Integrating Externalities Into Incentive Design in Multidivisional Firms

ABSTRACT Interdivisional externalities are largely overlooked in the incentive design for division managers aimed at solving capital allocation inefficiencies in multidivisional firms. We model the allocation problem and demonstrate how neglecting externalities leads to a distorted corporate objective function. We propose an optimal incentive scheme based on a corporate objective that accounts for externalities. This optimal incentive scheme promotes overall firm performance while also providing individual‐based rewards. It incentivizes division managers to be truthful in the communication process with headquarters, thus facilitating optimal capital allocation. The model is easy to implement and yields a unique incentive package for each division manager.