Integrated capacity and marketing incentive contracting for capital-intensive service systems

Abstract

Capacity investment and capacity allocation have always been critical management decisions, especially in the presence of agency issue for capital-intensive and congestion-prone service organizations. Prior research has often modeled only one aspect of the issue, such as proposing internal pricing scheme for capacity allocation ignoring demand uncertainty and the influence of the manager, optimizing capacity alone ignoring the agency issue, or incentive contract design ignoring capacity limit and service delay. We show that simply employing a traditional incentive contract (which often ignores service delays) for the manager responsible for promoting a center's services will provide incorrect incentives and lead to a more congested and less profitable system. When firms focus on optimizing operational capacity alone, ignoring the impact of managers on service demand, they are able to maintain the optimal utilization and service quality by balancing capacity and delay costs. However, they forgo profit-increasing opportunities, as they ignore the impact of the optimal incentive contract and do not motivate the managers enough to boost demand. To tackle the management challenges faced by modern service centers, we take an integrated capacity-contracting approach by incorporating operational delays and capacity decisions within the incentive contract design. Embedding a queuing model in a general incentive contracting framework, we present a novel approach to deriving the optimal compensation contract and operational capacity for a service center. We illustrate in numerical examples that a Pareto improvement can be achieved with our integrated contracting approach because every party, from the firm to the manager, to customers, to equipment and software vendors, benefits.