Optimal Overhead Cost Allocation in an Agency Model with Moral Hazard and Private Information

Abstract

This paper develops a model of moral hazard and private information to explore the properties of efficient cost allocations. The production function uses two complement inputs: the agent’s effort and a resource supplied by the principal. After contracting, the agent receives non-contractible (private) information related to the productivity of the resource that is relevant to his effort level decision. The optimal cost allocation rate reflects the trade-off between the need to recover overhead costs and the need to provide incentives to the agent. It is shown that the optimal cost allocation charge is lower than the resource cost as a result of the need to compensate the agent for the uncontrollable risk. Further, the allocation rate might be negative or positive, depending on whether or not the effect of recovering overhead costs prevails over the incentive effect. When the agent uses two resources whose productivities are positively and strongly correlated, the optimal resource charge rate is higher than the resource cost. Interestingly, the reason for this is to expose the agent to less controllable risk. The results in this paper explain some empirical evidence related to cost allocation practice and to the relationship between risk and incentives.