Inventory related compensation in decentralized organizations

Abstract

We consider a principal agent problem in a decentralized organization. The agent holds private information with respect to an uncertain demand within a single selling season. As such his task is to determine the optimal order quantity. Being head of a profit center, however, he naturally focuses on maximizing profit of his particular unit while the principal aims at maximizing long run firm value. This goal incongruency results in a systematic shortfall of order quantity chosen by the agent as opposed to the strategically optimal level.

We show that a menu of contracts offered to the agent to pick from is suitable to solve the agency problem and to achieve first best outcomes. Each contract specifies a fixed payment and a bonus or a penalty, conditioned on the inventory level at the end of the selling season, along with a prescribed order quantity. An exogenously given profit share is added to reflect the assumed profit center structure. Omitting any of the contracting elements specified above, however, destroys first best. The paper not only demonstrates that first best can be achieved in the described setting, it also provides a theoretical explanation for the widely observed practice of using inventory related compensation elements in organizations.