PROFIT-SHARING AND STANDARD-SETTING IN PRODUCTION AND PROCUREMENT MANAGEMENT

This paper deals with the interaction between procurement and production management. The production costs crucially depend on the materials, components and subassemblies purchased by the procurement department, and on the effort expended by the production department. An agency model is utilized based on the Scanlon-Atkinson plans which share gains from production cost improvement after attaining pre-specified cost standard. The materials' quality is used to adjust the cost standards for the production department. It is shown that in both the first-best and second-best cases, profit-sharing compensation is always preferred to fixed salary by the risk-averse principal. Comparing with the first-best case, the principal has to provide a greater sharing pool in order to induce the managers' efforts, and each manager, in fact, works less hard in the second-best case. The agents' compensations are tied to their positions as well as their risk attitudes when the principal lacks a costless monitoring mechanism. The department of strategical importance is the one that benefits the most from such a circumstance. Agency cost is then considered as the expected value of getting a perfect monitoring mechanism. Detailed comparative statics are provided to suggest the principal ways of modifying existing compensation plans due to the changes of structural parameters.