Homogeneous Contracts for Heterogeneous Agents: Aligning Sales Force Composition and Compensation

Observed contracts in the real world are often very simple, which partly reflects the constraints faced by contracting firms in making the contracts more complex. In this article, the authors focus on one such rigidity: the constraints faced by firms in fine-tuning contracts to the full distribution of heterogeneity of their employees. The authors explore the implication of these constraints for the provision of incentives within the firm. The study’s application is to sales force compensation, wherein a firm maintains a sales force to market its products. Consistent with ubiquitous real-world business practice, the study assumes that a firm is restricted to fully or partially set uniform commissions across its agent pool. The authors show that this restriction implies an interaction between the composition of agent types in the contract and the compensation policy used to motivate them, leading to a “contractual externality” in the firm and generating gains to sorting. This article explains how this contractual externality arises; discusses a practical approach to endogenizing agents and incentives at a firm in its presence; and presents an empirical application to sales force compensation contracts at a U.S. Fortune 500 company that explores these considerations and assesses the gains from a sales force architecture that sorts agents into divisions to balance firmwide incentives. Empirically, the authors find that the restriction to homogeneous plans significantly reduces a firm’s payoff, relative to a fully heterogeneous plan, when the firm is unable to optimize the composition of its agents. However, a firm’s payoff under a homogeneous plan comes very close to that under a fully heterogeneous plan when the firm can optimize both composition and compensation. Thus, in the empirical setting of this study, the ability to choose agents mitigates the loss in incentives from the restriction to uniform contracts. The authors conjecture this result may hold more broadly.