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Chapter Four
Organizational
Architecture
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
Self-interested Behavior
Fundamental assumption of economics:
Individuals act in their own self-interest to
maximize utility.
Opportunity set:
work for employer, work on other projects, relax, etc.
Resource constraints:
time, money, knowledge, etc.
Utility:
preferences for money, working conditions, leisure,
etc.
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Team Production
Individuals form teams or firms because:
 can produce more in a team than they can acting
alone
 generate a larger opportunity set
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-forprofit organizations, and other entities.
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Firm as a Nexus of Contracts
From Brickley, C. Smith, and J. Zimmerman, Managerial Economics
and Organizational Architecture, Fifth Edition, (Boston: McGrawHill/Irwin, 2009).
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The firm is a legal entity that can contract with many
parties and enforce these contracts in courts of law.
labor contracts: employee, union, independent
contractors
supply contracts: inventory, materials, utilities
customer contracts: sales, warranties
finance contracts: insurance, leases, franchises, debt,
stock
Some contracts are explicit written documents and
others are implicit oral agreements supported by the
reputation of the parties.
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Principal-Agent Model
Principal-agent model
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Economic model of relationships in a firm
Principals are managers or firm owners
Agents are employees or independent contractors
Agents perform functions for principals
Numerous principal-agent relationships exist in firms
Agency costs
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Reductions in firm value caused when agents pursue
their own interests to the detriment of the principal
(goals are incongruent)
A major use of internal accounting systems is to
control agency costs
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Contract Issues to Consider
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Agents cannot be compensated on effort (input)
which is not observable by the principal.
Thus as indicated in the text, portfolio performance
(output) can be selected as a performance measure.
However, since factors not under the control of the
agent can influence this output performance
measure, possibly negating the value of all his effort
(input), the agent must be compensated for the
higher risk inherent in an output measure contract.
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Agency Problems
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.
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Agency Asymmetry Problems
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.
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What Kind of Agency Problem is This?
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In the text, the issue of corporate jet pilots refueling
on intercontinental flights in the middle of the
country, e.g., Kansas or Nebraska.
Some refuelers offer incentives to pilots to forgo
discounts in exchange for unreported gifts such as
steaks, wine, or top-of-the-line golf gear.
What kind of agency problem is this?
What strategy would you use to address the
problem?
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Decision Rights
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:
 Centralize (“micro-management”)
 Decentralize (employee empowerment)
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Role of Knowledge
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.
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Markets versus Firms
Firms can obtain goods and services by either:
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making within the firm, or
buying from outside markets (outsource).
Factors to consider in make-versus-buy:
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Efficiency and effectiveness
Cost of acquiring knowledge
Contracting costs
Monitoring costs
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Influence Costs
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 senioritythere is no
supervisor deciding who gets which route.
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Organizational Architecture
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.
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Measure Performance
Types of performance measures
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Objective criteria: production rate, sales, meeting
budgets and schedules
Subjective criteria: helping others, innovation, improving
team spirit, etc.
Financial measures: profits, costs, revenues, inventory
level, etc.
Nonfinancial measures: quality, defects, customer
satisfaction, employee turnover, etc.
Design issues
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Determining relative weight for each measure.
Costs to collect and analyze measures.
Internal accounting system provides some of these
measures.
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Reward and Punish Performance
Types
 Pecuniary rewards: salary, bonuses, retirement
benefits, etc.
 Nonpecuniary rewards: prestigious job titles, better
office location and furnishings, reserved parking
places, country club memberships, etc.
 Punishments: reprimands, ridicule, demotion,
termination, etc.
Design Issues
 Linked to performance measures
 External job market
 Employment and tax law
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Partition Decision Rights
Types
 Centralize decision rights with top executives
 Decentralize decision rights to lower levels
Design issues
 Board of Directors has ultimate authority
 Linking knowledge and decision rights
See Self-Study Problem, “Span of Control.”
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Separation of Management and
Control
Steps in the decision process
1. Initiation (management)
2. Ratification (control)
3. Implementation (management)
4. Monitoring (control)
Separation of management and control
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Separation is particularly important for actions with large
impacts across many agents, such as employee hiring,
plant construction, etc.
Hierarchical structure of organizations allocates the
decision rights over these four steps to different
managers or agents.
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Example: Building a New Plant
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.
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Accounting’s Role in the
Organization’s Architecture
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.]
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Accounting Measures of Performance
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Effective control systems require that accounting
and audit functions are independent of the people
being monitored
Accounting data may aggregate so many individual
transactions that they are not useful for decision
making.
But aggregate accounting data are useful for control
by averaging out random fluctuations.
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Nonaccounting Measures of
Performance
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Useful information for decision making, such as
product quality, customer demand, machine
performance, etc.
Nonaccounting measures are often custom-designed
for each individual or team.
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Accounting and Economic Darwinism
Economic Darwinism implies that seemingly irrational
accounting procedures survive when the benefits of
these procedures exceed agency costs.
Examples:
 Average historical costs achieved by a department
are useful for control, even though may not be
useful for decision making
 Depreciation and other indirect costs are allocated
to production departments to make them use firmwide resources more efficiently
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Executive Compensation Contracts
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.
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A Maxim for All Seasons?
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A person should not be assigned decision rights if
the exercise of these rights cannot be measured and
rewarded.
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Is this a maxim for all seasons?
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Is this a maxim for all environments?
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