Date of Original Version

6-2007

Type

Working Paper

Rights Management

All Rights Reserved

Abstract or Description

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 sales whereas operations compensation is usually heavily weighted towards expense reduction. In this paper, we invoke agency theory to determine compensation plans for sales 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 sales manager for increasing sales 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 sales and reducing costs, and (2) rewarding him separately for reducing missed sales 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 characterize how the parameters of the optimal contracts vary with product and demand characteristics. For instance, we find that when costs are high, the sales commission for the sales manager can increase with uncertainty in demand, a result which 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 simple contracts, which we characterize as either a sales-focused organization (a separate sales manager for every product, one operations manager for all products) or an operations-focused organization (a separate operations manager for every product, one sales 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.

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