Question

A principal is worried that her agent may not do what she wants. As a solution, she should consider: a. Commissions. b. Bonuses. c. Profit sharing. d. All of the above.

Short answer

d. All of the above.

Step-by-step solution

Understand the Principal-Agent Problem

The principal-agent problem occurs when there is a conflict of interest between a principal (employer) and an agent (employee). The agent may not act in the best interests of the principal because of differences in goals and motivations.

Define Potential Solutions

The principal can use various financial incentives to align the agent's interests with their own. These include commissions, bonuses, and profit sharing.

Analyze the Options - Commissions

Commissions are payments based on the outcomes of the agent's performance (e.g., a percentage of sales made). This method can motivate the agent to perform well because their earnings are directly tied to their efforts.

Analyze the Options - Bonuses

Bonuses are lump-sum payments given for achieving specific targets or exceeding expectations. They can be motivational by providing extra compensation for exemplary performance.

Analyze the Options - Profit Sharing

Profit sharing involves giving agents a portion of the profits if the company performs well. This mechanism aligns the interests of the agent with the financial success of the company.

Conclude on Best Approach

All three options (commissions, bonuses, and profit sharing) serve to motivate the agent to act in the principal's best interest by linking their compensation to performance metrics that reflect the principal's goals.

Key concepts

Commissions

Commissions play a key role when it comes to motivating employees, especially those directly involved in sales and revenue generation. A commission is a percentage of the sales price awarded to the salesperson. This means that the more sales the agent makes, the more money they earn. As a result,

• salespeople often work harder to close more deals,
• foster better client relationships, and
• seek new potential customers actively.

The principal benefits because the agent’s objectives, driven by commissions, align closely with their own goal of maximizing sales. Through commissions, risks are shared. Both principal and agent benefit from an increase in sales, but they also bear the consequences of poor sales performance together, balancing interests.
Commissions help create a direct consequence link between the agent’s efforts and their rewards, encouraging a proactive work ethic.

Bonuses

Bonuses are another effective incentive that principals can use to align the interests of their agents with their own. These bonuses are usually one-time payments given when specific goals, targets, or milestones are achieved. For example, a company might offer a bonus at the end of the year if certain performance metrics are met.
Bonuses serve as a tool to encourage:

• higher performance levels,
• exceeding of expectations, and
• innovation and strategic thinking.

Employees often strive to exceed their usual benchmarks to secure these rewards, knowing their extra efforts can lead to substantial financial gain. This system is beneficial to the principal as it ties the agent’s monetary incentive directly to the principal's desired outcomes, encouraging agents to invest their best efforts to bring about the company's success.

Profit Sharing

Profit sharing introduces a collective success mentality within a company by directly linking an agent’s compensation to the company's performance. In a profit-sharing scheme, employees receive a percentage of the company's profits, typically on a quarterly or annual basis.
This system has several benefits:

• Ensures that employees understand the impact of their personal contribution to the company’s overall success.
• Promotes teamwork and collaboration, as everyone works towards a shared goal.
• Aligns the collective interest of employees with the principal, fostering a unified corporate vision.

Profit sharing incentivizes employees to work more efficiently and responsively, as they recognize that this can directly improve their own financial standing. Thus, it fosters a sense of ownership and accountability among staff, driving them to support activities that promote the company’s wellbeing.