Principal Agent Theory You are the sales manager in a retail company. Using PA theory argue for and against the use of salary and commissionbased compensation? PA theory is a useful framework for thinking about incentive compensation plans, particularly the implication of risk sharing and avoidance. The practical use of compensation suggests three basic methods being, salary only, salary plus commission/bonus, or commission only. Research shows that a combination of salary and commission is most commonly used in sales functions, however the appropriateness of such compensation method depends on several factors, e.g. whether the work effort is verifiable and measurable, whether the agent is risk averse, whether there is a high degree of compensation uncertainty, the span of control and the degree of programmability, the type of product sold and its buying cycle etc. Researchers only conclude vague relations between the PA theory applicability and the practical use of such PA theory for compensation contracts. However, recent research has made links between theory and the use in practise more clear and valuable. K. Eisenhart (1988) suggests that a mix between agency and institutionaltheory best determines the optimal contract and compensation policy. The argumentation used in PA theory departs according to Eisenhart from the following assumption: 1) If the principal knows what an agent has done a contract based on behaviour is most efficient. 2) If the principal does not know what an agent has done, a selfinterested agent may or may not perform as agreed. The principal has two options 1) to discover the agent’s behaviour by investing in information or 2) to contract at least partially on behaviour by aligning the agent’s preference by those of the principal, but at the price of transferring risk to the agent. 3) The choice between a contract based solely on behaviour and one partially based on outcome depends on the tradeoff between the cost of measuring behaviour and the cost of transferring risk to the agent through a contract partially based on outcome (Demski & Feltham, 1978). Now, from the manager’s perspective, me being the principal, I would consider the following factors in deciding on the salary/commission contract. First of all I want the agent to perform in accordance with my preferences, but at the same time I believe in freedom for responsible actions. Commissions simply make people dependent on outcomes that they only partially control, and such risk bearing is the role of company owners. On the other hand, if behaviours cannot be readily evaluated, commissions are attractive because they align the goals of salespeople with those of the company in which they work. So on one hand I want to allow the agent a certain span of control, but along with this responsibility I either want to be able to verify the agent’s performance or I prefer a partially outcomebased compensation contract. I would prefer some degree of programmability in the job description, to make sure the agent performs in accordance with his job description. Programmability, Eisenhart, does not clearly relate to the use of salary instead of commission, so this is just a basic need to insure the principal against unfavourable actions, selfinterest and moral hazard. On the other hand I want to motivate the agent by allowing a certain span of control over his effort. Since outcome uncertainty is slightly positively
related to the use of salaries and negatively related to the use of commission, this, with a larger span of control, reduces the agent’s compensation uncertainty. I believe commission is an effective way to select the best salespeople and further commission, as an appropriate sharing of profits, makes employees consider themselves as professional salespeople. More uptodate research by Holmstrom and Milgrom has revealed that the problem of providing incentives to agents and employees is far more intricate than represented in standard PA theory. Through multitask PA analysis they argue that given a highly incomplete set of performance measures and a highly complex set of potential responses from the agent, how can the agent be motivated to act in the social interest of the company. Hence, there are split opinions about the applicability of PA theory for practical use in compensation contracts.