Inventory‐Related Compensation in Decentralized Organizations

We consider a principal agent problem in a decentralized organization. The agent holds private precontracting information with respect to an uncertain demand in a single period setting. Being head of a profit center, his only task is to determine the optimal order quantity. We show that using a profit share as the only performance measure to incentivize the agent creates agency costs. In fact, offering a menu of profit‐sharing contracts to the agent to pick from, requires rent payments to motivate the agent to always choose the desired contract. This result still holds if a fixed payment is added. Using an inventory‐related component as a third measure, however, allows one to solve the agency problem and to achieve first best outcomes. Precisely, each contract needs to specify a bonus or a penalty conditioned on the inventory level at the end of the selling season combined with a profit share and a fixed pay. The paper not only demonstrates that first best can be achieved in the described setting, it also provides a theoretical explanation for the observed practice of using inventory‐related compensation elements, such as service‐level agreements, in organizations.