Microsoft PowerPoint - TCE - Sales management

The previous lecture Sales Management • How do firms design the optimal compensation plan for sales employee?

Mickael Bech

– Tradeoff between risk and high-powered incentives (simple moral hazard model) – Tradeoff between distortion of effort and high-powered incentives (multitask model) – The compensation plan as an screening instrument (adverse selection model)

Assistant professor University of Southern Denmark

Risk profile – All (n=42) Flat wage

Expected bonus

Choose B (%)

20,000 20,000

9,000 8,500

23.8% 31.0%

20,000 22,000 22,000

8,000 9,000 8,500

17.1% 70.0% 70.7%

22,000 24,000

8,000 9,000

24,000 24,000

8,500 8,000

Risk profile – women (n=19) Flat wage 20,000 20,000

Expected bonus 9,000 8,500

Choose B (%) 26.3% 21.1%

20,000 22,000

8,000 9,000

21.1% 52.9%

48.8% 88.1%

22,000 22,000 24,000

8,500 8,000 9,000

55.6% 44.4% 73.7%

92.1% 90.5%

24,000 24,000

8,500 8,000

84.2% 84.2 %

Agenda

1. The problem (I) •

1. What is the problem?

2. The value chain (Porter) 3. The Transaction Cost Economics (TCE) framework a) Assumptions b) Transaction costs c) Choice of governance structure

What is the most efficient: – – –

Should the firm have its own retail shops?

Should the firm have its own sales employees or should it use independent sales representatives?

When is it efficient for the firm to vertically integrate the sales function?

4. Empirical evidence a) Anderson 1985 b) Masten et al. 1989

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1. The problem (II) •

What is the efficient choice of governance mode?

– –

•

2. The value chain (I)

Hierarchy or market Make-or-buy

Raw material

Contracts are incomplete and costly – it is costly to use the market

Transportation

Wholesales marketing and sales

2. The value chain (II) •

Michael Porter (1985): – –

–

Intermediate products

Final product

Transportation

Retail marketing and sales

2. The value chain (III) •

Porter 1985

2. The value chain (V)

Vertical Integration – –

Consumers

Value chain analysis describes the activities within and around an organization Porter argues that the ability to perform particular activities and to manage the linkages between these activities is a source of competitive advantage Porter distinguishes between primary activities and support activities.

2. The value chain (IV) •

Transportation

Forward (down-stream) integration Backward (up-stream) integration

Raw material

Transportation

Wholesales marketing and sales Backward

Transportation

Intermediate products

Final product

Transportation

Retail marketing and sales

Consumers

Forward

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3. TCE – Assumptions (I) • The firm is maximizing profit • The firm choose the boundaries of the firm and the degree of integration into production stages depending on efficiency

3. TCE – Assumptions (II) •

Behavioral assumptions – –

–

3. TCE – Assumptions (III) •

Why are contracts incomplete?

– – – –

Not all outcomes can be described in the contract because of bounded rationality Information is costly to obtain and costly to process which limits the search for additional information Opportunism imply that contractual hazard is an everpresent treat A contract is incomplete in the sense that the contract specifies some contingencies and some actions that the parties must take, but not all

• •

Transaction costs (TC): The cost accompanying contractual relationship; negotiating, writing, monitoring and enforcing contracts. There is no frictionless transaction Ex ante TC: searching, negotiation and writing of contracts Ex post TC: monitoring and enforcement of contracts

NB: PA theory assumes complete rationality (the principal can make a contract taking all possible outcomes into account, and both the principal and the agent is assumed to be maximizing their own utility

3. TCE – Transaction costs (I) •

• •

3. TCE – Transaction costs (II) •

Bounded rationality: ‘Intended rational, but only limitedly so’ Opportunism – maximize self-interests with guile

Coase (1937): it is not costless to do transactions in the market, and this is the reason for the existence of firms Common (1934): the unit of analysis is the transaction Williamson (1975, 1985): Transaction Cost Economics

3. TCE – Transaction costs (III) •

• •

It is impossible or inconceivably costly to write a contract that anticipates all the events that may occur and the various actions that are appropriate in these events Imply that it is optimal to write incomplete contracts When transactions are complex and have multiple attributes the contract will be incomplete and open to contractual hazard

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3. TCE – Governance structure (I) • •

•

Transactions differ with regard to: Asset specificity, uncertainty, frequency, and measurability High degree of asset specificity imply small numbers exchange relation – there is not a great number of alternative partners in the market Higher degree of uncertainty and lower degree of measurability (together with bounded rationality) imply more incomplete contracts

3. TCE – Governance structure (II) •

•

3. TCE – Governance structure (III) •

Hold-up and lock-in – – –

•

Disputes about the utilization of transaction specific assets Hold-up problems by the renewal of the contract Bilateral dependency (lock-in)

