Intertemporal 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 using a simple and natural allocation rule for investment, called the relative replacement cost (RRC) rule, under a broad range of plausible circumstances, the firm can choose the fully optimal sequence of investments over time simply by choosing a level of investment each period in order to maximize the next period's accounting income. Furthermore, in a model in which shareholders delegate the investment decision to a better-informed manager, it is shown that if accounting income based on the RRC allocation rule is used as a performance measure for the manager, robust incentives are created for the manager to choose the profit-maximizing sequence of investments, regardless of the manager's own personal discount rate or other aspects of the manager's personal preferences.