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Article Excerpt
We study a channel relationship in which manufacturer(s) use independent sales representatives (rep firms), which employ salespeople to do the actual selling. We show that commission-only payments by manufacturers to rep firms lead to suboptimal outcomes for the manufacturer relative to those obtained under a vertically integrated channel. From the manufacturer's standpoint, these inefficiencies can be ameliorated through the use of sales incentives given to the rep firm's salespeople directly by the manufacturer (called "spiffs").
In a monopolistic environment, spiffs are shown to improve the manufacturer's profits in the face of contractual restrictions on the channel members' ability to set separate commission rates by product. For certain types of restrictions, spiffs may generate manufacturer outcomes close to the fully coordinated ones achieved under vertical integration even when compensating the rep firm through commission-only contracts.
In a competitive environment, spiffs are shown to be used by a powerful manufacturer that shares a rep firm's sales efforts with the product of a weaker manufacturer (i.e., in the case of "common agency"). In this case, spiffs are used as a strategy to deter the weaker manufacturer from challenging the stronger manufacturer for the salesforce's valuable selling effort.
Key words: agency theory; channels of distribution; compensation; salesforce; competition
1. Introduction
The use of independent sales representatives (rep firms) is a growing trend in the current business environment (Coughlan et al. 2006). In the 1970s, it was estimated that 50% of all manufacturers used rep firms exclusively or in combination with their own salesforces (Research Institute of America 1975). More recently, the National Association of Manufacturers completed a survey of its members in which 67% of the respondents indicated that they use rep firms. Moreover, among those using rep firms, 63% indicated that during the past three years they had either maintained or increased their use of rep firms (Manufacturer's Agents National Association (MANA) 2001b). Rep firms are used in a wide variety of companies and industries; Anderson and Trinkle (2005) list a number of companies that use rep firms, such as Ingersoll-Rand (air and electronic power tools), Avery Dennison (pressure-sensitive adhesives, office products), Master Lock Company (padlocks and security products), Kraft Foods (snacks, beverages, cheese, convenience foods), and Kimberly-Clark Corporation (health and hygiene products).
Rep firms are independent companies (which can have few or many salespeople in their employ) that sell a set of products but do not perform physical possession, ownership, financing, risking, or other channel flows. A rep firm commonly covers a specific territory and specializes in a limited range of products. Typically, the line carried by a rep firm includes products from an array of manufacturers that may be unrelated or complementary in demand. Rep firms generally are compensated by their manufacturers with commission payments only, amounting to 5%-15% of a product's wholesale cost (Minority Business Development Agency (MBDA) 2003). Companies choose to use rep firms for a variety of reasons, among them the need to trim sales costs and fixed overhead, their own lack of expertise in dealing with different sales territories, and to gain access to an experienced, committed salesforce in local markets (Churchill et al. 1997, pp. 112-113; Novick 2000, pp. 30-34; MBDA 2003).
The use of a rep firm raises fundamental agency issues for a manufacturer. Even though a rep firm is a downstream channel member functioning as the manufacturer's sales organization, usually the manufacturer has very little control over the rep firm's salesforce. In contrast, a manufacturer with its own employee salesforce can exert greater control over salespeoples' activities because the common organizational culture provides consistent values and norms (Heide and John 1992, MBDA 2003), and also because the vertically integrated manufacturer can implement a richer system of monitoring, rewards, and punishments to motivate the employee salesforce than if it used an independent rep firm's salesforce (Anderson 1985, Anderson and Oliver 1987, John and Weitz 1989).
The job of aligning incentives when using a rep firm is doubly challenging because of the need to align the incentives of both the rep firm's owner (hereafter called the "rep firm") and the rep firm's salespeople with the manufacturer's own goals. The challenge intensifies when commission rates are not customized by product at the manufacturer or rep firm levels, in cases where the products sold do not have the same demand characteristics. The business press literature illustrates that different types of representation contracts are used in the marketplace and that both individualized and single commission rates are currently used (Srikonda 2001, Electronics Representatives Association 2003). In personal interviews, (1) we found evidence from both manufacturers and rep firms of contracts involving common commissions across different products. For instance, in one rep firm that sold different forms of granite, the manufacturer (mining company) supplying the granite offered the firm the same commission rate for all grades of granite, even though some of the more rare and beautiful colors and patterns had different values as well as selling difficulties associated with them. In turn, the rep firm paid its salespeople the same commission on sales for every type of granite.
Government regulation or policies may also impose common commission rates. For example, the U.S. government's General Services Administration (GSA) specified that brokers yielding commissions from a carrier should propose a single commission rate to be used with all carriers selected by the broker to provide transportation and accessorial services under GSA's program (GSA 1997). In the insurance industry, some states (2) in the United States allow insurance companies to use only a single commission rate in the entire state for insurance products in the same risk rating tier. Following the European Treaty, the European Commission regulates European businesses so that companies cannot impose unfair purchase or trading conditions, exclusionary prices or trading conditions, or dissimilar conditions for equivalent transactions. (3) These regulations force companies to employ commissions that stay in a "narrow" band. Labor regulations can also prevent a rep firm from discriminating between salespeople by offering different commission rates in different sales territories, creating one-commission-rate restrictions. (4)
These are important representative examples of various contractual limitations between the manufacturer and the rep firm, or between the rep firm and its salesforce, that can restrict the channel's ability to fit rewards to the specifics of various possible demand (or selling) situations. They are not the only ones to which our research could apply. Our work also speaks to the completely analogous case of how to set rep firm channel compensation for a single product through different periods of time, in situations where demand changes through time. For instance, the demand for many products is seasonal throughout a single year, yet compensation contracts are frequently reevaluated only annually (Mantrala et al. 1997). This situation does happen in the real world; for example, a former director of IBM reported that contracts with rep firms were renegotiated every 12 months, frequently with common commission rates across products, and no firm wanted to engage in mid-year renegotiations (interview with Steve Corio referenced above). A former rep firm owner, now a consultant to the industry, corroborated this pattern from the rep firm's perspective (interview with Bob Trinkle referenced above). This creates the same coordination and agency problem as those for two different products sold in the same period but facing different demands. Another possible interpretation of our research context is to the situation in which a single product is sold through a rep firm with two sales territories facing some sort of labor regulation preventing the firm from discriminating between salespeople by offering different commission rates in different sales territories (see the aforementioned Footnote 4).
