A Structural Model of Sales-Force Compensation Dynamics: Estimation and Field Implementation

We present an empirical framework to analyze real-world sales-force compensation schemes and report on a multi-million dollar, multi-year project involving a large contact lens manufacturer in the U.S., where the model was used to improve sales-force contracts. The model is built on agency theory and solved using numerical dynamic programming techniques. The model is flexible enough to handle quotas and bonuses, output-based commission schemes, as well as ratcheting of compensation based on past performance, all of which are ubiquitous in actual contracts. The model explicitly incorporates the dynamics induced by these aspects in agent behavior. We apply the model to a rich dataset that comprises the complete details of sales and compensation plans for the firm’s U.S. sales force. We use the model to evaluate profit-improving, theoretically-preferred changes to the extant compensation scheme. These recommendations were then implemented at the focal firm. Agent behavior and output under the new compensation plan are found to change as predicted. The new plan resulted in a 9% improvement in overall revenues, which translates to about $12 million in incremental revenues annually, indicating the success of the field implementation. The results bear out the face validity of dynamic agency theory for real-world compensation design. More generally, our results fit into a growing literature that illustrates that dynamic programming-based solutions, when combined with structural empirical specifications of behavior, can help significantly improve marketing decision-making, and firms’ profitability.