Chapter Four
Organizational Architecture
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Outline of Chapter 4
Organizational Architecture
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Basic Building Blocks
Organizational Architecture
Accounting’s Role in the Organization’s
Architecture
Example of Accounting’s Role: Executive
Compensation Contracts
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Self-interested Behavior
Fundamental assumption of economics: Individuals act in their own selfinterest 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-for-profit 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, Fourth Edition, (Boston: McGrawHill/Irwin, 2007.
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
 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
 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:
 making within the firm, or
 buying from outside markets (outsource).
Factors to consider in make-versus-buy:
 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
 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
 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
 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
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Accounting data may aggregate so many
individual transactions that they are not
useful for decision making.
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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.
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Nonaccounting measures are often customdesigned 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 firm-wide
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.
Is this a maxim for all seasons?
Is this a maxim for all environments?
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