Incentives for Efficient Inventory Management: The Role of Historical Cost

Abstract

This paper examines inventory management from an incentive and control perspective. We demonstrate that the residual income performance measure based on historical cost accounting provides managers with incentives to make optimal production and inventory depletion decisions. The lower-of-cost-or-market rule is shown to be effective in situations where inventory may become obsolete due to unexpected demand shocks. Our analysis also considers settings in which the unit variable cost of production can be lowered by initial investments. Proper incentives require that the depreciation charges for these initial fixed costs are independent of the actual production and sales quantities. Therefore, a variable costing format, rather than an absorption costing format, is essential for the purpose of managerial performance evaluation.