These sorts of alternative interpretations describe realistic incentive problems faced by the manufacturer seeking to sell through a rep firm to the market; however, for simplicity of exposition henceforth, we use the first interpretation above.
Apparently in response to these coordination challenges when selling through a rep firm channel, some manufacturers employ a tool known as "spiffs" (direct incentives offered by the manufacturer to a rep firm's field salesforce, rather than to the rep firm itself). Spiffs can be used, for example, to give a new-to-the-market product an extra boost by increasing the time spent on selling it by the rep firm's field salesforce or to lift sales in the slow holiday season; one industry participant remarked on the incentive effect of spiffs by saying "competitive products at competitive commissions usually win the day, [but] carrier incentives and spiffs can often tip the scale on close deals" (Teal 2004). An article on using and managing sales reps explains regular commissions and spiffs this way (MANA 2001a, p. 44):
Commission rates ... are determined by the marketplace. (...) There are situations where we believe higher than normal commission rates or special payment timing also result in win-win situations. One example is the need for missionary effort to either help a company get established in a territory where they have little presence or in the launching of a new product for a company already well-received in the territory. Substantially increasing the commission rate ... allows the rep to more rapidly recover the cost of their missionary selling efforts. These special incentives should last for a sufficient time to allow reps to more rapidly recover their missionary effort costs. The added incentive also provides greater assurance to the manufacturer that prompt market penetration, so necessary for competitive advantage, is achieved.
The quote above demonstrates not only the common use of spiffs to alter a rep firm's salesforce's incentives to sell a specific product, but also the use of spiffs as a competitive tool. The appropriate length of time to let a spiff run depends on the market conditions and the desired outcome; while many believe spiffing is a short-term phenomenon, the evidence suggests that longer-term spiffs can also occur. One rep firm owner, familiar with spiffs granted by manufacturers to help launch new products, responded to an interviewer about the optimal length of spiffing by saying, "A minimum of six months is best, but the duration can also vary." Another rep, interviewed for the same article, said, "We don't get too excited about short-term incentives. We do, however, like long-term programs (one year or more) that reward a steady and consistent sales effort" (MANA 2001c, p. 35).
Indeed, if spiffs are so useful as tools to help solve the agency problem, an interesting question is why not use them more often or, indeed, all the time? This research recognizes both the continued use of spiffs in these channels and their apparent strategic value, and investigates when they are best used and under what market and demand circumstances they are (and are not) profitable tools to manage the rep firm channel.
Our work uses three major research streams as inputs. The first is the research in salesforce management, more specifically salesforce compensation (see Coughlan and Sen 1989 and Couglan 1993 for reviews of this literature). Early work such as Farley (1964), Farley and Weinberg (1975), and Srinivasan (1981) focused on the optimal multiproduct salesforce commission in a deterministic world. After the development of agency theory, research considered a world with stochastic sales and risk-averse salespeople. The work of Basu et al. (1985) models a single-product salesperson and, more recently, Lal and Srinivasan (1993) consider salesforce compensation plans for single- and multiproduct salesforces. Joseph and Thevaranjan (1998) study compensation incentives coupled with monitoring of selling agents, and Godes (2003) considers the effect of task complexity on the relative importance of salespeople selling skills. This literature considers only two-level hierarchical organizations consisting of a sales manager (the principal) and the salesforce (the agents). In most of these papers, compensation is the only instrument available to sales managers to align the salesforce's objectives with their own. Thus, while this work forms an important foundation for this research, it does not include all the key features of the agency problem when selling through a rep firm channel.
The second relevant research stream is the work in agency theory that considers multilayered organizations, including Baron and Besanko (1992), who investigate different hierarchical organizational structures and the implications of hidden communication; McAfee and McMillan (1995), who analyze the delegation of incentive contracts; and Melumad et al. (1995), who analyze the delegation of incentive contracts allowing the third party to be a productive agent as well. Other related work considers principal-supervisor-agent types of hierarchies and focuses on collusive behavior among supervisor and agents (as in Bernheim and Whinston 1986, Laffont and Tirole 1991, Kofman and Lawarree 1993, Laffont and Martimort 1998).
A third research stream of interest is the work in marketing channels, in particular the channel coordination literature. Much of this literature (such as Jeuland and Shugan 1983, 1988; Shugan 1985; Moorthy 1987) focuses on mechanisms such as quantity discounts and two-part tariffs to coordinate channel behavior. The work of McGuire and Staelin (1983) and Coughlan (1985) focuses on the profit division between retailer and manufacturers in a duopoly with substitute products and the resulting implications for equilibrium channel structure. Other authors, such as Ingene and Parry (1995, 2000) and Choi (1991), investigate different two-level hierarchical channel structures. Additional articles in this stream include the work of Moorthy (1988), who studies how strategic interaction with other manufacturers might affect manufacturers' channel structure decisions; and Lal (1990), who studies the role of monitoring and incentives in coordinating franchising relationships. More recently, research in channels by Iyer and Villas-Boas (2003) and Raju and Zhang (2005) consider situations in which the manufacturer is not the dominant player.
While the above literature contributes to our understanding of independent...
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