The Effect of Earnings-Based Metrics on Vertical Efficiency
Version of Record online: 30 DEC 2009
© 2009 Production and Operations Management Society
Production and Operations Management
Volume 19, Issue 4, pages 406–417, July/August 2010
How to Cite
Arya, A. and Mittendorf, B. (2010), The Effect of Earnings-Based Metrics on Vertical Efficiency. Production and Operations Management, 19: 406–417. doi: 10.1111/j.1937-5956.2009.01111.x
- Issue online: 14 JUL 2010
- Version of Record online: 30 DEC 2009
- History: Received: August 2008; Accepted: August 2009, after 2 revisions.
- supply chains
The tendency to rely on accounting earnings as the primary metric of corporate performance has been subject to criticism in recent times. A key concern is that earnings misrepresent changes in value in that cash outlays occur upfront but expenses are recognized only over time. While recognized expenses indeed add up to the initial cash outflow, the equality holds only in undiscounted (nominal), not discounted (real), terms. Accordingly, corporate earnings figures suffer from a form of money illusion. In this paper, we demonstrate that such money illusion can have an upside when it is present in vertical relationships subject to self-interest. In particular, a buyer who focuses on earnings has incentives to increase purchases since it does not immediately encounter the full cost of cash outflows. These added incentives can promote more efficient trade. We also show that the increased incentives to buy can also lead to Pareto improvements by spurring the supplier to invest more in developing technology. Finally, we demonstrate that judiciously chosen inventory valuation rules can lead to efficient supply chain outcomes. Thus, efficiency can be achieved when supply chain parties freely trade and regulators specify only the accounting rules under which they operate.