Idle Capacity Expenses and Executive Bonus Compensation

This study examines whether boards of directors shield executive bonuses from the income-decreasing effects of idle capacity expenses (IDCEs). Using a sample of Taiwanese-listed manufacturing firms from 2009 through 2019, we find that reported income before IDCE is given more weight than IDCE in determining the average annual bonus level of executives, suggesting that bonuses are shielded from IDCE. Further analyses reveal that shielding executive bonuses from IDCE this year relates to better following-year capacity performance, as evidenced by more efficient capacity investments, better utilization of existing fixed assets, and less overproduction. Cross-sectional analyses show that higher agency costs are associated with less shielding from IDCE, whereas higher potential congestion costs are associated with more shielding from IDCE. Overall, this study provides evidence that boards design executive bonuses to mitigate agency conflicts arriving from explicit idle capacity reporting.