Much like an architectural blueprint, a firm’s organizational chart can reveal important insights into the inner workings of the firm. Managers, analysts, and consultants can easily glean information about the structure—and even draw inferences about a firm’s culture—by knowing both the number of levels in an organization and the size of teams reporting to each person on the chart. Research by David Besanko (Professor of Management and Strategy at the Kellogg School of Management) and colleagues Pierre Régibeau and Katharine Rockett (both of the University of Essex) suggests that analyzing a firm’s organizational structure can also reveal much about the competencies and areas of competitive advantage within the organization.
Besanko, Régibeau, and Rockett explored two different approaches that firms use when organizing their business. The first organizational architecture is functional form, meaning that the firm organizes itself by business functions such as marketing, research and development (R&D), or manufacturing. Contrasting this approach are firms that organize themselves by product line, such as the models and vehicle types within an automotive company or the brands owned by a consumer packaged goods company. The researchers used economic theory to isolate the economic and organizational fundamentals that make it more profitable for a firm to select one organizational form over the other.
An important difference between the two organizational forms is how each structure informs managerial compensation. To elicit high-quality effort and align the manager’s actions with the firm’s objectives, firms tie compensation to observable performance measures such as profitability or stock price. But performance measures are often affected by factors outside an individual manager’s control. For example, firm profitability might be affected by competitors’ actions or by macroeconomic conditions that affect input costs or market demand. As a result, by tying a manager’s pay to performance, a firm introduces “noise” into the manager’s compensation, and managers will typically require additional pay (such as a higher base salary) for bearing the risk associated with this noise.
The Product-Line Organization
A key advantage of a product-line organization is that it enables the firm to incentivize the employees’ efforts by using pay-for-performance mechanisms that involve less noise than those used in a functional organization. This is because the contribution of a product line to firm profitability is typically easier to measure than the financial contribution of functions such as human resources or marketing. In a product-line organization, compensation can be directly tied to the performance of the product line that the manager controls. In a functional organization, although compensation can still be tied to product-line profitability, the link between the choices for which managers have responsibility and the performance metrics on which they are rewarded is weakened, injecting greater noise into their compensation. Thus, these managers require a higher base salary to compensate for this risk. The ability to reward performance at a product-line level provides an advantage for product-line organizations over functional organizations by efficiently providing incentive-based compensation to motivate managerial effort.
A product-line organization provides another benefit to firms in which cross-functional coordination is critical: by consolidating decision making for all functions within a single product unit, managers can better coordinate functional choices. In a functional organization, coordination is attenuated because responsibility for functional choices is dispersed across functional units. For example, if tight coordination between manufacturing and marketing is needed within each of the firm’s product lines, that coordination is better achieved if there are leaders responsible for manufacturing and marketing within each product-line unit. This is in contrast to separate manufacturing and marketing units, in which leaders are responsible for manufacturing and marketing decisions across all of the firm’s product lines.
The Functional Organization
Although considerations relating to incentive-based compensation and cross-functional coordination favor a product-line organization, other factors could motivate a firm to organize by function. In particular, asymmetries between functions or in the function/product mix tend to favor a functional organization. For example, when marketing competencies are far more critical to the firm’s success than any other function, the firm might benefit from a functional organization with a central marketing group responsible for the marketing decisions for all of the firm’s product lines. This arrangement would allow the firm to provide especially attractive incentives to its marketing managers in order to elicit the high-quality marketing effort that is essential to the firm’s success, while providing somewhat softer incentives in the functions that are less critical to a its success.
The following chart summarizes how several important economic and organizational fundamentals affect the trade-off between a functional organization and product-line organization:
The authors use IBM’s organizational structure in the years prior to 1990 to illustrate their insights on the drivers of a firm’s choice of organizational form. Before 1990, IBM was able to charge a price premium of 20–30 percent over its competitors for mainframe computers. This competitive advantage and the strength of IBM’s brand came not so much from distinctive skills in manufacturing, R&D, or new product development, but from its legendary customer-service network. Based on the firm’s strong competence in a particular functional area (customer service) and the existence of functional area externalities across product lines, IBM selected a functional organization. This consisted of two groups: a marketing group, which sold IBM’s products to its corporate and government customers in the United States and was responsible for its customer service; and a product group, which was responsible for manufacturing and new product development. Although IBM tied managers’ pay to performance, which typically favors a product-line organization, this potential drawback for a functional organization was outweighed by the strength of the customer-service function and its competitive advantage across many of the firm’s product lines.
There are significant advantages to a product-line organization—including the ability to accurately measure and compensate effort and the ability to more easily coordinate cross-functionally when organized within a product line. However, firms with either significant variation in functional competencies or a particular function that dominates the others may find that a functional organization is more beneficial than a product-line organization. Managers, analysts, and consultants can learn about not only the culture and hierarchies within a firm, but also its competencies—if they analyze the firm’s organizational structure with these functional differences or dominance in mind.
Matthew Krehbiel graduated from the Kellogg School of Management with an MBA degree in 2008.
Besanko, David, Pierre Régibeau, and Katharine E. Rockett. 2005. “A Multi-Task Principal-Agent Approach to Organizational Form.”Journal of Industrial Economics, 53(4): 437-467.
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