Question

Division managers are padding cost estimates so as to show​ short-term efficiency gains when the costs come in lower than the estimates. Which of the following statements correctly identifies the cost and possible solution for the agency problem in this​ case?  ​(Choose all correct​ responses.)

A. One agency cost is that money budgeted to cover the project proposal is not available to fund other projects that may help to increase shareholder wealth.
B. There is no agency cost in this problem.
C. One way to reduce the agency cost is to base the reward system on how close the​ employee's estimates come to the actual cost rather than having them come in below cost.
D. A reward system based on increasing shareholder wealth might motivate the division managers to make more accurate estimates in order to be able to take on additional profitable projects

Answer 1

A, C and D

Step-by-step explanation:

A - When you freeze money for future use in an investment project, you are losing money that could be earned doing something else at least until the new project starts (opportunity cost). So instead of freezing money the company should use it for other investments until it is needed.

C - A safe but ineffective way of always being below cost is to overestimate costs. So instead of rewarding employees for performing below cost is to estimate more "real" costs and rewarding employees for performing at the real cost levels.

D - Generally speaking top management receives bonuses when shareholders' wealth is increased, so the same practice can be done with middle management in order to motivate them.