Aligning Incentives in the Workplace: The case of sales-force compensation.

Before pursuing a career in academia, I had several jobs in the real world – or as real of a world as you can find in Las Vegas. One of the things I did was to analyze employee performance for the reservations department at a major resort. The primary job of these agents involved converting availability inquiries into reservations and upselling guests. In an attempt to improve the performance of the department, we decided to change the incentive scheme for new hires. Instead of just a fixed hourly wage, agents received a lower fixed hourly wage plus a sales commission in such a way that an average employee could expect to make the same amount of money. In addition to hiring new people onto this incentive structure, we also gave the incumbent employees an opportunity to switch over to the new incentive scheme with the option to switch back if they did not like it. A few interesting things happened.

  1. New hires had slightly higher conversion and higher upsells.
  2. Agents on the new incentive plan took fewer and shorter breaks.
  3. Agents on the new incentive plan converted the same rooms at lower average rates.
  4. While roughly 15% of over 100 incumbent employees tried out the new incentive scheme, only one stayed on past the trial period.

The first of these effects is what standard economic intuition would have one believe. The simple effect of aligning compensation with performance metrics that map to a firm’s profit should lead to an increase in the desired observable performance. This, in itself, is unsurprising. However, what is interesting is how some of the improvements were achieved.

The second and third effects illustrate the mechanism for improved sales performance more clearly. One way for reservations agents to convert more upsells is to be on the phone more. We observed many of the reps on commission pay regularly skipped half of their lunch, their 15-minute breaks, and rarely took restroom breaks in order to stay on the phone longer. While this behavior wasn’t bad from the employer’s perspective, it did bring into question the frequent long lunches, extra-long “15 minute” breaks, and multiple restroom breaks that fixed wage employees took.

The more alarming way that higher conversion and upsells were achieved is illustrated by the lower rates at which rooms of the same type were sold by commissioned versus fixed wage employees. After digging further into this phenomenon by monitoring converted calls, we found that some agents were defaulting to the fallback rate without offering the standard rate first. Even worse, agents were booking guests into special promotions that the guests had not received! In retrospect, since the agents knew that they would not usually get caught, and the type of individuals that tend to enjoy sales jobs are risk takers, it is only natural that some of the risks these employees took would include bending the rules.

The last effect we observed opened our eyes to an often-overlooked dimension of changing compensation. It seems the employees that we hired onto a fixed wage may have been of a different type than the ones we hired onto the commission based compensation plan. While these incumbent reps were on the commissioned scheme, they did not perform as well as the new hires, though they still on average made a higher income than they would have on a fixed wage. The self-selection of employees back into the flat wage shows that they may be better suited for that compensation scheme. Perhaps they are more risk averse, or perhaps they are worse salespeople. Regardless of the reason, this anecdotal evidence suggests that changing incentives to be more intuitively in line with the organization’s goals will not always lead to significantly better outcomes. It may depend on the type of employees you currently have, and the type of employees that your firm may be able to attract.

The type of compensation issue in the above example is generally referred to as an agency problem in the context of sales-force compensation in the economic theory literature (Holmstrom, 1979). The idea in this literature is that the underlying “effort” that an agent exerts can be (partially) unobserved though the outcome is fully observed. Furthermore, this literature assumes that agents cannot perfectly control their observable performance, have some risk-averse preferences for higher income, and a dislike for exerting effort. The assumptions are fairly realistic when we map them back onto our example. We cannot perfectly monitor that reps are doing their best to convert and upsell every call, but we see the outcome of converted sales. In addition, the agents cannot predict their commissioned income precisely, they prefer more money to less, but also don’t want to work as hard as possible because it is a draining task. The most basic theoretical result of this literature is that neither a fixed wage nor a straight commission will be optimal, but rather some mix of the two depending on the relative weights the agents place on income, risk aversion, and cost of effort. VALiNTRYcrm can help to help you identify needs and implement long-term solutions to grow your business.

This literature has subsequently found a home in the applied field of marketing (Basu, Lal, Srinivasan, & Staelin, 1985), where many more real-world settings that impact incentives have been studied. Recently, marketing scientists at Rochester and Stanford have found empirical evidence that salespeople dynamically alter their efforts in the presence of quotas, ratcheting (the setting quota levels based on past performance to fine tune quotas to sales potential), and bonuses (Misra & Nair, 2011). Their result suggests that distant incentives can affect an employee’s current effort in expectation of future consequences. For example, having to contend with the possibility of a higher quota in the next period due to drastically exceeding the current period’s quota can disincentivize salespeople from selling aggressively once the current quota is within reach. This richly studied field has taught us that there are many factors that affect individuals’ response to incentives and that often there are unintended consequences to the best-intentioned compensation schemes. Aligning incentives with your workforce is not as trivial a task as merely paying per unit of some measured of outcome.

What we can glean from my personal example and the academic research is that there is no simple solution when it comes to designing incentive-aligned compensation schemes. It really depends on your organization, the traits of your employees and potential hiring pool, and your ability to monitor and control undesired consequences. To successfully design incentives for your organization you must truly know your company.

References:

Basu, A., Lal, R., Srinivasan, V., & Staelin, R. (1985). Salesforce Compensation Plans: An Agency Theoretic Perspective. Marketing Science (4), 267-291.

Holmstrom, B. (1979). Moral Hazard and Observability. Bell Journal of Economics (10), 74-91.

Misra, S., & Nair, H. (2011). A structural model of sales-force compensation dynamics: Estimation and field implementation. Quantitative Marketing and Economics (9), 211-257.

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