A Decision Theory Approach to the Determination of Optimal Compensation Plan Structures

Abstract

Sales force compensation research has received much attention over the last few years. One of the major problems being addressed is the design of optimal sales force compensation plan structures, and especially determining the relative importance to be given to salary versus incentive pay (see for instance John and Weitz 1989). Starting with the pioneering article by Basu, Lal, Srinivasan, and Staelin (1985), agency theory has become the leading paradigm for analyzing this complex management issue. Unlike previous sales force compensation work, agency theory has allowed researchers to take risky situations into account. Because of a lack of information, or of unforeseen erratic events, selling situations are typically stochastic. Including risk into the sales force compensation problem was therefore warranted. According to the agency theoretic framework, management (the principal) devises an expected profit maximizing compensation plan, based on some knowledge of (1) salespersons’ utilities, (2) salespersons’ attitudes toward risk, and (3) the (stochastic) sales response functions to a salesperson’s selling efforts. As a result, salespeople (the agents) make decisions on their effort level and allocations, given their understanding of (1) the compensation plan imposed by management and (2) the (stochastic) territory sales response functions to their own selling efforts.