Cost‐System Choice and Incentives—Traditional vs. Activity‐Based Costing

We incorporate information and managerial incentives into the analysis of a common cost‐management tool—activity‐based costing (ABC). We study the choice of a costing system in a firm where the owners contract with a manager to use either a traditional or an ABC system and make production decisions. We show that, as commonly argued in managerial‐accounting literature, in a first‐best setting with no informational asymmetries the ABC system is always preferred to the traditional costing one. However, when the firm’s manager has relevant private information, the owners’ choice of a costing system is not as clear. We demonstrate that the firm earns higher expected profits under the ABC system when the uncertainty about the manager’s private information is high. Conversely, the firm's expected profit is higher under the traditional costing system when the uncertainty surrounding the manager’s private information is low because the gross benefits of better information provided by ABC are exceeded by the additional informational rents the owners must pay the manager under this system. Our results provide a formal explanation of the coexistence of traditional and ABC systems in practice.