Organizational Architecture. Chapter Four. Outline of Chapter 4 Organizational Architecture. Basic Building Blocks Organizational Architecture Accounting’s Role in the Organization’s Architecture Example of Accounting’s Role: Executive Compensation Contracts.
Fundamental assumption of economics: Individuals act in their own self-interest to maximize utility.
work for employer, work on other projects, relax, etc.
time, money, knowledge, etc.
preferences for money, working conditions, leisure, etc.
Individuals form teams or firms because:
Firm is defined as a nexus of contracts among resource owners who voluntarily contract with individual team members to benefit both the firm and the individuals.
Firms in an economic sense include for-profit corporations, divisions within a corporation, not-for-profit organizations, and other entities.
From Brickley, C. Smith, and J. Zimmerman, Managerial Economics andOrganizational Architecture, Third Edition, (Boston: McGraw-Hill/Irwin, 2004.
The firm is a legal entity that can contract with many parties and enforce these contracts in courts of law.
Some contracts are explicit written documents and others are implicit oral agreements supported by the reputation of the parties.
Free-rider problem: Agents have incentives to shirk because their individual efforts are not directly observable.
Solutions: Incentive contracts, monitoring, etc.
Horizon problem: Agents expecting to leave firm in near future place less weight on long-term consequences.
Solutions: Incentive contracts, monitoring, etc.
Employee theft: Employees take firm resources for unauthorized purposes.
Solutions: Buy fidelity bond, monitoring, inventory control, etc.
Empire-building: Managers seek to manage larger number of agents to increase their own job security or compensation.
Solutions: Modify incentive contracts, benchmarking, etc.
Adverse selection: Prior to contracting, agents have better private information than principals.
Solutions: pre-contract investigation, post-contract penalties.
Moral hazard: After contracting, agents have an incentive to deviate because the principal cannot readily observe deviations (hidden action or hidden information).
Solutions: inspecting, monitoring.
Decision rights are restrictions on how economic assets of a firm can or cannot be used.
Management determines how decision rights are to be allocated among various agents within a firm.
Alternative styles of allocating decision rights:
Some knowledge useful for decision making is costly to acquire, store, and process.
Linking knowledge and decision rights is a key issue for organizational architecture.
Example where knowledge and decision rights are linked:
Machine operator schedules own machine.
Example where knowledge and decision rights are not linked:
Sales representatives know customer’s demand curve best, but only sales manager may approve sales price changes. Giving pricing decision rights to representatives could result in customer kickbacks.
Firms can obtain goods and services by either:
Factors to consider in make-versus-buy:
Problem: Agents spend time and other resources trying to influence decision makers.
Solution: Limit active decision making by imposing bureaucratic rules.
Example: Airlines allocate routes to flight attendants based on senioritythere is no supervisor deciding who gets which route.
Organizational architecture depends on three legs:
(1) Measure performance
(2) Reward and punish performance
(3) Partition decision rights
In external markets these functions are served by market prices, supply and demand, and the law of contracts.
For transactions inside the firm, management must implement administrative devices to accomplish these functions.
All three legs must be balanced and coordinated.
Types of performance measures
See Self-Study Problem, “Span of Control.”
Steps in the decision process
1. Initiation (management)
2. Ratification (control)
3. Implementation (management)
4. Monitoring (control)
Separation of management and control
1. Initiation: Division managers with specialized knowledge of production process and customers initiate construction proposal.
2. Ratification: Proposal is analyzed by specialists in finance, marketing, human resources, real estate, and other areas. Senior management uses all this information to decide whether to accept, reject or modify proposal.
3. Implementation: Employees and outside agents construct facilities.
4. Monitoring: Internal accountants prepare financial reports on project.
Accounting reports are more useful for control (ratifying and monitoring) than for decision management (initiation and implementation). [Recall Chapter 4.]
Decision management requires forward-looking opportunity costs, but accounting data is primarily backward-looking historical results. [Recall Chapter 2.]
Accounting also reduces some agency costs such as employee theft and shirking. [Recall Chapter 4.]
Economic Darwinism implies that seemingly irrational accounting procedures survive when the benefits of these procedures exceed agency costs.
Agency Problem: Align interests of shareholders (principals) and top executives (agents).
(1) Measure performance: Board of Directors’ compensation committee sets performance goals based on financial and nonfinancial measures.
(2) Reward and punish performance: Compensation consists of base salary and bonuses. Bonus plans may have lower and upper limits.
(3) Partition decision rights: Directors initiate contracts. Shareholders ratify contracts. Accountants monitor performance.