Can We All Get Along? Incentive Contracts to Bridge the Marketing and Operations Divide

Abstract

The marketing and operations management arms in a firm must work in coordination: marketing efforts to create demand go to waste if supply is suboptimal, and vice versa. However, achieving this coordination has remained a long-standing problem, because in most firms these units are managed in a decentralized manner. A major source of conflict is that marketing compensation is usually heavily weighted towards whereas operations compensation is usually heavily weighted towards expense reduction. In this paper, we invoke agency theory to determine compensation plans for and operations managers to coordinate their activities in the best interests of the firm. We first show in a single product scenario that, by rewarding the manager for increasing and the operations manager for reducing total cost, a firm cannot coordinate the two functions. Furthermore, a simple profit-sharing contract does not work, either, because of the free-rider problem. However, we show that each of the following two contract schemes can always achieve coordination: (1) rewarding the operations manager separately for increasing and reducing costs, and (2) rewarding him separately for reducing missed and leftover supply. We thus show that choosing the right performance metrics (before choosing the contract parameters) can mean the difference between being able to align the interests of the salesforce with those of the firm and not being able to do so. We identify coordination between demand and supply as a new driver of compensation structure and find, for instance, that the commission for the manager, even in the presence of risk aversion, can increase with uncertainty in demand, a conclusion that runs contrary to results from classic agency theory. In a multiproduct scenario, when one manager manages several products, the coordinating contracts are fairly complicated. However, we show that choosing the right form of workforce allocation: either a sales-focused organization (a separate manager for every product, one operations manager for all products) or an operations-focused organization (a separate operations manager for every product, one manager for all products) can help a firm to achieve near-perfect coordination. This is in line with the observation that most firms have either a sales image or a cost image, and sheds some light on how the underlying objective of aligning marketing and operations, while keeping the size of the salesforce small and compensation contracts simple, can influence the organization of a firm.