Salesforce Compensation with Inventory Considerations

Abstract

We study a scenario in which a firm designs the compensation contract for a salesperson who exerts effort to increase the level of uncertain demand and, jointly, the firm also decides the level of inventory to be stocked. We use a newsvendor-type model in which actual sales depend on the realized demand but are limited by the inventory available, and unfulfilled demand cannot be observed. Our study provides a number of surprising insights for both salesforce compensation and inventory management, attributable to the interplay between them. With regard to the compensation contract of the salesperson, we find that the presence of inventory considerations can lead to the firm choosing a higher-powered incentive contract as compared to the situation in which inventory considerations are absent. Interestingly, increasing demand uncertainty leads to a higher-powered contract for the salesperson. With regard to inventory management, we find that, to increase the observability of the effort of the salesperson, the firm can find it optimal to over-stock inventory compared to the first-best level, and this happens only when inventory cost is in a medium range. We also obtain other interesting results. For instance, as the cost of inventory increases, the firm may pay the salesperson a larger reward for clearing a lower level of inventory.