Leading Indicator Variables, Performance Measurement and Long-Term versus Short-Term Contracts

Leading Indicator Variables, Performance Measurement and Long-Term versus Short-Term Contracts

By Stefan J. Reichelstein, Sunil Dutta
2002Working Paper No. 1756

This paper develops a multiperiod agency model to study the use of leading indicator variables in managerial performance measures. In addition to the familiar moral hazard problem, the principal faces the task of motivating a manager to undertake soft investments. These investments are not directly contractible, but the principal can instead rely on leading indicator variables which provide a noisy forecast of the investment returns to be received in future periods. Our analysis relates the role of leading indicator variables to the duration of the managers incentive contract. With short-term contracts, leading indicator variables are essential in mitigating a hold up problem resulting from the fact that investments are sunk at the end of the first period. With long-term contracts, leading indicator variables will be valuable if the managers compensation schemes are not stationary over time. The leading indicator variables then become an instrument for matching the future investment return with the current investment expenditure. We identify conditions under which the optimal long-term contract induces larger investments and less reliance on the leading indicator variables in comparison to short-term contracts. Under certain conditions, though, the principal does better with sequence of one-period contracts than with a long-term contract.