Saleforce Compenation: An Analytical an Empirical Examination of the Agency Theoretic Approach Sanjog Mira, Anne Coughlan an Charavarthi Naraimhan 1 Forthcoming in Quantitative an Mareting Economic 1 Sanjog Mira: Simon School of Management, Univerity of Rocheter, Rocheter, NY 1467. (585)75-89. E-mail: mira@imon.rocheter.eu Anne T. Coughlan: Kellogg School of Management, Northwetern Univerity, 1 Sherian Roa, Evanton, IL 68-8. (847)491-719. E-mail: a-coughlan@ellogg.northwetern.eu Charavarthi Naraimhan: Olin School of Management, Wahington Univerity in St. Loui, Campu Box 1133, St. Loui, MO 6313. (314)935-6313. E-mail: naraimhan@olin.wutl.eu page 1
Saleforce Compenation: An Analytical an Empirical Examination of the Agency Theoretic Approach Abtract Since the paper of Bau et. al. (1985) an Lal an Srinivaan (1993), mareting acaemic have been interete in the eign an implementation of optimal compenation plan. The literature ha focue on agency theory a a founation to help ecribe an unertan thi proce. Although there ha been much theoretical wor on thi topic, empirical evience to upport thi theory remain pare. Stuie by Coughlan an Naraimhan (199) an John an Weitz (1988, 1989) have foun ome early evience that upport agency theory. In thi paper we reviit the iue of aleforce compenation on both theoretical an empirical front. On the theory ie we buil a game theoretic moel of aleforce compenation that account for ri averion on the part of both the principal an the agent. We further how that accounting for the firm ize within the analytical framewor yiel new inight into the nature of compenation eign. The reult obtaine from our moel, while ubtantiating pat fining, offer ome new inight into the compenation eign proce. In particular we fin that firm emographic play an important role in the eign of the optimal compenation cheme. We then ue two ataet collecte ten year apart by the Dartnell Corporation to invetigate an tet hypothee generate by our moel an the extant literature. Our reult how that the baic tenet of agency theory continue to hol over time an that our new theoretical hypothee are conitent with the ata. Uing the two ataet we alo fin that inter-temporal change in aleforce compenation coincie with the avent an aoption of new technologie. Our reearch thu a to our ubtantive nowlege of the river of aleforce compenation, while aing to the theoretical tructure through taing account of the poibility of principal ri averion. Keywor: Saleforce Compenation, Saleforce Management, Agency Theory, Game Theory page
I. Introuction Depite the emergence of new technologie an elling format, the importance of the aleforce a a mareting tool remain uniminihe. If anything, intenifying competition an the value place by conumer on face-to-face contact ha focue even more attention on the management of aleforce. Poibly the mot critical element in thi proce i the eign an implementation of an efficient an effective aleforce compenation plan. From the analytic founation in Farley (1964), Weinberg (1975), an many intervening piece of reearch uing a certainty perpective, the mechanic of compenation eign ha been tuie by mareter (Bau et. al. 1985; Lal an Srinivaan 1993; Joeph an Thevaranjan 1998) an economit alie (Holmtrom 1979; Holmtrom an Milgrom 1987) more recently from an agency theoretic perpective. In the pat ecae or o there have alo been ome attempt to empirically valiate the theoretical reult erive in the aforementione paper. Uing ata from the Dartnell Corporation, Coughlan an Naraimhan (199) fin upport for many hypothee rawn from agency theory an other economic-bae theoretical reearch. Other looing at the iue empirically inclue John an Weitz (1988, 1989), Krafft, Lal an Alber (1996), an Joeph an Kalwani (1998), among other. In thi paper, we propoe an analytic moel of aleforce compenation that exten the Lal an Srinivaan (1993) framewor by examining the cae of a ri-avere principal (firm) a well a a ri-avere agent (ale peron). In particular our formulation allow u to capture the impact of firm ize on the compenation contract it offer to the ale peron. Thi i important becaue a ey apect of the aleforce compenation ata i the high egree of heterogeneity in the ize of the firm. The hypothee we erive are conitent with thoe erive in earlier agency-theoretic For review of the aleforce compenation literature, ee Coughlan an Sen (1989) an Coughlan (1993). page 3
aleforce compenation moel, but a ome not previouly available. We ue our moel an the extant literature to propoe a more complete et of tetable hypothee concerning optimal total pay an the optimal plit between alary an incentive pay in the aleforce. We follow thi with an empirical invetigation of the factor governing aleforce compenation bae on our analytical moel. Our empirical analyi help ubtantiate (or refute) fining in the extant literature (e.g. Coughlan an Naraimhan 199; John an Weitz 1989). However, our wor oe more than imply replicate earlier reult. Firt, we are able to tet hypothee unavailable in earlier tuie, an thu expan our nowlege of the river of aleforce compenation. Secon, we provie a longituinal view on the river of aleforce compenation, letting u compare an contrat toay veru 1 year ago to ee if compenation i motivate by the ame factor over time. Our fining reveal that change in the technological an managerial environment are relate to change in the eign of aleforce compenation. In particular we note that the wie prea ue of information technology an the ecreae in cot of uch technology ha coincie with firm moving to more incentive bae compenation plan. Thir, by jointly etimating regreion uing (a) total pay an (b) the alary-to-total-pay ratio a epenent variable we are able to more preciely etimate the impact of the exogenou river on the incentive contract. The ret of the paper i organize a follow: In the next ection we review the aleforce compenation literature an follow thi with our analytical moel. After thi we ecribe our ata an variable operationalization. Following thi, we preent our etimation reult an a icuion of our fining. We conclue with a ummary an irection for future reearch. page 4
