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Group self-management is more appropriate than a hierarchy when work outcomes benefit from frequent group interaction and group incentives (such as from information sharing or from increased motivation and group support) and when the costs of group coordination do not detract from other group outcomes. Organizing by self-managing groups, however, makes it difficult to monitor and control individual outputs and align individual incentives with the activities of the larger firm, whose goals can come into conflict with those of the group. Armen Alchian and Harold Demsetz raise these issues about groups and hierarchies in explaining why firms exist.3 Beyond a certain size, group self-management becomes too costly, and some form of hierarchy is necessary to maintain and evaluate the group as well as reduce agency problems that occur when individuals try to influence firm decisions for their private benefit.

For examples of these tensions, consider investment banks. Although these banks may organize their front-office selling and trading on an individual basis, it would be less appropriate to organize middle-office activities, such as risk management, or back-office activities, such as order execution, on an individual basis, since these necessarily focus on firm performance with scant opportunities for individual incentives. Moreover, if these activities became subject to competition among groups for key resources, the overall effect for the firm and its reputation could be very negative, such as when trading partners come to doubt the firm’s ability to fulfill its obligations in clearing transactions. How much control is introduced depends on the extent of agency problems and the time and effort needed to control them. These comprise the influence costs that we also discussed in Chapter 3.

Although nearly everyone is familiar with these issues in organizing small firms or work groups, this level of organizing is seldom of strategic importance in larger firms, especially when compared to the investments these firms make to achieve large scale or serve extended markets. In small firms, these simpler structures can be readily changed, but can also affect relatively small numbers of individuals at a given time. Of much greater importance are the organizational schemes used in larger firms that affect considerable numbers of people and govern the allocation of significant organizational assets. These are complex hierarchies, which involve organizing large numbers of groups within extensive and potentially overlapping schemes. These are discussed in more detail below.

Complex Hierarchy

Large firms require complex hierarchies—that is, the structure of the firm involves multiple groups and multiple levels of groupings. Complex hierarchy arises from the need not just to organize individuals into groups, but to organize groups into larger groups. This process quickly becomes complicated and involves two related problems:

1.Departmentalization, or partitioning of workers into subgroups

2.Coordination of activities within and between subgroups to attain the firm’s objectives

Most organization designs combine solutions to departmentalization and coordination problems under the specific conditions a firm faces.4

Departmentalization

Departmentalization involves the partition of the organization into different groups and sets of groups. It may occur along several dimensions: tasks (or functions), inputs,

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outputs, geography, and time of work. Given that multiple dimensions are at work, this process involves two related steps. First, the dimensions that are relevant to a given firm need to be identified. Should products or functions be used as an organizing dimension? What about geography or customers? Second, along with identifying the dimensions, it is also necessary to specify the relationships between chosen dimensions. Which coordination problems need to be handled first? Which problems are best handled at a more general level within a firm, after more basic issues of coordination have been considered? It is the need to choose organizing dimensions as well as relationships among those dimensions that makes organization design difficult in large firms.

At its most basic level, departmentalization represents the choices of managers regarding the appropriate division of labor in the firm. Samples of departments organized around common tasks or functions include accounting, marketing, and production. Other grouping schemes can focus on criteria related to the firm’s inputs and outputs. Examples of these schemes include the Pepsi Bottling Group and Fountain Beverage Division that we discussed earlier.

To illustrate how grouping schemes can differ internationally, consider Jaipur Rugs, in 2008 the largest manufacturer and exporter of Indian hand-knotted rugs, with 2008 revenue of $21.1 million and compound annual growth of over 30 percent. The firm offers a wide range of products, operates in a complex production environment, and must organize the activities of 7 family members, 300 full-time employees, and 40,000 contractors, of whom 28,000 are weavers, with the remainder involved in other aspects of the firm’s complex supply chain. The business had traditionally been organized as an association of separate legal entities tied together by family. With rapid growth, the firm has had to change from a partnership into a corporation to coordinate its activities through investments in information technology. It has also reorganized into a unified hierarchy focusing on key functions of marketing, finance, operations, supply chain, design and development, and human resources and information technology.5

Departments and divisions can also be organized around locations, such as with regional sales offices or service centers. There can even be time-based groupings that would reflect different priorities in organizational activities at different times of the week or some other cycle of activities. This is illustrated by 24-hour call centers, whose employees deal with the customer service issues of people in different parts of the world, depending on the shifts they work. While outsourcing customer service activities to these centers has been popular with many U.S. consumer products firms, large retail banks, such as Citigroup or Chase, have been the leaders. These centers have largely been located in India, but by early 2011 the Philippines had taken a narrow lead, with 350,000 call center employees versus 330,000 in India. The reasons for the change appear to be that U.S. customers have fewer problems with the accents of Filipinos and employers there have fewer problems recruiting workers for night-shift positions.

Deciding how to organize tasks within a firm reflects the choices of managers regarding what activities are to be done and their relative importance. These reflect key elements of the firm’s strategy, including who its core customers are and which of its activities will be the most critical for its success. Thus, departmentalization is also associated with the choice of a firm’s boundaries. For example, diversification into new businesses will be reflected in an expansion in the set of a corporation’s divisions, departments, and other groups. A decision to outsource a significant function will lead to a contraction of a firm’s structure; this removes the individuals and

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activities associated with that function from the organization, placing it outside the firm’s boundaries. We discussed decisions about the firm’s boundaries in earlier chapters, and the results of boundary choices will be apparent in the contours of a firm’s structure.

