Decentralization in Organizations:
Learning Objectives:
- Define and explain the term "decentralization".
- What are the advantages and
disadvantages of decentralization in business organizations?
- What are business segments?
- Define and explain cost, profit, and
investment centers.
Definition and Explanation of Decentralization
A decentralized organization is one in
which decision making is not confined to a few top executives but rather
is throughout the organization, with managers at various levels making
key operating decisions relating to their sphere of responsibility.
Decentralization is a matter of degree, since all organizations are
decentralized to some extent out of necessity. At one extreme, a strongly
decentralized organization is one in which even the lowest-level managers
and employees are empowered to make decisions. At the other extreme, in a
strongly decentralized organization, lower-level managers have little
freedom to make decisions. Although most organizations fall somewhere
between these two extremes, there is a pronounced trend toward more and
more decentralization.
Advantages/Benefits of Decentralization:
Decentralization has many
advantages/benefits, including:
- Top management is relieved of much
day-to-day problem solving and is left free to concentrate on strategy,
on higher level decision making, and coordinating activities.
- Decentralization provides lower level
managers with vital experience in making decisions. Without such
experience, they would be ill-prepared to make decisions when they are
promoted into higher level positions.
- Added responsibility and decision
making authority often result in increased job satisfaction.
Responsibility and the authority, that goes with it makes the job more
interesting and provides greater incentives for people to put out their
best efforts.
- Lower level managers generally have
more detailed and up to date information about local conditions than
top managers. Therefore the decisions of lower level management are
often based on better information.
- It is difficult to evaluate a manager's
performance if the manager is not given much latitude in what he or she
can do.
Disadvantages of Decentralization:
Decentralization has four major
disadvantages:
- Lower level managers may make decisions
without fully understanding the "big picture." While top level managers
typically have less detailed information about local operations than
the lower level managers, they usually have more information about the
company as a whole and should have a better understanding of the
company's strategy.
- In a truly decentralized organization,
there may be a lack of coordination among autonomous managers. This
problem can be reduced by clearly defining the company's strategy and
communicating it effectively throughout the organization.
- Lower-level managers may have
objectives that are different from the objectives of the entire
organization. For example, some managers may be more interested in
increasing the sizes of their departments than in increasing the
profits of the company. To some degree, this problem can be overcome by
designing performance evaluation system that motivate managers to make
decisions that are in the best interests of the organization.
- In a strongly decentralized
organization, it may be more difficult to effectively spread innovative
ideas. Someone in one part of the organization may have a traffic idea
that would benefit other parts of the organizations, but without strong
central direction the idea may not be shared with, and adopted by other
parts of the organization.
Definition and Explanation of Segment:
A segment is a part or activity of an organization about which
managers would like cost, revenue or profit data. Examples of segments
include divisions of a company, sales territories, individual stores,
service centers, manufacturing plants, marketing departments, individual
customers and product lines.
Effective decentralization requires segment reporting.
In addition to the companywide income statement, reports are needed for
individual segments of the organizations. These
segmented income
statements are useful in analyzing the profitability of segments and
measuring the performance of segment managers. These reports have been
discussed in more detail on our
segment reporting and profitability
analysis page.
Cost, profit and
investment centers:
Decentralized companies typically categorize their business segments
into cost centers, profit centers, and investment centers--depending on
the responsibility of the segment managers of the segment.
Cost center:
A cost center is a business segment whose manager has control over
costs but not over revenue or investment funds. Service departments such
as accounting, finance, general administration, legal, personnel and so
on, are usually considered to be cost centers. In addition, manufacturing
facilities are often considered to be cost centers. The managers of cost
centers are usually expected to minimize the costs while providing the
level of services or the amount of products demanded by the other parts
of the organization. For example, the manager of a production facility
would be evaluated at least in part by comparing actual costs to how much
costs should have been for the actual number of good units produced
during the period.
Standard costing and variance analysis page deals this evaluation of
the performance of cost centers in detail.
Profit center:
A profit center is any business segment whose manager has control over
both cost and revenue. Like a cost center, a profit center generally does
not have control over investment funds. Profit center managers are often
evaluated by comparing actual profit to targeted or budgeted profit.
Segmented income statements should be used to evaluate the performance of
profit center managers.
Investment center:
An investment center is any segment of an organization whose manager
has control over cost, revenue and investments in operating assets.
Investment centers are usually evaluated using
return on
investment or
residual income measures.
Responsibility Center:
Responsibility center is broadly defined as any part of an
organization whose manager has control over cost, revenue, or investment
funds. Cost centers, profit centers and investment centers are all known
as responsibility centers.
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