Organizational Architecture

One of the fundamental tenets of economics is that individuals act in their self-interest to maximize their
utility. Limited resources (time, money, or skills) force people to make choices. When confronted with
constraints or a limited set of alternatives, individuals will use their resourcefulness to relax the constraints and
generate a larger opportunity set. Individuals coalesce to form a firm because it can (1) presumably produce
more goods or services collectively than individuals are capable of producing alone and (2) thus generate a
larger opportunity set. Team production is the key reason that firms exist.
Besides providing information for making operating decisions, accounting numbers are also used in controlling conflicts of
interest between owners (principals) and employees (agents). Agency problems arise because self-interested employees maximize
their welfare, not the principals welfare, and principals cannot directly observe the agents actions.
The free-rider problem, one specific agency problem, arises because, for agents working in teams, the incentive to shirk increases
with team size. Usually it is more difficult to monitor individual agents as team size increases. Also, each agent bears a smaller
fraction of the reduced output from his or her shirking. The horizon problem, another agency problem, arises when employees
expecting to leave the firm in the future place less weight than the principal does on those consequences occurring
after they leave.

Decision rights over the firms assets are assigned to various people within the firm who are then held
accountable for the results. If an individual is given decision-making authority over some decision (such as
setting the price of a particular product), we say that person has the decision right for that products price.
Employee empowerment is a term that means assigning more decision rights to employees (i.e.,
decentralization).

Accounting-based budgets assign decision rights to make expenditures to specific employees. Although they
are rational and self-interested, individuals have limited capacities to gather and process knowledge. Since
information (knowledge) is costly to acquire, store, and process, individual decision-making capacities are
limited. Because knowledge is valuable in decision making, knowledge and decision making are generally
linked; the right to make the decision and the knowledge to make it usually reside within the same person. In
fact, a key organizational architecture issue is whether and how to link knowledge and decision rights

Production occurs either within a firm or across markets. Nobel Prize winner in economics Ronald Coase
argued that firms lower certain transactions costs below what it would cost to acquire equivalent goods or
services in a series of market transactions. Thus, markets not only measure decision makers performance but
also reward or punish that behavior.

Transactions that occur across markets have fewer agency problems because the existence of markets and market prices gives
owners of an asset the incentive to maximize its value by linking knowledge with decision rights. But once transactions occur
within firms, administrative devices must replace market-induced incentives. In particular, firms try to link decision rights with
knowledge and then provide incentives for people with the knowledge and decision rights to maximize firm
value.

In fact, markets do three things automatically that organizations (firms) can accomplish only through elaborate
administrative devices: (1) measure performance, (2) reward performance, and (3) partition rights to their
highest-valued use. When Adam Smith described the invisible hand of the market and how the market
allocates resources to their most highly valued use, he was describing how the market influences behavior and
assigns decision rights.

Sometimes, however, firms use bureaucratic rules that purposely limit active decision making. One potential
benefit of limiting discretion in making decisions is that it reduces the resources consumed by individuals in
trying to influence decisions. By not assigning the decision right to a specific individual, influence costs are
lowe-red because there is no one to lobby. This policy, however, can impose costs on an organization. For
example, consider individuals who are competing for a promotion. Each of these individualshas an incentive to
provide evidence to the supervisor that he or she is the most qualified person for the promotion. Such
information is often useful in making better promotion decisions.

However, the information comes at a costemployees spend time trying to convince the supervisor that they
are the most qualified candidate rather than performing some other activity
such as selling products.

To maximize firm value, which involves minimizing agency costs, managers design the organizations architecturethree
interrelated and coordinated systems that measure and reward performance and assign decision rights. The analogy of the three-
legged stool illustrates how important it is that the three legs be matched to one another. Changing one leg usually requires
changing the other two to keep the stool level. Ultimately, all organizations must construct three systems:
1. A system that measures performance.
2. A system that rewards and punishes performance.
3. A system that assigns decision rights.


The internal accounting system, used to measure agents performance, provides an important monitoring function. Hence, the
accounting system usually is not under the control of those agents whose performance is being monitored. Primarily a control
device, accounting is not necessarily as useful for decision making as managers would like.
The performance evaluation system, one leg of the stool, consists of both financial and nonfinancial measures of performance.
Executive compensation plans routinely use accounting earnings as a performance measure both to evaluate managers and to
reduce agency costs by constraining the total bonus payouts to managers.

Performance measurement systems generally use financial and nonfinancial measures of performance. Nonfinancial
metrics include: percentage of on-time deliveries, order completeness, factory ability to meet production schedules,
excess inventory, employee turnover, manufacturing quality, percentage of defects and units of scrap, schedule
performance, and customer complaints. Financial indicators are collected and audited by the firms accountants,
whereas nonfinancial measures are more likely to be self-reported. Therefore, financial measures are usually more
objective and less subject to managerial discretion. Nonfinancial indicators usually relate to important strategic
factors. For example, airline profitability is very sensitive to the fraction of airline seats occupied. Thus, load factors
are an important strategic measure in airlines. Nonfinancial measures provide information for decision making.
Financial measures of performance tend to be for control.

Decision management refers to those aspects of the decision process in which the manager either initiates or
implements a decision. Decision control refers to those aspects of the decision process whereby managers either
ratify or monitor decisions. After a certain period, the employees performance is evaluated. In general, the
following steps in the decision process occur (categorized according to decision management or decision control):
(1) initiation (management), (2) ratification (control), (3) implementation (management), and (4) monitoring
(control). Initiation is the request to hire a new employee. Ratification is the approval of the request.
Implementation is hiring the employee. Monitoring involves assessing the performance of the
hired employee at periodic intervals to evaluate the person who hires the employee.