In general, when selecting organizing dimensions, managers should consider economies of scale and scope, transactions costs, and agency costs. A firm should combine workers or teams into a department when their activities involve economies of scale or scope. For example, if a multiproduct firm can achieve significant scale economies in research and development, then an organizational structure that included a companywide research department would be more efficient than dispersing R&D personnel throughout a number of independent product groups. This would be the case for research into core technologies that clearly influence most of the firm’s products. The classic example of this would be the 3M Corporation, with its longstanding skills in adhesive chemistry. However, there may also be situations in which research is most valuable when it focuses on production processes or on how the firm’s products are best employed by customers. This would suggest the wisdom of organizing R&D on the basis of divisions or distinct customer business areas. An example of a firm with such an approach to R&D would be Crown Holdings (formerly Crown Cork and Seal) which shifted its research in a mature business (metal cans) to help its customers best employ Crown’s products to advantage in their own production processes.

While it is easy to recommend that managers organize around available scale or scope economies, in practice this is often difficult to do, since in any given situation, there may be potential economies both within units and between units, such that the “best” structural choice is not apparent in advance. For an example of this, consider Apple’s success in coming to dominate the digital music business through the combination of its iPod and its iTunes Store. A natural question that observers asked while this domination was taking place was what Sony would do about it. Sony was the firm that launched portable music players with its Walkman, owned a substantial record company, and was one of the few firms that could compete with Apple in producing stylish electronics for consumers. Yet Sony failed and Apple transformed the industry.

A possible reason for this outcome is organizational. Apple’s triumph came from combining its iPod device with its rights management regime. This is what convinced the major record companies and artists to agree to sell their works on iTunes. This success involved a merging of hardware and content that was the key to the product. Although Sony possessed significant hardware and content, it was not organized to combine them effectively. Instead, it was organized into distinct divisions, each with its own responsibilities and profit objectives. This allowed Sony to capitalize on the economies specific to hardware or to content, but not the synergies between them. When Sony attempted to imitate Apple, this arrangement created a conflict that limited cooperation and allowed Apple, which was not organized into divisions, to find a solution that worked.6

Finally, the choice of an organizing dimension has implications for agency costs, such as we discussed in Chapter 12. For example, measuring the performance of a firm’s functional departments, such as finance and purchasing, can be difficult because it is difficult to identify tangible outcomes directly related to profitability. Moreover, because of the weak linkage with overall firm performance, individuals in these departments are likely to think of their performance in terms of functional excellence rather than overall firm success. This makes it hard to evaluate and reward department managers, which further increases agency costs inside the firm.

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Coordination and Control

Once groups have been identified and organized, the interrelated problems of coordination and control arise. Coordination involves the flow of information to facilitate subunit decisions that are consistent with each other and with organizational objectives. Control involves the location of decision-making and rule-making authority within a hierarchy. Coordination and control choices can affect both efficiency and agency costs. They influence efficiency because decision makers need access to lowcost, accurate, and timely information, while assuring that the firm takes full advantage of economies of scale and scope in production. For example, poor coordination between the Pepsi Bottling Group and Pepsi USA resulted in technical inefficiencies when the two divisions failed to economize on marketing and sales efforts. This suggests that decision rights should be allocated so that individuals with the best and most timely information are empowered to make decisions, provided of course that the decision maker’s goals are aligned with those of the firm.

Coordination and control also affect agency costs because structures designed for similar tasks may differ in the opportunities they offer managers to pursue personal or unit objectives that are inconsistent with the firm’s objectives. By allocating formal decision rights throughout a hierarchy, a firm’s managers designate a legitimate basis of authority that they perceive will best support overall firm objectives. In the next chapter, we will discuss formal authority and its relationship to other bases of power and influence.

By addressing coordination and control issues, organization structure provides a focus for accountability—aligning individual and group tasks with those of the firm and aligning incentives so that individuals and groups will consistently work in the same direction. Structure also needs to be capable of adjusting to changes in both the firm’s capabilities and its business environment. These shifting and potentially conflicting demands comprise what Robert Simons calls the “creative tensions” that are part of organization design.7

Two examples of these tensions illustrate the need for firms to adapt their structures to align with their strategic needs. First, consider the situation faced by a relatively focused firm with divisions in mature high-volume businesses. A divisional structure coupled with a control system stressing sales volume and production efficiency may be an optimal structure for such a firm. However, if that firm decided to diversify and acquire smaller firms in high-growth innovative businesses, the structure would be far from optimal. This structure would penalize managers at the newly acquired divisions because their businesses could not match the volume and cost performance of established divisions. A new structure and set of performance metrics would be needed to adapt to the firm’s change in strategy and capabilities. David Garvin and Lynne Levesque discuss this as a problem of organizing for corporate entrepreneurship and cite IBM and Ashland Oil as examples of firms that crafted hybrid organization designs to accommodate the developmental needs of new subsidiaries as well as their needs for eventual incorporation into the corporation’s broader organization.8

Firms facing a changeable business environment that necessitates a change in strategy would also benefit from adaptability. For example, consider the Lincoln Electric Company, a manufacturer of welding equipment headquartered in Cleveland. Lincoln had a long record of success serving U.S. customers with a complex structure and control system that made heavy use of piece-rate incentives. When the evolution of its industry required that the firm expand into international markets in the late 1980s, however, its initial efforts met with less success. Lincoln Electric was unable to