This paper takes a step toward answering this question by examining the special case of a firm that must incur incremental fixed costs to complete any or all of the several projects for which it is submitting simultaneous bids. An independent private-values bidding model is employed to endogenously determine an optimal cost allocation; we term such a cost allocation ˇ§implicit.ˇ¨ The optimal implicit fixed cost allocation is shown to fully allocate fixed costs ex ante, although the fixed costs may be under, over, or exactly allocated ex post.

Firms that supply goods to the government often produce these goods in conjunction with other goods, incurring joint or common production costs. When the government uses costs as a basis for contracting with such firms, questions of cost allocation naturally arise. This paper presents, in the context of a bidding model, conditions under which a fixed-price contract is optimal (in the class of linear contracts) for the government. Under these conditions the problem of cost allocation is totally avoidable.

Recent research has refined the notion that a manager's evaluation should be based only on controllable measures of performance. In this paper, issues concerning contract form and controllability are addressed in the context of a procurement model based on that of McAfee and McMillan (Rand Journal of Economics, 17; 1986). A linear incentive contract that depends on: (1) an imperfect signal of non-controllable costs; and (2) total costs, is shown to Pareto dominate a contract based on total costs alone. Thus, some theoretical justification for the use of cost escalation clauses is demonstrated. It is shown that as observability of the non-controllable costs increases, the form of the optimal contract moves closer to a fixed-price contract, and the expected utility of both the purchaser and potential suppliers increases. Hence, a complete ranking for a class of costless post-decision information systems is provided. Separating out some of the non-controllable costs allows better risk-sharing and lets the purchaser sharpen the trade-off between the incentives to deal with the hidden action problem versus the hidden information problem.

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