II. Literature Review The exiting analytical literature ha focue on the eign of the compenation plan in the preence of moral hazar (Holmtrom 1979; Shavell 1979) ariing from private information an lac of obervability of aleperon effort. Bau et. al. (1985) icu a two-part compenation cheme coniting of alary an a commiion on ale, an provie a theoretical bai for an analyi of the impact of uncertainty, ri averion, ale repone effectivene, marginal cot, an other parameter on the nature of the compenation cheme. Lal an Staelin (1986) exten thi by preenting an analyi that relaxe the ymmetric information aumption. Rao (199) provie an alternate approach to the problem. He analyze the iue uing a elf-election framewor with a heterogeneou aleforce. The aleperon pic a commiion level an a quota bae on her utility maximizing mechanim. While thee paper o invetigate optimal compenation, given a linear compenation cheme, they o not how the optimality of uch a cheme in general. In a path-breaing paper, Holmtrom an Milgrom (1987) how that, uner certain aumption, uch linear compenation cheme can inee be optimal. They o o uing a ynamic framewor with negative exponential utilitie an an unerlying Brownian motion that reflect the tochaticity of ale. Lal an Srinivaan (1993) ue thi framewor to moel aleforce compenation an gain ome intereting inight into ingle-prouct an multiprouct aleforce compenation. Holmtrom an Milgrom (1991) further introuce a theory of multitaing on the part of the agent, in which agent perform a number of ta that have ifferent iutilitie an affor them varying payoff. More recent analytic reearch aim at applying an extening the claic agency moel in variou irection, incluing competition, price elegation, multiple (ubtitutable or complementary) prouct, monitoring, an cutomer atifaction meaure of performance (ee page 5
Bharwaj 1, Zhang 1994, Joeph an Thevaranjan 1998, an Hauer, Simeter, an Wernerfelt 1994). A number of empirical reearch tuie have attempte to valiate theoretical fining generate in the tuie icue above. Interetingly, a large portion of the empirical wor one in the area of aleforce compenation i bae on tranaction cot analyi (Williamon 1975). John an Weitz (1989) an Aneron an Oliver (1987) are goo example. In another important empirical tuy, John an Weitz (1988) fin ignificant icor between agency theoretic hypothee an empirical reult. In particular they fin ignificant evience that i contrary to agency theoretic preiction about the relation between ri, uncertainty, effort effectivene an bae ale an the alary/commiion tructure. Ghoh an John () conuct a erie of experiment to explore the inurance incentive traeoff containe in the agency theory moel. They fin general upport for the agency theory preiction only in the cae when the agent are ri-avere an their effort i not verifiable. They conclue by tating that further wor i warrante to explore why the theory preiction o not hol when the agent are ri-neutral or when the effort exerte i verifiable. However, other invetigation have been more ucceful in valiating agency theory reult. Coughlan an Naraimhan (199) ue Dartnell Corporation urvey ata from 86 companie in 39 ifferent inutrie an fin broa upport for the agency-theoretic approach. Another tuy by Lal, Outlan an Staelin (1994) ue ata from a urvey of alepeople from three ale group within a ingle organization. Their reult alo trongly upport agency-theoretic hypothee. Joeph an Kalwani (1998) tuy the impact of environmental uncertainty on the eign of compenation plan an fin trong upport for the precription of agency theory a well. For a goo overview of the literature on incentive, pleae ee Penergat (1999). The literature thu provie a broa et of analytically erive precription on optimal compenation-etting, which are by an large upporte in empirical tuie (with the exception of page 6
John an Weitz 1988). However, ome iue remain to be attace. The iue of whether comparable reult can be foun over time, i.e., the robutne of the theoretical preiction, ha never been invetigate; we eal with thi in the current paper by analyzing ata from the Dartnell Corporation for 1986 an 1996, ten year apart. The theoretical literature ha not treate the cae of ri averion on the part of the principal a well a the agent, typically auming the principal to be ri-neutral both for analytical tractability an becaue of a belief that it i the ifference between ri attitue between principal an agent, rather than the abolute level of ri averion, that mattere. However, we analyze uch a moel in thi paper, an fin that the tanar moel reult turn out not to be robut to thi change in aumption. The reulting preiction better fit the ata on compenation practice a well. Finally, ome of the exiting empirical literature ha coniere both optimal total pay etting an the optimal etting of the ratio of alary to total pay, but never in a joint framewor that account for correlation between the two. We propoe an etimation framewor bae on a imulate metho of moment approach that account for the correlation between the two epenent variable, the cenoring iue in the ratio variable an the exitence of heterogeneity acro firm. III. Ri-Avere Principal an Scale Effect: Doe Firm Size Matter in Compenation Deign? The current theory on aleforce compenation (an the executive compenation literature in economic, accounting an finance) i bae on the aumption that a ri-neutral firm employ ri-avere alepeople. Conequently the extant theory mae an implicit aumption that a firm preference towar ri have no impact on the eign an management of compenation tructure. Auming that firm are ri neutral ha a long traition in the mareting, finance an economic literature. Thi aumption, bae on Fiher eparation theorem (193), argue that an page 7
