1st session:
Organizational Architecture and Accounting
Performance Evaluation
IMSc in Business Administration
September – October 2009
Organizational Architecture
• Basic Building Blocks
• Organizational Architecture
• Accounting’s Role in the Organization’s
Architecture
• Example of Accounting’s Role: Executive
Compensation Contracts
Adapted from Zimmerman, Jerold L., 2006, Accounting for Decision Making and
Control, 5e, Chapter 4, McGraw Hill
Ricardo F Reis
rireis@fcee.ucp.pt
Session 01 - 2/26
24/03/2016
Performance Evaluation
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.
Ricardo F Reis
rireis@fcee.ucp.pt
Session 01 - 3/26
24/03/2016
Performance Evaluation
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.
Ricardo F Reis
rireis@fcee.ucp.pt
Session 01 - 4/26
24/03/2016
Performance Evaluation
Firm as a Nexus of Contracts
From Brickley, C. Smith, and J. Zimmerman, Managerial Economics and
Organizational Architecture, Third Edition, (Boston: McGraw-Hill/Irwin,
2004.
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.
Ricardo F Reis
rireis@fcee.ucp.pt
Session 01 - 5/26
24/03/2016
Performance Evaluation
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
Ricardo F Reis
rireis@fcee.ucp.pt
Session 01 - 6/26
24/03/2016
Performance Evaluation
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.
Ricardo F Reis
rireis@fcee.ucp.pt
Session 01 - 7/26
24/03/2016
Performance Evaluation
Agency Problems
Free-rider problem: Agents have incentives to shirk because their individual efforts are
not directly observable, rather only a collective effort is.
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.
Ricardo F Reis
rireis@fcee.ucp.pt
Session 01 - 8/26
24/03/2016
Performance Evaluation
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.
Ricardo F Reis
rireis@fcee.ucp.pt
Session 01 - 9/26
24/03/2016
Performance Evaluation
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?
Ricardo F Reis
rireis@fcee.ucp.pt
Session 01 - 10/26
24/03/2016
Performance Evaluation
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)
Ricardo F Reis
rireis@fcee.ucp.pt
Session 01 - 11/26
24/03/2016
Performance Evaluation
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.
Ricardo F Reis
rireis@fcee.ucp.pt
Session 01 - 12/26
24/03/2016
Performance Evaluation
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
Ricardo F Reis
rireis@fcee.ucp.pt
Session 01 - 13/26
24/03/2016
Performance Evaluation
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.
Ricardo F Reis
rireis@fcee.ucp.pt
Session 01 - 14/26
24/03/2016
Performance Evaluation
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.
Ricardo F Reis
rireis@fcee.ucp.pt
Session 01 - 15/26
24/03/2016
Performance Evaluation
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.
Ricardo F Reis
rireis@fcee.ucp.pt
Session 01 - 16/26
24/03/2016
Performance Evaluation
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
Ricardo F Reis
rireis@fcee.ucp.pt
Session 01 - 17/26
24/03/2016
Performance Evaluation
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.”
Ricardo F Reis
rireis@fcee.ucp.pt
Session 01 - 18/26
24/03/2016
Performance Evaluation
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.
Ricardo F Reis
rireis@fcee.ucp.pt
Session 01 - 19/26
24/03/2016
Performance Evaluation
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.
Ricardo F Reis
rireis@fcee.ucp.pt
Session 01 - 20/26
24/03/2016
Performance Evaluation
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.]
Ricardo F Reis
rireis@fcee.ucp.pt
Session 01 - 21/26
24/03/2016
Performance Evaluation
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.
Ricardo F Reis
rireis@fcee.ucp.pt
Session 01 - 22/26
24/03/2016
Performance Evaluation
Nonaccounting Measures of Performance
• Useful information for decision making,
such as product quality, customer demand,
machine performance, etc.
• Nonaccounting measures are often customdesigned for each individual or team.
Ricardo F Reis
rireis@fcee.ucp.pt
Session 01 - 23/26
24/03/2016
Performance Evaluation
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
Ricardo F Reis
rireis@fcee.ucp.pt
Session 01 - 24/26
24/03/2016
Performance Evaluation
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.
Ricardo F Reis
rireis@fcee.ucp.pt
Session 01 - 25/26
24/03/2016
Performance Evaluation
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?
Ricardo F Reis
rireis@fcee.ucp.pt
Session 01 - 26/26
24/03/2016
Performance Evaluation