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A STRATEGY FOR RISK REDUCTION IN INCENTIVE CONTRACTING *
Author(s) -
Gandhi Devinder K.
Publication year - 1979
Publication title -
decision sciences
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.238
H-Index - 108
eISSN - 1540-5915
pISSN - 0011-7315
DOI - 10.1111/j.1540-5915.1979.tb00032.x
Subject(s) - incentive , viewpoints , microeconomics , profit (economics) , cost reduction , risk analysis (engineering) , computer science , business , economics , marketing , art , visual arts
An important question with respect to government incentive contracts that has received little attention is: What alternatives to the current practice of making single‐stage choices of incentive sharing rates can lead to situations in which these sharing rates can be chosen under reduced risk or cost uncertainty? This paper provides a decision‐theoretic framework that illustrates a possibility of reducing risk, from the viewpoints of both the contracting parties, given some negotiated estimate of costs to be incurred. It is shown that such a possibility can arise in a situation in which it is technically feasible to separate or partition the contractual work into closely related tasks or units. Specifically, it is demonstrated that for a given cost estimate (target cost) and target profit, a set of optimal sharing rates (one for each unit) yields a higher risk‐adjusted value of the contract than the single‐stage sharing rate for the entire contract.