otherwie ri-avere owner will mae eciion efficiently (i.e. in a ri neutral manner) an then inure againt ri in the financial maret, which are aume to be perfect. Note that even in Fiher realm the owner i not aume to be ri neutral but becaue financial (creit an capital) maret are perfect there i no reaon for the firm owner to act inefficiently by itorting the financial eciion with her ri preference. In other wor a firm action will eem ri neutral even if the owner i not. Thi aumption relie funamentally on the exitence an availability of perfect financial maret an without perfect financial maret the eparation theorem brea own. In fact Stiglitz (1) poit, in hi Nobel lecture, that thi i preciely why oberve firm behavior oe not conform to neo-claical economic theory. He argue that in the face of information aymmetrie, wea equity maret, an incentive eign iue, firm will ten to act in a ri-avere manner. Stiglitz alo a that thi ri averion cannot be manage away an will be reflecte in action. He ugget that ri-avere firm mae maller ajutment to variable the conequence of which are more uncertain. Such ri verion i liely to vary acro firm. We believe that a ey river of thi heterogeneity i firm ize an that firm ize i relate to a firm egree of firm ri averion. Evience ugget that there i a trong relation between a firm ize an it attitue towar ri. Thi view i hare by reearcher in the finance an inurance area. The following i an excerpt from Smith (1995): Neverthele ome firm have owner who o not hol well-iverifie portfolio. Thi i mot liely the cae in firm where ownerhip i concentrate. Thu in partnerhip, proprietorhip, an cloely hel corporation, ri averion of the firm owner can provie an important ri management incentive. Further, there i alo empirical evience in the ame literature that implie that maller firm will ten to be ri avere. For example, uing a ample of inurance firm, Mayer an Smith (198) how that larger firm ten to re-inure le. Preumably thi reflect a le intene eman for rireucing financial invetment, which in turn i conitent with a le ri-avere attitue. page 8
Converely, a tronger propenity to re-inure among maller firm i conitent with a higher egree of ri averion, uggeting that maller firm are more ri-avere than larger one. Alo note that in our urvey ample, many reponent are mall firm that operate in a local area an are privately hel (private 89%, public 11%). Such firm are liely to have le iverifie invetment than larger firm, an therefore to exhibit ri-avoiing behavior in the invetment in which their capital i concentrate. There i, therefore, aequate reaon to believe that thee firm are ri avere. Ultimately, compenation eign i a much about haring ri a it i about proviing incentive. It woul eem then that in any ri haring arrangement the ri preference of both partie houl be taen into account. At the very leat it woul eem worthwhile to examine the robutne of exiting contract theory by relaxing the aumption of the ri neutral firm. Firm ize i an important moerator of the pay-performance relationhip not only in the aleforce context, but alo in the empirical executive compenation literature (e.g., Larner 1966; Demetz an Lehn 1985; Jenen an Murphy 199; Hall an Liebman 1998). Compenation practice thu oe vary with firm ize. At the ame time, thi literature alo argue that larger firm ten to have a larger cale of operation that coul poibly lea to higher variance in their output; thi i not relevant for compenation policy uner an aumption of firm ri neutrality, but become important if firm are not purely ri-neutral. Further complicating thi iue i that larger firm might be more efficient; which in turn might lea to higher level of prouctivity an effort on the part of their employee. While thee argument ecribe a complex proce, they point towar the importance of unertaning the interaction an impact of firm ize an firm ri attitue on compenation policy. The ey iue, of coure, i not whether firm ize matter but how it matter. A mentione earlier, the compenation literature aume that firm are ri neutral. The argument behin thi aumption i that larger firm have hareholer who can hol iverifie portfolio an can page 9
therefore prea their ri acro negatively correlate ignal. While thi argument may hol for a hanful of large publicly hel firm, it oe not hol for the vat majority of mall buinee (for example, the ri averion of a ole proprietorhip i equal to that of it owner). In other wor, if we place firm on a ize-continuum, we houl expect maller firm to be more ri avere. We therefore aume that the firm i ri avere an moel it ri averion parameter a a negative function of firm ize. Note that the cae of a ri-neutral firm an a ri-avere aleperon i the bai for the prior analytic literature on agency theory. The cae of ri neutrality of both the firm an the aleperon i equivalent to the alreay-analyze cae of a eterminitic ale repone function an obervable aleperon effort. The cae of a ri-avere firm an a ri-neutral aleperon i not an intereting one, becaue in thi cae, the firm optimal behavior i to ell the firm to the aleperon, who will bear reiual ri in the firm without being overly conervative. However, the cae of ri averion on the part of both the firm an the aleperon ha not been coniere in the aleforce literature. By relaxing thi aumption, we are thu alo contributing to the agency theoretic literature on aleforce compenation. Firm ize ha an equally important effect on ale repone. Larger firm will not only have better reputation, tronger bran, larger mareting outlay, an more efficient ytem, but they will alo operate on a larger cale. A aleperon woring for a larger firm may be able to ell a broaer range of prouct, or may be able to gain acce to potential cutomer more eaily, than the aleperon woring for a maller firm. On the other han, larger firm may alo face greater variability in ale. We term thi cumulative effect the Scale Factor effect, an moel it by allowing firm ize to poitively affect the ale repone function. page 1
The Analytical Framewor Bae on the above icuion, we poit an agency-theoretic moel of aleforce compenation in which not only the aleperon, but alo her employer firm, i ri avere. The framewor alo explicitly allow for firm ize to affect both the firm ri averion an it cale of operation. We account for the cale effect by auming that the ale repone function i multiplie by a cale factor, g()>, where enote the ize of the firm, an where g ()>. We further account for the firm ri averion through a contant abolute ri averion (CARA) formulation with functional form R()>. Specifically, we aume that R() = ρ/g(), where ρ i the firm ri averion parameter. Thi aumption i intuitive in that it implie that the firm ri averion ecreae in the cale of it operation R ()<. We ue a linear effort repone function with normal error a i tanar in the literature (ee Holmtrom an Milgrom 1987 an Lal an Srinivaan 1993). Thu we can repreent ale (x) a (1) x = g ( h e ε ) with ε N σ () ~ (, ) where e i the aleperon effort level, h> i the bae level of ale (in the abence of aleforce effort), > i the marginal prouctivity of ale effort, an ε i the normally itribute error term in the ale repone function. Thi irectly implie that () ( ) x~ N g( ) h e, g( ) σ We now ecribe the aleperon optimization program. The ale agent i aume to be ri avere with contant abolute ri averion parameter r>. The aleperon utility function can then be characterize a (3) = K exp( rw ). U S W in (3) repreent net wealth, an K i a poitive parameter. Thi net wealth can be imply ecribe a Total Pay Cot of Effort. Holmtrom an Milgrom (1987) how that the linear compenation page 11
