Decentralization

Conceptual Overview

Most modern firms are both multiunit and multilevel organizations. These organizations tend to have a hierarchical structure, which arises naturally when the economic gains from division of labor and specialization are accompanied by the need for managerial coordination of specialized activities. Such division of labor may be carried out in diverse ways, depending on how the subtasks are combined into distinct activity modules, which can then be assigned to different organizational units. The dividing of tasks may be along functional lines—e.g., Departments of Accounting, Finance, and Production—as in traditional U-form (unitary) organizations. Alternatively, it may be along product lines as in more modern M-form (multidivisional) organizations. In either case, a central problem facing a hierarchical organization is where to allocate the decision-making authority. Should the decisions be centralized and made by the CEO at the central head-quarters, or should they be decentralized and made by the managers of the lower-level units such as departments and divisions?

It is useful to frame the question of centralization versus decentralization by first identifying the features that are central to all human decision making. Human decision making involves three fundamental questions: (1) What is the decision maker's objective? (2) What are the courses of actions available to the decision maker? and (3) What are the constraints on the available actions as perceived by the decision maker? In this context, rational decision making entails choosing, out of all possible actions, the one that best meets the objective. The ultimate choice is then determined by two factors. First, the choice depends on what the decision maker knows about the environment, since this determines what options the individual perceives as being feasible. This is the “knowledge” factor. Second, the choice is based on the objective of the decision maker, and different decision makers have different objectives. This is the “incentive” factor. When applied to a multiunit/ multilevel organization with a hierarchical structure, the interaction between the knowledge factor and the incentive factor becomes the main determinant of the organizational performance.