The Economics of Organizational Architecture
James Brickley, Clifford Smith, and Jerald Zimmerman
(from Chew , (1999, 2nd edition) p 127
also from chapters 1, 8, 15 of their book Organizational Architecture)
Executive Summary: The environment in which a firm operates and how the firm is organized influences how the firm pays its managers and employees. Specifically as you push down decision rights, you also must push down property rights and accountability which in turns changes the way pay should be structured.\ Paper starts off discussing the Baring’s debacle and how it shows that Organizational Architecture is important. For example Nick Leeson got around internal controls and was both trading on his own account and the firm’s proprietary account. This paper is an attempt to prevent the problem before it happens. Basic idea is that as you push decision rights down (become more decentralized) you must adjust the control and compensation plans as well. The authors contend that this work differs from other “Business Week” type books is that this paper is well grounded in economic theory and, a main thrust of the paper, this paper looks at any change from a company wide perspective. The paper defines corporate architecture as corporate organization plus evaluation and pay plans. The basic framework upon most of the paper is written is simple
- The assignment of corporate decision rights.
- The structure of performance evaluation systems for both individuals and business units must be examined.
- The method of rewarding individuals is important.
The authors define the main purpose of any economic system is to produce an output at the lowest cost possible. Problem: those making the decisions often do not have the correct information (and it is costly to get the information) and/or they do not have the right incentives. Any system must weigh the costs and benefits of this information/cost tradeoff and consider it when designing the control/pay systems. For example: if the firm is decentralized, then it ids difficult to have the correct information. So the manager may delegate the decision making rights, this lowers the information costs, but raises agency costs. Information flows not only up from the front lines, but also down from the top. Without this two way flow, lower level managers and employees will not have the “big picture.” Obviously this will lead to poor decisions for without the correct pay and control plans managers will only focus on their own well being. Factors that affect corporate architecture:
- Deregulation has increased the importance of decision making and speed of reaction. The paper cites the example of AT&T which in the face of deregulation decentralized decision-making and gave lower level managers greater incentives and adopted EVA. At small firms and in regulated industries, upper level managers may be able to make all decisions but not as industries are deregulated.
- Technology can increase or decrease decentralization. On one hand it allows upper level managers to monitor and process information. On the other hand, it allows information to flow downward as well and allows better control systems.
- Globalization and necessary quality improvements have also pushed decision rights down the chain of command.
Many papers have looked at the benefits of organizational changes. For example, this paper looks at a case study of ITT. ITT went through a restructuring and as such set specific goals at lower levels and gave the managers and employees larger bonuses and increased ownership. These changes were followed by improved performance (sales up 26% and EBIT were up 50% in next two years.) However, these changes are often offset by costs (both direct and indirect) associated with the restructuring. Frequent restructurings will lead to short-term thinking and may offset any benefits. The authors quote Petronius Arbiter (210 BC) as saying frequent reorganization is “a wonderful method [in that] it can be [used] for creating the illusion of progress while producing confusion, inefficiency, and demoralization.” There are direct as well as indirect costs of these changes. Uses XEROX example that shows that without the proper evaluation and incentive systems no matter how hard management pushes quality improvements, employees and managers will not make the necessary changes. The authors discuss Economic Darwinism and serves to remind managers that prior to any change they must be sure to recognize why and how the current architecture came about and how the changes would improve things. Finally, “surviving architectures” are not necessarily the absolutely the best, but only in a relative sense since as the environment changes, so too do the optimal organizational structures.