Incentives for Efficient Inventory Management: The Role of Historical Cost

This paper examines inventory management from an incentive perspective. We show that when a manager has private information about future attainable revenues, the residual income performance measure based on historical cost can achieve optimal (second-best) incentives with regard to managerial effort as well as production and sales decisions. The LIFO (last-in–first-out) inventory flow rule is shown to be preferable to the FIFO (first-in–first-out) rule for the purpose of aligning incentives. Our analysis also finds support for the lower-of-cost-or-market inventory-valuation rule in situations where the manager receives new information after the initial contracting stage.