Case 5.1: Incentives in the Firm – Managing the Carpet Store Jerry runs a small

Question

Case 5.1: Incentives in the Firm – Managing the Carpet Store

Jerry runs a small carpet store. His firm sells and installs carpets. He manages the operation from his office in the store where carpet is displayed. He pays his receptionist/secretary an hourly wage.

He has a saleswoman in the office whose job it is to sell carpet to people who come in shopping; she sells carpet that Jerry has already priced by the yard. Jerry pays this woman on a commission basis, as a fraction of the revenue generated.

Jerry also employs a salesman who goes to people’s homes to price the installation of carpet. This man has discretionary authority to price the installation of the carpet as he sees fit, and Jerry has a profit sharing arrangement with him: he gets to keep half of the revenue he generates over and above the cost of the carpet plus installation.

Finally, Jerry employs a couple of guys who actually install carpet in homes. Jerry pays them by the job, so many dollars per square yard installed, with a penalty in the event that any customer complains after the job is done.

With reference to any principal-agent (i.e., moral hazard) problems, critique the way Jerry compensates his employees. Then give Jerry a grade on his compensation policies (e.g., A+, B-, D, etc.)

Your critique/assessment:

Your letter grade for Jerry’s compensation plan:

Explanation / Answer

I think Jerry does a good job of compensating employees as per their roles as the more strategic roles which contributes to the business bottomline are paid on a revenue sharing or profit sharing model. And the transactional roles are paid based on the amount of work done as measured by hours served or square yard installed.

By incentivizing the sales woman in the store through a revenue sharing model, the compensation is designed to encourage the woman to sell more and induce customers. Similarly by profit sharing of the installation salesman, he is encouraged to maximize the revenue and not sell at a low price. Other roles such as secretary or installation personnel being more transactional in nature are paid on the amount of work done only, which is the correct way.

On an overall basis, Jerry’s compensation plan would get an A+

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