Organizational Architecture Chapter Four Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

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. 4-2

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. 4-3

Firm as a Nexus of Contracts From Brickley, C. Smith, and J. Zimmerman, Managerial Economics and Organizational Architecture, Fifth Edition, (Boston: McGraw- Hill/Irwin, 2009). 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. 4-4

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 4-5

Contract Issues to Consider 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. 4-6

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. 4-7

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. 4-8

What Kind of Agency Problem is This? 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? 4-9

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) 4-10

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. 4-11

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 4-12

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. 4-13

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. 4-14

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. 4-15

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 4-16

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.” 4-17

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. 4-18

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. 4-19

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.] 4-20

Accounting Measures of Performance 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. 4-21

Nonaccounting Measures of Performance 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. 4-22

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 4-23

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. 4-24

A Maxim for All Seasons? 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? 4-25