CHAPTER FOUR

Organizational Architecture
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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

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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-for-profit organizations, and other entities.

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Firm as a Nexus of
Contracts
From Brickley, Smith, and Zimmerman, Organizational Architecture,
Second Edition, (Boston: McGraw-Hill/Irwin, 2001), pp. 131-132.

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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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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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
 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
 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 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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