Organizational Architecture

When we hear the phrase ‘Organizational Architecture’ it either evokes the idea of vast tree diagrammed org charts or some intangible notion of a company’s culture that we can’t quite define. In truth, there is a standard definition for Organizational Architecture, and it comes with it an instructive way to think about the firm and the individuals that comprise the human capital that makes it tick.

There are three distinct parts to the firm’s makeup, sometimes referred to as the Three Legged Stool of Organizational Architecture. They are as follows:

A. Assignment of Decision Rights

B. Performance Measurements

C. Systems of Rewards and Punishments

The interplay between these three concepts is critical to understanding just what it is you’re supposed to be doing at work...

What to do... What to do...

The assignment of decision rights may seem like a fairly straightforward concept, but it is wrought with tradeoffs that must be made. Decisions in the firm are made in some degree either through centralization or decentralization. In the case of the centralized decision making, decision rights are made in the top-down manner from which we’re accustomed to a hierarchy of chain of command. Organizations of this type run from the typical C-level architecture on one end of the spectrum to the somewhat more nefarious centrally-planned governments of the failed Soviet Block. The tradeoff involved is one of control in the decision making and the availability of specific information that is more available to line workers and managers. If you expect Mussolini to keep the trains running, the risk you run is that the chief engineer might get strung up upside down in the town center. Alternately, if the specific information needed to keep the trains running is more localized, there is also a two-fold risk. One is that the information costs to synchronizing the trains is left to the individual stations, suggesting that two trains could hypothetically meet head on at the end of some less-than-hypothetical math problem. The second is that the individual stations would know more about their particular routes than the central planning, so the question is again one of tradeoffs.

Performance Anxiety

Performance Measures are by far the most hand-wrenching and neglected of the three legs of the stool. It works on two levels. One is the individual performance of the managers and employees. The other is the firm’s performance as a whole. The complicating factor is that these two are inextricably mixed. The level of individual performance measure, in theory, should be tied to the firm’s performance, but it rarely works this way. As such, a great deal of make-shift constructions and outright neglect of individual performance reviews exist in the real world. The firm’s performance is typically measured through stock price (in a public company) and some assumptions about growth. They’re tied to budgets and forecasts and re-forecasts and budget revisions. These nebulous constructions can lead to analysis paralysis that usually is put priorities-wise ahead of individual performance of all except the very top levels of management.

Compensation and Incentives

The third and final leg of the stool is one of incentives & disincentives. For the firm, these are typically broken down by Strategic Business Units (SBUs) internally and market-based incentives both internally & externally. In practice, the SBUs are subject to a great deal of in-fighting over transfer pricing and decisions of scope concerning what activities should be taken up by the firm itself and which should be outsourced. Incentives gauge how much the individual should be paid for their contribution to the firm’s success or failures, and the diametric opposition of these two interests are the basis of agency theory. Agency theory purports that an agent works on behalf of a principal, and that any work against the principal's best interests are costs that must be accounted for in the larger scheme of incentive compensation.

If interests of the firm and the individual worker or manager are aligned, then transaction costs are low. However, since many incentive systems are subject to human error (both unintended and otherwise) transaction costs revolving around the misalignment of incentives may prevail.

It is only when the totality of these three components are evaluated on the individual, SBU and firm level that the alignment of incentives can be measured in terms of the operational decision rights that a firm must undertake to be successful. Collectively, this success or failure is determined under the precepts of transaction cost economics.

AE - 11.13.2012

The Ambidextrous Economist is a beautiful mess. He can be reached at AmbidextrousEconomist@gmail.com.