contract i optimal for thi problem. Therefore, W = α β x c( e), where α i the alary pai by the firm to the aleperon an β i the commiion rate. The function c(e) enote the iutility to the aleperon of exerting effort level e, an i capture by the formulation c e (4) = e, where >. In the above equation i the cot of effort parameter. Subtituting into the aleperon utility function an taing expectation, we arrive at the expecte utility function: (5) E( U ) [ K ( r{ x c( e) }) ] f ( x ) S exp α β = x Recognizing the relation between (5) an the moment generating function of the normal itribution, we can rewrite (5) a r E U S = K r α β E x c e β Var x (6) exp. Maximizing (6) i equivalent to maximizing the term inie the curly bracet. Thi i nown a the certainty equivalent. The aleperon then maximize her certainty equivalent, SCE, which can be ecribe a (7) r SCE = α β[ g( )( h e)] e β g( ) σ The aleperon maximize thi expreion with repect to e, which give u the following incentive compatibility (IC) conition efining the level of effort the aleperon will exert: β g (IC) β g() e = e =. In aition to the incentive contraint, the firm alo ha to enure that the aleperon mae at leat her reervation utility. Thi can be reflecte through the Iniviual Rationality (IR) contraint, ecribe by: page 1
(IR) SCE Wo, where W i the minimum certainty equivalent of the aleperon (or equivalently, her opportunity cot of time). The (IC) an (IR) contraint are both taen into account by the firm in it own profit maximization problem. The firm i aume to be a ri-avere profit-maximizing entity, alo characterize by a CARA utility function. In particular, we aume that the firm ri averion i capture by the function R(). We alo aume that the firm face a contant marginal cot, an without lo of generality we et that marginal cot equal to zero. One can then interpret ale a being repreente in ollar term. Following a imilar logic a in the aleperon cae, the firm certainty equivalent can then be enote by R () FCE = (1 β ) g( )( h e) α (1 β) g( ) σ. (8) [ ] The firm maximize FCE ubject to the contraint impoe by the contracting cenario. In the firt bet cae, thi involve only the iniviual rationality (IR) contraint, while in the econ bet cae, both the iniviual rationality (IR) an incentive compatibility (IC) contraint nee to be atifie. The olution an their interpretation are icue in etail below. The Firt Bet Solution In the firt bet olution, the firm ha the ability to oberve an hence inuce any eire level of effort by the aleperon. In previou reearch, uch a cenario i uually hown to reult in a forcing contract. However, thi reult oe not immeiately follow when the principal i ri avere. In the firt bet worl the firm problem i to maximize FCE over e an β. However the firm oe have to meet the (IR) contraint. We aume that the (IR) contraint i bining, implying page 13
r that α = W c() e β g() σ β [ g()( h e) ] implifying, we obtain the total certainty equivalent: (9) TCE g()( h e) e g(). Now ubtituting α into FCE an r R = β σ g() ( 1 β ) σ W. Maximizing thi with repect to β an e yiel: ( ) (1) β * = R R() ρ = () r ρ r g() ; * e = g ( ). Thi pair reflect the Pareto-optimal ri haring arrangement between the firm an the aleperon. The value of β * alo repreent the lower boun on the commiion rate. Any haring rule with a β below thi woul not be acceptable to the aleperon (it woul violate the (IR) contraint). Notice that ale repone function uncertainty (via σ) oe not play a role, ince effort i perfectly obervable. The haring rule (β * ) an effort have one common element, viz., firm ize. Alo notice that β * i zero for ρ= (a ri-neutral firm), while for any ρ> (a ri-avere firm), the β optimal compenation contract mut inclue commiion. Further, >, an β * 1 a ρ. ρ Thi i in contrat to the ri-neutral cae, where many contract (incluing the forcing contract) are poible. 3 The Secon Bet Solution While the firt bet cae ecribe an ieal cenario, in reality the effort of the aleperon i not perfectly obervable an hence not contractible. In the econ bet worl, the firm therefore cannot inuce the aleperon to put in the firt bet effort. Thi lea to a moral hazar problem (ince the aleperon now ha an incentive to hir) that caue the firm to tae account of the * 3 The forcing contract i in fact a pecial cae of our moel, obtaine by etting ρ=. page 14
incentive compatibility contraint (IC). Subtituting thi contraint (implicitly efine by () β g e = ) into the maximization problem epicte in (9), we have (11) TCE = g g() h r g () () β g() β σ () R g β () ( 1 β ) σ W Thi problem i imilar to the Lal an Srinivaan (1993) problem except for the penultimate term, which arie ue to the relaxation of the aumption regaring the principal ri neutrality. Maximization of TCE with repect to β give u (1) * R() σ g() ρσ β = = ( ( r R ()) σ ) g () ( ( gr () ρ) σ ) an e * * β g() = Note that when the firm can oberve the aleperon effort (in the firt-bet olution, given by (1)), the aleperon exert more effort an the commiion rate i lower than when the firm cannot oberve the aleperon effort (in the econ-bet olution, given by (1)). Alo note that when ρ=, we obtain the ame reult a Lal an Srinivaan (1993). We can ue the fact that SCE = W o to obtain the optimal α, which i now ecribe a * r * * * ( e ) g() ( β ) σ g()( h e ) * α = W β. * * * * Total expecte pay i T = α β g()( h e ), which can be implifie to (13) * * r * T = Wo e g() β σ. page 15
