Managerial incentives for capacity investment decisions

Abstract

In a setting where the owner of a company delegates the authority to make overlapping capacity investments to a manager, the decision on such investments depends on how the decision-maker perceives the marginal cost of capacity. This covers the cost for one additional unit of capacity made available for only one period of time, although expenditures for capacity investments are a common cost of capacity that can be used over multiple periods. If the manager’s performance measure is residual income, the level of the marginal cost of capacity and the associated investment incentives depend on the applied depreciation schedule and the manager’s time preferences. We examine the direction of the effect of several depreciation schedules on the marginal cost of capacity that the manager perceives and analyze the extent to which this cost is distorted. Our analysis shows that a performance measure based on residual income, combined with several practically relevant depreciation schedules, creates the desired investment incentives for the manager, because differently structured depreciation schedules have a relatively small effect on the level of the marginal cost of capacity. We also examine how partial direct expensing can increase the objective congruence of residual income as a managerial performance measure if the straight-line depreciation schedule or the annuity depreciation schedule is used.