Optimal Compensation Under Inventory Delegation and Supply/Demand Mismatch

Abstract

Problem definition: We study how a firm should design its compensation plan to include both the sales performance and the operational performance (i.e., the supply/demand mismatch), for its sales division, who not only exerts unobservable demand-enhancement efforts but also makes the inventory ordering decision based on her private information about the local sales territory. Methodology/results: We build on the classical agency model by incorporating the supply/demand mismatch and inventory ordering delegation. We derive the closed-form expression for the firm's optimal compensation scheme in the most general contract space and show that it takes a simple form, coupling the classical linear compensation scheme with a compensation component contingent on some operational metric. Managerial implications: First, the firm should include a compensation component that is tied to operational metrics such as the sales division's leftover inventory and the unfulfilled demand. Second, the optimal compensation scheme needs to be adapted to the distinct operational features such as demand being censored or not, lost sales or backorder. Third, the optimal compensation scheme possesses the property of piece-wise linearity in demand (or sales) with a drop in the commission rate after demand exceeds the available inventory. This is in contrast not only with the classical linear compensation scheme, but also with the quota-based compensation scheme featuring a progressively increased commission rate when the demand exceeds a prespecified quota.