Thi equation highlight the fact that the aleperon total income i a um of the opportunity cot of hi time (W ), the cot of hi effort ( * e alo compute the ratio of alary to total pay a r g * ), an the ri premium ( () β σ ). We can (14) * * α π =. α* β* g ()( h e* ) Thi ratio ha wiely been ue a a epenent meaure in a number of empirical tuie (ee Coughlan an Naraimhan 199; Lal, Outlan an Staelin 1994). Dicuion of Comparative Static Before proceeing further, we firt analyze ome of the comparative tatic that emerge from our olution. In particular, we are interete in the effect of variou parameter on Total Pay (T * ) an the ratio of alary to total pay (π * ), ince thee are the epenent variable ue in our empirical analyi. Table A ecribe the comparative tatic of T * an π * with repect to the exogenou variable in the moel. Appenix A preent the etaile erivation of the comparative tatic effect. While mot of our comparative tatic are conitent with thoe foun in earlier literature (e.g. Lal an Srinivaan 1993), ome are not. Since the comparative tatic with repect to aleperon ri averion, opportunity cot an the bae level of ale are the ame a foun in the extant literature, we o not icu them here. 4 However, Table A oe offer ome new inight. 4 The reaer i referre to Bau et. al. (1985), Lal an Srinivaan (1993) an Lal an Staelin (1986) for more etail. page 16
Table A : Comparative Static Salary/ Total-Pay (π * ) (a) Total Pay (T * ) Firm Size () - (b) Firm Ri Averion (ρ) - Saleperon Ri averion (r) - (c) Variance (σ ) ~ () Opportunity Cot (W o ) Bae level of Sale (h) - Marginal Prouctivity () - Cot of Effort () - (a) (b) (c) () The ign in the cell inicate the change in the column variable with repect to the row variable. The ign hol uner reaonable retriction on the parameter pace. See Appenix A for etail. The ign hol uner reaonable retriction on the parameter pace. See Appenix A for etail. Thi erivative i negative for low value of the firm ri averion, but poitive when the firm i very ri-avere. See Appenix A for etail. Firt, we preict that firm ize ha a poitive effect on total pay, an a negative effect on the ratio of alary to total pay. In our moel, firm ize ha two effect: larger firm have larger ale per aleperon (becaue our ale repone function i moele a x = g( )( h e ε ) ), an larger firm are le ri avere than maller firm. Note from (1) that firm ize affect the aleperon marginal prouctivity of effort. Therefore, the aleperon put in a higher level of effort an, to compenate for thi effort, total pay mut increae. Becaue even baeline ale are larger at larger firm, a large firm alo optimally give the aleperon a more incentive-heavy pay plan than that offere by a maller firm. Secon, the incluion of the firm ri averion an cale effect allow u to invetigate how they affect optimal compenation in the moel. It i not urpriing that an increae in the firm ri averion parameter, ρ, ten to increae the preicte commiion rate (ee equation (1)). Conequently, thi alo reult in an increae in the optimal level of effort an ultimately in the total compenation pai to the aleperon. Further, a more ri-avere firm pay a lower alary than a le ri-avere firm oe. Thu, more ri-avere firm rely proportionately more heavily on page 17
incentive. Another important effect of moeling the firm a a ri-avere entity i that although the ign of many of the comparative tatic (e.g. aleperon ri averion) are the ame a thoe in earlier wor, the magnitue of their impact i now moerate by the firm ri averion parameter. The thir new reult pertain to the effect of uncertainty (σ ) on total pay. Note that we can write total pay a the um of the reervation utility, cot of effort an the ri premium. That i: r T W e g β σ * * * = o () * From equation (1), we can ee that both β an e * are ecreaing in σ.. If ρ=, then it can be hown that T * i alo ecreaing in σ (See Lal an Srinivaan 1993). However, if ρ i ufficiently large, total pay i increaing in σ. 5 In economic term, thi implie that if the principal i ufficiently ri avere, an increae in uncertainty lea to higher total pay ue to an increae in the ri premium caue by the incremental uncertainty. The fourth reult of note concern the impact of marginal prouctivity () an the cot of effort () on the ratio of alary to total pay (π). Lie Lal an Srinivaan (1993), we fin that thee two effect cannot be igne unconitionally. Lal an Srinivaan how that for a high bae level of π π ale (i.e. h large enough) the effect can be etermine (i.e. <, > ). In our more comprehenive moeling tructure, auming a large h alone i not ufficient to guarantee the ign of thee effect, but uner mot reaonable parameter value, we alo fin that the ratio of alary to total pay fall with an rie with. The new inight preente above help u gain aitional inight into the river of aleforce compenation. While affirming the tanar agency theoretic literature fining, we have page 18
alo unerline the complexity of the interaction between thee variable. In ome cae it might inee be ifficult to iolate the effect of the variable in quetion. Clearly, however, the ize an ri attitue of the firm cannot be trivially aume away. IV. Data an Variable Operationalization To tet the implication of the theoretical moel, we nee to operationalize the ey contruct. We now ecribe our ataet an the operationalization of our meaure. The ata come from the Dartnell Corporation' 1996-1998 aleforce compenation urvey (publihe in 1998). Thi i an annual urvey of aleforce manager, querying them about their compenation practice an the characteritic of their alepeople. The earlier Coughlan an Naraimhan (199) paper ue Dartnell' 1986 ata. Thu, thi invetigation provie an intriguing opportunity to invetigate the ynamic robutne of aleforce compenation practice acro time in a comparable et of reponent. However, the content an lit of quetion in the 1998 urvey o iffer from thoe in the 1986 urvey. Firt, entire ection on Quota an Payment Horizon 6 have been roppe. In our icuion with Dartnell, no particular reaon wa given for thi change; the eletion wa eviently purely bae on the quetionnaire length contraint. While thee ifference mae a fuller comparion between our analyi an that in Coughlan an Naraimhan (199) impoible, they are only tangentially relate to the ey contruct ue in thi tuy an in our opinion o not raically change the nature of reult. Our analyi therefore ue both ataet (1986 an 1996) to etimate our new moel an thu facilitate a clear unertaning of the ynamic change in U.S. aleforce g[ ρ > 8 8 rσ r σ rσ σ See Appenix A for etail of the erivation. 6 For etail of the 1986 urvey an ata, pleae ee Coughlan an Naraimhan (199). 5 4 Specifically, for, total pay rie with σ. page 19
