A Theory of Responsibility Centers

We consider a principal-agent model to examine the effectiveness of responsibility centers, in particular cost or profit centers. We show that rather than contracting with each agent directly, the principal can create equally powerful incentives by setting up a responsibility center structure. The principal contracts with only the "manager" of the center and delegates contracting with other agents and coordinating their activities. The principal then must monitor some measure of financial performance such as the center's cost or profit. We also find that responsibility centers dominate direct contracting with the agents when communication is limited.