Decentralization in Organizations

Decentralization in Organizations:

Learning Objectives:

  1. Define and explain the term “decentralization”.
  2. What are the advantages and disadvantages of decentralization in business organizations?
  3. What are business segments?
  4. 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:

  1. 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.
  2. 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.
  3. 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.
  4. 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.
  5. 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:

  1. 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.
  2. 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.
  3. 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.
  4. 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.

You may also be interested in other articles from “decentralization, segment reporting and transfer pricing” chapter:

  1. Decentralization in organizations
  2. Traceable and common fixed costs
  3. Segment reporting and profitability analysis-segmented income statements
  4. Hindrances/Problems to Proper Cost Assignment in Segmented Reporting
  5. Segmented Financial Information on External Reports
  6. Return on Investment (ROI) for Measuring Managerial Performance
  7. Controlling and Improving Rate of Return on Investment
  8. Return on Investment (ROI) and Balanced Scorecard
  9. Criticism, Disadvantages or Limitations of Return on Investment (ROI)
  10. Residual Income-Another Method to Measure Managerial Performance
  11. Limitations, Criticism or Disadvantage of Residual Income Method
  12. Allow the managers involved in the transfer to negotiate their own transfer price (negotiated transfer pricing).
  13. Set transfer prices at cost using variable or full (absorption) cost
  14. Set transfer prices at the market price
  15. Divisional Autonomy and Sub optimization
  16. International Aspects of Transfer Pricing

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