compenation practice. Beyon thi, the ataet permit u to tet aitional hypothee not tete in the earlier wor, epecially the effect of firm ize. Data Decription an Dicuion Table 1 provie ecriptive tatitic of the ey variable ue in our analyi. We fin that while total pay ha increae, the ratio of alary to total pay ha marginally ecline over the ten year between the urvey ue. 7 During the ame perio training cot have ecline, training length ha increae, a ha the average tenure of a aleperon. Ae to thee i the fact the average number of call that it tae to cloe a ale ha alo been eclining. In the next few paragraph we icu the variable ue in our empirical analyi in more etail. Table report the itribution of firm ize in the 1986 an 1996 ample. The more recent ample contain a greater proportion of larger firm, but i not extremely ifferent in the range of firm ize repreente. Table 3 preent ummary tatitic for the ifferent experience level of alepeople in the firm urveye in 1986 an 1996. The U.S. Conumer Price Inex (CPI) roe 43. percent over the 1986-1996 perio, 8 while average total pay in the Dartnell ample roe by 51.6 percent, 46.5 percent, an 49. percent for experience, emi-experience, an trainee alepeople, repectively. Thu, aleforce pay increae overall beat the inflation rate by everal percentage point over thi time perio. Concurrently with the increae in total pay, all three clae of alepeople receive a lower proportion of total pay in alary in 1996 than in 1986. The epenent variable we ue in our analyi are Total Pay an the Ratio of Salary to Total Pay. The ratio of alary to total pay ha been ue in previou tuie (Coughlan an Naraimhan 7 While the table preent ollar figure a reporte, we alo examine the effect of ajuting them by the CPI to be comparable. All our reult an icuion hol for the CPI ajute meaure a well. 8 For a time erie of the Unite State CPI, ee http://www.bl.gov/cpi/home.htm. page
199; Lal, Outlan an Staelin 1994; John an Weitz 1989) a a meaure of the relative importance of incentive in the compenation plan. We ue everal inepenent variable in our analyi that relate to the agency theory contruct ue in our moel. The relation between our variable an thee contruct i ummarize in Table 4. For the ae of brevity we o not repeat the etail of the table in the text. Note, however, that the variable inicate by an ateri in Table 4 are the ame a thoe ue by Coughlan an Naraimhan (199). The et of variable we ue give u inirect evience uggetive of the role of firm-level ri averion in etting compenation. One ey variable that impact the tructure an nature of the ale compenation contract i Firm Size. An implicit aumption mae in mot empirical tuie i that firm are imilar in term of the cale of operation. However, thi i often not the cae, a Table how. Thi itribution of firm len ome creible jutification for the framewor ue in the theoretical analyi. We meaure ize of the firm by it ollar ale volume, which Dartnell urvey publihe a a categorical variable (a in Table 3). Bae on our theory, we preict that larger firm will offer higher total pay a well a a lower ratio of alary to total pay. V. Etimation Iue The Methoology The epenent variable π (proportion of alary to total pay) i boune between zero an one by virtue of being a proportion. Hence tanar leat quare metho will yiel biae etimate. To correct for thi we ue the Double Limit Tobit propoe by Coughlan an Naraimhan (199). Thi approach aume that the ata i cenore at both tail (pecifically at an 1). Since by efinition π cannot excee one or fall below zero it eem appropriate to conier the ata cenore. page 1
Since there are no tructural boun on the nature of the Total Pay variable we can ue orinary leat quare (OLS) to etimate the relevant effect. 9 Since our theory ugget that the effect of ize on compenation i complicate, we allow the ize effect to vary acro firm by allowing a normal mixing itribution to be place on the parameter that meaure the impact of ize on compenation. 1 In aition, we alo inclue a ranom effect on the intercept to account for other ource of potential heterogeneity. One lat econometric iue i the correlation that exit between total pay an the ratio of alary to total pay. The earlier empirical wor in thi area (uch a Coughlan an Naraimhan 199 an Outlan, Lal an Staelin 1994) ignore thi iue. By the very efinition an tructure of the contruct an timing of the eciion, there exit a correlation between the two regreion error. Allowing for uch correlation woul improve the efficiency of the etimation. We aopt a GMM proceure which account for thi correlation, ecribe in Appenix B. To ummarize, our etimation framewor: a) account for the ouble limit tobit nature of the alary to total pay variable; b) allow for heterogeneity in the Intercept an Firm Size effect; an c) allow for more efficient etimation by allowing for the eemingly un-relatene (correlation) of the two epenent variable. VI. Empirical Reult an Dicuion Our empirical analyi fin trong upport for the tenet of agency theory in general an our theoretical moel in particular. Mot of the variable exhibit ignificant effect an are generally in the irection we expect. Moreover, our approach to moeling the two apect of compenation 9 Pleae ee Figure 1 an in Appenix B for a epiction of the itribution of the two epenent variable acro the firm in the ata for 1996. 1 A an alternative, we tete variou functional form for the pecification of firm ize, an foun no qualitative ifference in the reult. Further etail of the etimation proceure are inclue in Appenix B. page
