The Behavioral Promise and Pitfalls in Compensating Store Managers

Abstract

Compensation systems have rapidly been shifting away from a fixed wage contractual payment basis. Many companies today are creating incentive compensation contracts to reward hard-working employees for jobs done well. Profit sharing (“sharing compensation contract”) and target with bonus (“target compensation contract”) are two common performance-based compensation contracts prevalent in business. We theoretically and behaviorally study the sharing and target compensation contracts in an operational context where a firm sets the parameters of the compensation contracts and a store manager, after observing the compensation contract offered to him, chooses his effort level (unobservable by the firm) and makes ordering decisions for the store. Our experimental data suggest systematic deviations from the theoretical benchmark and reveal behavioral promise and pitfalls under the two compensation contracts. In particular, the store manager is more willing to exert high effort under the target contract all else being equal. However, the store manager is also more likely to punish the firm for perceived “unfair” offers by submitting an extremely low order quantity. We find that bounded rationality plays an important role in driving a higher effort rate under the target contract than the sharing contract. We introduce a new formulation of the fairness concerns, which is referred to as by-state fairness, where individuals, rather than considering whether the expected profits received are fair, consider the fairness in the potential realized outcomes. This new formulation explains why managers are more likely to order very little to punish the firm under the target contract. In addition, we conduct validation experiments to verify our behavioral explanation. This paper was accepted by Jayashankar Swaminathan, operations management.