Agency Theory Explanations of Self-Serving Sales Forecast Inaccuracies

Both managers and front-line employees alike would agree that workplace behaviors are usually predetermined by how one is evaluated and measured. Indeed, one of the many clichés that has emerged in the corporate world is “show me how I’m measured and I’ll show you how I act.” This paper draws attention to a dysfunctional impact of this cliché by investigating how sales compensation systems can lead to lower firm performance through inaccurate and manipulative forecasts by the sales force.

As a result of constant environmental change, fluctuations in customer order volumes, and incorrect estimates of product demand, sales forecasting is a very complex process. Despite these complexities, sales forecasting remains a key determinant of superior planning and resource allocation because it is a key ingredient for managerial decision making (Lynn, Schnaars, & Skov, 1999; Rieg, 2010). Indeed, executives and managers rely on sales forecasts to make decisions that define strategic alternatives and how resources are allocated in the organization (Lynn, Schnaars, & Skov, 1999). Because of this, firms that forecast more accurately can deploy resources more efficiently.

But sales forecasts are frequently wrong. Simpson (2000) reported that 59% of procurement respondents believed that sales forecasts were only somewhat accurate. Because forecasts are relied upon as if they are accurate and are reference points for managerial decision-making (Lynn et al., 1999), imprecise forecasts cause firms to absorb superfluous carrying costs and/or liquidate excess inventory when consumer product demand subsides. In the latter case, companies may be required to take actions such as selling excess inventory below cost or disassembling manufactured products and reselling the standardized parts. Each of these scenarios could result in considerable financial cost. Thus, firms must take care not to overstate sales forecasts since they result in higher overall costs, which could put the firm at a disadvantage vis-à-vis competitors (Porter, 1980).

Sales forecasts are influenced in several ways, yet the factors impacting accuracy can be divided into three main components: (1) dynamic external, (2) dynamic internal, and (3) manipulative internal factors. Dynamic external factors generate forecast errors caused by exogenous factors, such as environmental scanning deficiencies, macroeconomic disruptions, technological discontinuities, as well as other factors (Hambrick & Mason, 1984). Not unlike the dynamic external factors that impact forecasting accuracy, there is also a dynamic component to internal forecasting error. Weaknesses in forecasting planning (e.g., incorrect trend analysis), human error, and other related factors generate internal forecasting errors. McCarthy, Davis, Golicic and Mentzer (2006) found that more than two-thirds of survey respondents reported an absence of accountability for forecast accuracy. Dynamic external and internal forecasting errors are eminent given the unpredictability of organizational and competitive environments. The focus of our paper, however, is on manipulative internal factors, which are factors that make inaccurate forecasts avoidable.

Specifically, inaccurate forecasts might result from how sales compensation systems are setup because such systems appear to create goal incongruence between managers and the sales force. Agency theory (Jensen & Meckling, 1976) may explain why this incongruence develops, and what managers can do to ‘close the gap.’ In its classical form, agency theory models the relationship between one who assigns responsibilities (the principal) and one who fulfils them (the agent, which in this case is the sales person). Conflict or goal incongruence arises from the contract that governs this relationship. Recognizing that organizations are fraught with divergent interests, the goal of agency theory is to establish optimal compensation contracts between principals and agents to induce agents to act in principals’ interests (Bloom & Milkovich, 1998).

Although most agency theory research has focused on top executive compensation (e.g., Nyberg, Fulmer, Gerhart, & Carpenter, 2010; Pepper & Gore, 2012; Rajgopal, Shevlin, & Zamora, 2006), we believe that the underlying problem is also evident in the relationship between management and salespeople. Sales compensation systems historically been designed to reward individuals for their direct contributions to firm revenues via commissions on sales. Such systems place compensation risk solely on the salesperson. However, by utilizing such systems, organizations may be writing a prescription for excessive inventory due to manipulative sales forecasts. Specifically, as compensation risk is inherently transferred to the salesperson in a commission-based structure (instead of a salary-based structure), an unintended consequence might be that sales forecasts are manipulated to transfer other forms of risk back to the principal.

 

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(The original author: Samuel Y. Todd, Tamara A. Crook, Tony Lachowetz

Published by Sciedu Press)

Excellent
Date Published: 08/05/2013
5 / 5 stars