Safeguards – –

Extensive contracting which is costly Unified ownership within which hierarchy is used to effect coordination

3. TCE – Governance structure (V) •

(Stereotypical) Hierarchical governance – –

– – – –

The interaction between the firms are long-term Resource allocation is controlled by hierarchical decision making – central authority coordinates the allocation of resources and has complete administrative control Unified ownership Law of private ordering – forbearance Loss of high-powered incentives No transaction costs but bureaucracy costs

Asset specificity: – Physical assets – Human assets – Site specificity – Dedicated assets – Brand name capital – Temporal specificity

Incomplete contracts and opportunism makes the firm vulnerable with high degree of asset specificity

3. TCE – Governance structure (IV) • •

Two ideal types of governance modes (Stereotypical) Market governance – – – – – –

The interaction between the two firms are short term and anonymous Prices contain all relevant information The two firms are two separate organizational and legal units Neoclassical law High-powered incentives Transaction costs

3. TCE – Governance structure (VI) • Predictions: – Hierarchical governance is efficient with high degree of asset specificity – Hierarchical governance is efficient with high degree of uncertainty and high degree of asset specificity – Incomplete or very costly court enforcement makes hierarchical governance (private ordering) more favorable

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4. Empirical evidence (I) • Anderson 1985:

4. Empirical evidence (II) • Anderson 1985 – Hypothesis 1:

– Sales force management: when and why do electronic component manufactures in the US outsource their sales function?

– Increasing degree of transaction-specific assets increases the likelihood of integration – Transaction-specific assets: • Special purpose knowledge and working relations: knowledge about the products, the firm’s procedures, the market and the customers • Confidential information • Costumer loyalty (long term relationship with the costumer)

– In which situations are sales representatives more efficient than sales employees. How can the observed pattern between the firms be explained?

4. Empirical evidence (III) • Anderson 1985 – Hypothesis 2:

4. Empirical evidence (IV) • Anderson 1985 – Hypothesis 3:

– The more difficult it is to evaluate sales performance, the more likely is the use of a direct sales force (forward integration) – Difficulty of evaluating performance:

– Higher uncertainty in combination with transaction-specific assets increase the likelihood of a direct sales force – Uncertainty:

• Team sales or inaccurate individual performance data • Sales volumes are not enough to make a fair evaluation

• Unpredictable markets, technological innovations etc.

– The argument: integration enables the principal to observe input which is unobservable when the parties are not integrated

4. Empirical evidence (VI)

4. Empirical evidence (V) •

Anderson 1985 – Other ‘standard’ hypotheses: –

–

– – –

Lower travel requirement per unit of sales (sales dispersion) potential increases the likelihood of a direct sales force Increasing attractiveness of the firms price-quality combination in a district increases the likelihood of a direct sales force Larger company size increases the likelihood of a direct sales force The greater importance of nonselling activities increases the likelihood of a direct sales force The longer the time span to feedback increases the likelihood of a direct sales force

•

Anderson 1985 – Results: likelihood of a direct sales force

Hypothesis H1

Variable Asset specificity: products Asset specificity: confidential information Asset specificity: customer loyalty

Coefficient 0.343 0.401 -0.584

H2

Difficulty of evaluating performance

0.987

H3

Asset specificity and uncertainty

0.452

H4

Travel requirements

H5

Attractiveness of product line

H6

Company size

H7

Importance of nonselling activities

H8

Time span of feedback

0.492 0.835 -

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4. Empirical evidence (VII) • Anderson 1985 – Conclusion: – TCE and PA theory adds significant explanatory power to prediction of a direct sales force

• Criticism: – What we observe is by definition efficient?

– Do we trust the sales managers’ reporting – circularity between theory and reporting?

4. Empirical evidence (IX) • Masten et al. 1989 – Physical as well as human assets are important in the auto industry – Integration of the production stages prevent disputes and hold-ups but high-powered incentives are lost – Higher degree of transaction specific asset increases the likelihood of integration

4. Empirical evidence (VIII) • Masten et al. 1989 – Explain the observed pattern of vertical integration in the US auto manufacturers applying factors suggested in TCE – Is transaction specific human capital more important than transaction specific physical capital?

4. Empirical evidence (X) • Masten et al. 1989 - Results Variable Engineering (human assets) Asset (physical assets) Site specificity

Relationship between variable and degree of vertical integration + The most important + Insignificant Insignificant

Issues for discussion • Assumption about the individual: costliness of effort/opportunism • Knowledge from psychology – cost of external motivation and crowding out effects • Are other social mechanisms ‘more efficient’?

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