(Total Pay an Salary/Total Ratio) jointly reult in increae level of efficiency. 11 Thi improve efficiency i a irect reult of accounting for the inter-equation correlation, which i negative an ignificant in both ataet. Any unoberve variable that affect the total pay equation poitively (negatively) woul imply that the alary/total pay iturbance woul be negative (poitive) in general. While it i theoretically poible for the error to be poitively correlate, we upect that in general the correlation i liely to be negative. Temporal Shift in Compenation Deign Our ata offer a unique opportunity to tet whether compenation practice evolve over time ue to change in economic conition an firm characteritic. To acertain whether there were any ifference between the 1986 an 1996 ata at a global level, we conucte a pooling tet bae on ifference of Hanen J tatitic (Hanen 198; Ogai 1993.) The combine J-tatitic for the two ataet wa 7.4 while the poole ata moel obtaine a J-tatitic of 74.91. The ifference of the two tatitic i.49 an i aymptotically itribute a χ with one egree of freeom. We therefore conclue that pooling i rejecte at le than the.1 level. Thi fining i ignificant, a it implie that the ynamic of the 1986 an 1996 ata are ifferent. In particular it implie that the effect of the variable inclue in our moel on compenation are ifferent in the 1986 an 1996 ataet. Comparing the reult in Table 5a an 5b, we uncover ome noteworthy hift in compenation eign over time. For example, the compenation ifference between experience an le experience alepeople are le pronounce in 1996 than in 1986. While a enior ale rep till receive approximately $15,5 more in total pay than a new ale rep in 1996, the tructure of compenation for all rep i more incentive-riven than in 1986. Furthermore, the ratio of alary to 11 While etail are not reporte here becaue of pace concern, we fin that etimating the regreion eparately page 3
total pay of a enior rep i only 7% lower than that of a new rep in 1996, compare to about 1% in 1986, an the incentive ifference between enior an intermeiate alepeople ha been reuce. We conjecture that the change in compenation eign are relate to change in the technological environment between 1986 an 1996. Perhap the mot ramatic change uring thi perio i the wieprea aoption of information technology a a aleforce enhancement tool. During the ame time technology became cheaper an monitoring an training metho improve. Thee change are reflecte in the ecline in the training cot meaure in Table 1. More recently the tren ha continue an aleforce automation oftware ha allowe firm to better trac an monitor effort, while the wieprea ue of the Internet an other electronic communication ha increae prouctivity an lowere training cot. The impact of technology on elling an aleforce management i complex an there exit very little formal reearch on thi topic. Neverthele, there i enough evience to claim that technological enhancement in thi perio have manifete themelve in the form of a) Increae prouctivity (Increae cutomer information) b) Lowere monitoring cot (Eaier to trac ale people an activitie) c) A hift from non-elling to elling activitie (Time on non-elling activitie reuce) Our theory ugget that each of thee woul reult in an increae emphai on incentive (relative to alary). Thi i exactly what our ata reveal. Table 3 reveal that, for all level of experience, compenation i more incentive focue in 1996 compare to 1986. While we o not have ata from Dartnell for later year, a imilar tuy one by Sale an Mareting Management in 1- how a continue tren towar more incentive leverage compenation plan. The increae ue of the Internet for aleforce automation an management houl contribute to a continuation in the tren towar increae incentive. reult in ignificantly higher GMM objective function an tanar error. page 4
The Impact of Firm Size Some ey fining in our reult pertain to firm ize. Firt, we fin that firm ize i a critical eterminant of both compenation level an tructure. Thi i evience by the fact that the mean effect of firm ize i ignificant (albeit marginally o for the alary/total ratio in 1986) in all moel an it coefficient ign are eentially conitent with our theoretical preiction. Specifically, the mean coefficient for firm ize i negative in the alary to total pay regreion, an larger firm ten to pay more in total, both a per our theory. Secon, we oberve ignificant heterogeneity acro firm in the way firm ize impact compenation. All effect of firm ize alo exhibit ignificant variance which are fairly large. While computation of the poterior reveal that the marginal effect of ize i contrary to our theoretical preiction for a mall number of firm, 1 the fining overall upport our theoretical preiction an moreover highlight the importance of coniering ize in invetigation of compenation tructure. Generally peaing, thee fining o, however, unerline the nee for incluing firm ize an other factor relating to cale an firm ri averion in theoretical an empirical moel of aleforce compenation. The Effect of Other Variable A mentione earlier, mot of the coefficient ign are conitent with our theoretical preiction. The variable poitively correlate with our theoretical contruct of marginal prouctivity inclue Senior Dummy, Intermeiate Dummy an Training Length. We expecte each of thee to have a poitive effect on total pay an a negative effect of the alary to total pay ratio. The reult in Table 5a an 5b how that our expectation are met an the effect are ignificant. Interetingly, although our ecriptive tatitic how an increae in overall pay level from 1986 to 1996, they 1 See note (b) in Table A. For etail ee Technical Appenix. page 5
clearly how that the incremental premia in total pay ue to eniority have not increae, either for intermeiate or enior alepeople; a compreion effect in pay i evient. Further, the coefficient are maller in abolute value in the 1996 alary-to-total-pay regreion than in the 1986 one. Thi i conitent with the notion that firm are moving towar more incentive-heavy pay pacage, becaue of better monitoring abilitie. Since better monitoring reuce uncertainty in the effort-ale relationhip, it lea to increae reliance on incentive pay. The effect of the outie option on compenation i meaure by Service an Turnover. The greater the experience level of the aleforce an the higher the aleforce turnover in the firm, the higher are the opportunity cot for a aleperon (becaue on average, the aleperon i more ille, which ugget a greater ability to get another job; an becaue turnover ugget that people o in fact fin other job). Correponingly, one houl ee a higher alary component an a higher level of total pay for increae in thee two variable. The effect of Service i poitive an ignificant in the alary-to-total-pay regreion, a preicte: the more experience