Inter-temporal cost allocation and investment decisions

This paper considers the profit maximization problem of a firm that must make sunk investments in long-lived assets to produce output. It is shown that if per period accounting income is calculated by using a particular allocation rule for investment called the relative benefit and replacement cost (RBRC) rule, that, in a broad range of plausible circumstances, the fully optimal sequence of investments over time can be achieved simply by choosing a level of investment each period to maximize next period's accounting income. In the basic model, it is assumed that there is a single centralized decision maker so the role of the cost allocation rule is that it simplifies the seemingly-complex multi-period optimization problem by decomposing it into a series of simple single period problems. An extension to the basic model considers the case where shareholders delegate the investment decision to a better-informed manager. It is shown if accounting income based on the RBRC allocation rule is used as a performance measure for the manager, robust incentives are created for the manager to choose the profit maximizing level of investment regardless of the manager's own personal discount rate.