Appendix: Each partner in a simple profit-sharing contract that splits the independently verifiable sales revenue minus unobservable cost has an incentive
A) to reject an automatic renewal of the contract
B) to understate fixed cost
C) to overstate avoidable cost
D) to understate customer loyalty for repeat purchases
E) to renew the partnership contract

Question

Quizplus · Accepted Answer

Each partner would try to maximize their share of the profit by maximizing their own performance and minimizing their own costs. However, in a profit-sharing contract that splits the independently verifiable sales revenue minus unobservable cost, partners would have an incentive to overstate avoidable costs, which are the costs that can be reduced or eliminated by changing business practices. This would lead to a lower profit for the partnership, and both partners would ultimately lose out on potential profits. Therefore, choice C is the best option.

Appendix: Each Partner in a Simple Profit-Sharing Contract That Splits