i the firm aleforce overall, the higher it alepeople opportunity cot of time i liely to be, an hence the more certain their pay houl be. Service alo ha a marginally ignificant poitive effect on total pay in the 1996 ata, again conitent with the theoretical preiction, but ha an inignificant effect on total pay in the 1986 ata. The weaer total pay effect coul be ue to the notion in agency theory that a more certain (more alary-heavy) pay pacage for a ri-avere aleperon nee not be a large a a more leverage one, becaue it certainty equivalent value i higher, ceteri paribu. We note that the effect of Turnover i inignificant in all of our regreion. There are two poible explanation for thi reult. On the one han, it might ugget that the turnover variable i an imperfect proxy for the opportunity cot of a aleperon, leaing to our wea reult. The other, more plauible, explanation i that our meaure of turnover i a very coare meaure an conequently, variation in it oe not capture the cro-ectional variation in our epenent page 6
variable. Specifically, the Dartnell turnover meaure i a hort-run meaure (of the amount of turnover thi year veru lat year in the firm), which may not have trong implication for the overall pay tructure. One variable that goe againt our theoretical preiction i the Call to Cloe variable, a proxy for the uncertainty of ale. We follow Coughlan an Naraimhan (199) in the interpretation of thi variable. The average number of call it tae to cloe a ale i higher for prouct an ervice that have longer elling cycle. In turn, prouct that exhibit longer elling cycle have weaer effort-ale lin an are more liely influence by other factor. Hence the Call to Cloe variable act a a proxy for the uncertainty caue by longer elling cycle an the influence of outie factor. Having ai that, we cannot rule out the poibility that Call to Cloe alo act a a meaure of effort cot. Since both the primitive contruct impact the epenent variable in the ame way, we cannot empirically ientangle the effect. Uner thi proxy efinition, we expect a higher alary to total pay ratio an alo higher level of total pay in firm with a greater average number of ale call neceary to cloe a ale. However, apart from the 1986 total pay regreion, where the coefficient i not ignificant (although wealy in the expecte irection), all other effect of thi variable are contrary to our hypotheize irection. One explanation for thee reult i the poibility that Call to Cloe partially meaure the aleforce marginal prouctivity, in the following way. Clearly, a elling job that require more ale call to cloe the ale provie more opportunitie to loe the ale, an hence increae the uncertainty in the elling proce, all other thing equal. A firm repone to thi reality may imply be to focu it more experience alepeople on the more uncertain account, or inee to hire an overall more experience aleforce. Uner thi cenario, theory ugget that the optimal pay plan woul promie a higher total pay level, but rely more heavily on incentive, a we fin in our reult. page 7
The control variable ue in our analyi inclue two factor relating to mareting expeniture by the firm an a ummy repreenting whether the firm wa involve with inutrial prouct, ervice an/or cutomer. We fin that in general, an increae in upporting mareting expeniture reult in higher total pay an higher alary-to-total-pay ratio. Thee might reflect eliberate action on the firm part to trae off incentive with other ale-upporting activitie uch a promotion, expene buget an technology that alo upport ale. The coefficient of the Inutrial ummy in the 1996 ata i generally in the ame irection a thoe coefficient poitively relate to marginal prouctivity. Many firm ealing in inutrial prouct an ervice require more capable alepeople, an thi appear to lea to higher an more incentive-riven compenation pacage. To ummarize, the reult of our empirical exercie provie trong upport for our theoretical moel. The reult are generally robut from 1986 to 1996, although ome preictor are more ignificant in the 1996 regreion. Firm ize, in particular, i hown to be a ignificant preictor of pay pattern, even in the preence of the other factor coniere in prior reearch. Heterogeneity among firm in their ize a well a unoberve factor play a trong role in the compenation tructure. VII. Summary an Direction for Future Reearch Thi paper mae theoretical, methoological, an ubtantive empirical contribution to the Mareting literature on aleforce compenation. On the theoretical front, we exten the theory preente in Lal an Srinivaan (1993) approach to inclue the poibility of a ri-avere principal (Lal an Srinivaan aume that the principal i ri-neutral while it agent i ri-avere). We are alo able to compare the influence of important contruct on incentive pay an total pay acro two time perio. We fin that while the influence of ome of the river change acro time, the page 8
irectional impact acro the two time perio are robut. We alo fin that the tren towar more incentive oriente plan coincie with avent an aoption of prouctivity enhancing technologie. On the ubtantive empirical front, our reult emontrate the robutne of the general agency theoretic approach to preicting aleforce compenation practice. All of the hypothee upporte in the extant literature continue to hol in the newer ata, uggeting that companie fin thee rule for etting compenation to be broaly applicable acro time. However, our reult alo inicate the value of incluing firm ize in the etimation, a potulate in our analytical extenion. A preicte, larger firm pay more than maller firm, an allocate a larger fraction of pay to incentive. Future reearch in the aleforce compenation area can tae variou irection. Dual itribution combine with team elling, where an employee aleperon an an inepenent agent join together to mae the ale effort, i an intereting an uner-reearche area. The effect of competition among manufacturer on optimal aleforce compenation i alo important to invetigate. Coniering aleforce effort along with other mareting mix effort uch a promotion coul further improve aleforce compenation-etting. Thee are jut a few of the intereting topic that future reearch (both on the analytic an empirical front) can focu on to he further light on aleforce compenation practice. page 9