Revenues or Profits; Performance Evaluation with Asymmetric Information

Ram T S Ramakrishnan, University of Illinois - Chicago

ABSTRACT: Aggregation of line-items in financial statements for performance evaluation is analyzed. A corporate center setting up control schemes to monitor divisional managers is modeled. The inputs to the production process are a central resource, whose expenses are publicly observed and a private effort input from the divisional manager. The state of the world also affects production and only the division knows the uncertain state. We derive the optimal contract which rewards the division as a function of the observed line-items, revenues and expenses. We show that separable line-item controls, where revenues and expenses are evaluated separately are also optimal. More importantly we explore the conditions under which aggregate-profit, revenue alone and expenses alone sufficient. The conditions are respectively whether marginal productivity of the central resource, marginal productivity of effort or marginal substitutability between effort and central resource are observable.

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