Does a leading indicator improve a firm’s profit?
Jumpei Hamamura
Faculty of Business Administration, Momoyama Gakuin University, Osaka, Japan

Abstract
Research question: The choice of performance indicator is critical in designing a performance evaluation ina company. In management accounting, performance evaluation of managers and not just internal employees isimportant, as the former are also noticed in proxy statements. A proxy statement does not only reveal theperformance indicators and the weight placed on each but also discloses the achievement of goals andcompensations of managers. For example, Coca-Cola Ltd., utilizes both a short-term performance indicator (netoperating revenue and operating income) and long-term incentive plan (net operating revenue, earnings pershare, free cash flow, and total shareowner return modifier) to evaluate managers1. From the example of CocaCola Ltd., it is evident that owners of companies attempt to control managers’ behavior by using performanceindicator.
In management accounting, the balance of short- and long-term decisions must be carefully considered.
When the company achieves stable long-term profit, the value and reputation of the company will improve inthe long term. This can help the company last long.
In these cases, a leading indicator is frequently adopted to monitor long-term performance. The
importance of these nonfinancial performance indicators about customers/consumers is suggested by empiricalmanagement accounting research. For example, Ittner and Larcker (1998) find that customer satisfaction is not
only an indicator of the future profit at the business-unit level but also at firm level. In addition, Banker, Potter,and Srinivasan (2000) find the same evidence from the hospitality firm’s archival time-series data.
Ittner and Larcker (1998) have a significant finding about the choice of managers’ performanceindicators. If performance indicators about the customer/consumer are useful for estimating the future profit at
the firm level, setting a customer-related indicator as a manager’s performance indicator helps predict a firm’sfuture profit and is useful for reducing managers’ myopic behavior. Therefore, customer-related indicators areeffective for controlling the behavior of a firm’s manager by encouraging a long-term decision.
Prior management accounting research demonstrates improvement of future profit by considering acustomer-related indicator empirically. Therefore, prior literature finds that customer-related indicators
estimates future short-term profit and does not focus on the firm’s long-term total profit. Shareholders preferthat the firm achieves stable profit to maximize the total profit among holding stocks. Therefore, this study
focuses on a firm’s total profit for the long-term and analyzes the usefulness of a leading indicator. From theabove discussion, this study considers the following research question (RQ):
RQ: Does a nonfinancial leading indicator theoretically improve the total profit of the firm with product market
competition?

1I obtain this information from Coca Cola’s Proxy Statement for 2019, p.11:

https://www.sec.gov/Archives/edgar/data/21344/000120677419000735/ko_courtesy-pdf.pdf

Methodology: This study analyzes this RQ through a game theoretical approach, assuming quantity
competition in a product market. Prior literature analyzes the performance evaluation of managers, assuming
product market competition. For example, relative performance evaluation is analyzed in this area (e.g.,Aggarwal and Samwick 1999; Hamamura and Hayakawa 2019). In relative performance evaluation research,prior studies explore the optimal performance evaluation system to include competitor’s profit in a manager’sobjective function.
In addition, Hamamura (2019) considers the competitor’s profit as an additional performance indicator.
Hamamura (2019) explores the behavior of a manager evaluated through a long-term perspective.
Moreover, some studies analyze objective function, which includes consumer surplus different fromrelative performance evaluation research. This study examines the contract of the manager with the owner,
which uses consumer surplus as a leading indicator by comparing the non-leading indicator case, assuming theuse of a performance indicator in Arya, Mittendorf, and Ramanan (2019).
Findings: In equilibrium, my model demonstrates that each firm includes consumer surplus to objectivefunction as a leading indicator in a specific economic condition. However, this equilibrium is not Pareto optimal
in a specific economic environment. Because the adoption of a leading indicator enhances demand-enhancing
investment in the first term which remains in effect in the second term, the profit on the second term will improve.
However, the profit on first term will decline as the manager has incentive for storing excess supply byemphasizing consumer surplus. Because the balance of these trade-off effects is altered by exogenous variables,
the total profits of each of the firms for the two periods decline in a specific economic environment. When thisresult arises, the combination of payoff is like the prisoner’s dilemma.
Implications: This result suggests important implications in designing a performance evaluation inmanagement accounting research. It is obvious that future profit is improved by a leading indicator, as supported
by Ittner and Larcker (1998) or Banker et al. (2000). However, excess competition may arise by the adoptionof a leading indicator in the first term. As a result, the profit in the first term will decline via the leading indicator.
Hence, owners must adopt a leading indicator by carefully considering the economic environment.
It is important that excess supply arises not as a result of excess cost. Certainly, while excess supply
increases the total cost of production and investment, the resulting cut in price has serious effects on a firm’s
profit in my model. Hence, the adoption of a leading indicator impacts product market competition in thisresearch, and the owner can choose the performance indicator by considering competition. While managers
ordinarily perform customer-friendly management to improve customer-related performance indicators withcostly investments, my result is obtained from the impact of excess supply.
References
Aggarwal, R., and A. A. Samwick. 1999. Executive compensation, strategic competition, and relative
performance evaluation: Theory and evidence. Journal of Finance 54 (6): 1999-2043.
Arya, A., B. Mittendorf, and R. N. Ramanan. 2019. Beyond profits: The rise of dual-purpose organizations andits consequences for disclosure. The Accounting Review 94 (1): 25-43.
Banker, R. D., G. Potter, and D. Srinivasan. 2000. An empirical investigation of an incentive plan that includes
nonfinancial performance measures. The Accounting Review 75 (1): 65-92.
Hamamura, J. 2019. Unobservable transfer price exceeds marginal cost when the manager is evaluated using abalanced scorecard. Advances in Accounting 44: 22-28.

Hamamura, J., and S. Hayakawa. 2019. The optimal choice of a relative performance indicator in productmarket competition. MPRA paper ID 93921.
Ittner, C. D., and D. F. Larcker. 1998. Are nonfinancial measures leading indicators of financial performance?
An analysis of customer satisfaction. Journal of Accounting Research 36 (Supplement): 1-35.