Designing Structure: Vertical Differentiation - Principles of Management

Organization structure can be thought of in terms of three dimensions:

Vertical Differentiation in Organizational Structure

1. Vertical differentiation, which refers to the location of decision-making responsibilities within a structure (that is, centralization or decentralization) and also to the number of layers in a hierarchy (that is, whether the organizational structure is tall or flat).
2. Horizontal differentiation, which refers to the formal division of the organization into subunits.
3. The establlishment of integrating mechanisms, which are mechanisms for coordinating subunits.

We discuss these dimensions next.


A firm’s vertical differentiation determines where in its hierarchy the decision-making power is concentrated. Are production and marketing decisions centralized in the offices of upper-level managers, or are they decentralized to lower-level managers? Where does the responsibility for R&D decisions lie? Are important strategic and financial decisions pushed down to operating units, or are they concentrated in the hands of top managers?

There are arguments for both centralization and decentralization. Centralization is the concentration of decision-making authority at a high level in a management hierarchy.

Decentralization vests decision-making authority in lower-level managers or other employees.

Arguments for Centralization There are four main arguments for centralization. First, centralization can facilitate coordination. Consider a firm that manufactures components in California and performs final assembly in Seattle. These activities may need to be coordinated to ensure a smooth flow of components to the assembly operation. This might be achieved by centralizing production scheduling at the firm’s head office.

In another example, Microsoft recently reduced the number of divisions in its organization from six to three, thereby centralizing decision making in fewer senior managers, in an attempt at greater coordination. Microsoft felt that having six divisions in the company led to confused sales, marketing, and product development efforts and that greater centralization was required to harmonize efforts.

Second, centralization can help ensure that decisions are consistent with organizational objectives. When decisions are decentralized to lower-level managers, those managers may make decisions at variance with top managers’ goals. Centralization of important decisions minimizes the chance of this occurring. Major strategic decisions, for example, are often centralized to make sure the entire organization is pulling in the same direction. In this sense centralization is a way of controlling the organization.

Third, centralization can avoid duplication of activities by various subunits within the organization. For example, many firms centralize their R&D functions at one or two locations. Similarly, production activities may be centralized at key locations to eliminate duplication, attain economies of scale, and lower costs. The same may also be true of purchasing decisions. Wal-Mart, for example, has centralized all purchasing decisions at its headquarters in Arkansas.

By wielding its enormous bargaining power, purchasing managers at the head office can drive down the costs Wal-Mart pays for the goods it sells in its stores. It then passes on those savings to consumers in the form of lower prices, which lets the company grow its market share and profits.

Fourth, by concentrating power and authority in one individual or a management team, centralization can give top-level managers the means to bring about needed major organizational changes. Often firms seeking to transform their organizations centralize power and authority in a key individual (or group) who then sets the new strategic direction for the firm and redraws organization architecture.

Once the new strategy and architecture have been decided on, however, greater decentralization of decision making normally follows. Put differently, temporary centralization of decision-making power is often an important step in organizational change.

Arguments for Decentralization There are five main arguments for decentralization. First, top management can become overburdened when decision-making authority is centralized. Centralization increases the amount of information senior managers have to process. As a result of information overload, managers might suffer the constraints imposed by bounded rationality.

Decentralization gives top management time to focus on critical issues by delegating more routine issues to lower-level managers and reducing the amount of information top managers have to process, making them less vulnerable to cognitive biases.

Second, motivational research favors decentralization. Behavioral scientists have long argued that people are willing to give more to their jobs when they have a greater degree of individual freedom and control over their work. The idea behind employee empowerment is that if you give employees more responsibility for their jobs they will work harder, which increases productivity and reduces costs.

Arguments for Decentralization

Third, decentralization permits greater flexibility—more rapid response to environmental changes. In a centralized firm the need to refer decisions up the hierarchy for approval can significantly slow decision making and inhibit the ability of the firm to adapt to rapid environmental changes. 6 This can put the firm at a competitive disadvantage. Managers deal with this by decentralizing decisions to lower levels within the organization.

Thus at Wal-Mart, although purchasing decisions are centralized so the firm can realize economies of scale in purchasing, routine pricing and stocking decisions are decentralized to individual store managers, who set prices and choose the products to stock depending on local conditions. This enables store managers to respond quickly to changes in their local environment, such as a drop in local demand or actions by a local competitor.

Fourth, decentralization can result in better decisions. In a decentralized structure, decisions are made closer to the spot by individuals who (presumably) have better information than managers several levels up a hierarchy. It might make little sense for the CEO of Procter & Gamble to make marketing decisions for the detergent business in Germany because he or she is unlikely to have the relevant expertise and information. Instead those decisions are decentralized to local marketing managers, who are more in tune with the German market.

Fifth, decentralization can increase control. Decentralization can establish relatively autonomous, self-contained subunits within an organization. An autonomous subunit has all the resources and decision-making power required to run its operation daily. Managers of autonomous subunits can be held accountable for subunit performance. The more responsibility subunit managers have for decisions that impact subunit performance, the fewer excuses they have for poor performance and the more accountable they are.

Thus by giving store managers the ability to set prices and make stocking decisions, Wal-Mart’s top managers can hold local store managers accountable for the performance of their stores, and this increases the ability of top managers to control the organization. Just as centralization is one way of maintaining control in an organization, decentralization is another. We return to this issue in Chapter 9 when we discuss control systems.

The Choice between Decentralization and Centralization The choice between centralization and decentralization is not absolute. Frequently it makes sense to centralize some decisions and decentralize others, depending on the type of decision and the firm’s strategy. We have already noted, for example, how Wal-Mart has centralized purchasing decisions but decentralized pricing and stocking decisions.

Similarly, Microsoft performs major development activities for its Windows operating system at its Redmond corporate campus, but the company has decentralized responsibility for marketing and sales to local managers in each country and region where it does business. Although the choice between centralization and decentralization depends on the circumstances being considered, a few important generalizations can be made.

First, decisions regarding overall firm strategy, major financial expenditures, financial objectives, and legal issues are centralized at the senior management level in most organizations. Operating decisions, such as those relating to production, marketing, R&D, and human resource management, may or may not be centralized depending on the firm’s strategy and conditions in the external environment.

Second, when the realization of economies of scale is an important factor, there tends to be greater centralization. Thus purchasing and manufacturing decisions are often centralized in an attempt to eliminate duplication and realize scale economies. In contrast, sales decisions tend to be more decentralized because economies of scale are less of a consideration here.

Third, when local adaptation is important, decentralization is typically favored. Thus when there are substantial differences between conditions in local markets, marketing and sales decisions are often decentralized to local marketing and sales managers.

Many multinational consumer products firms, such as Unilever, centralize decisions about manufacturing and purchasing to realize scale economies, but decentralize marketing and sales decisions to local brand managers in different countries because competitive conditions differ from country to country and local adaptation is required.

Finally, decentralization is favored in environments that are characterized by high uncertainty and rapid change. When competitive conditions in a firm’s market are changing rapidly, with new technologies and competitors emerging and conditions changing in ways that are difficult to anticipate, centralization, because it slows down decision making, can put the firm at a competitive disadvantage.

This is why many high-technology firms operate with a greater degree of decentralization than firms operating in more stable and predictable environments. 8 At Google, for example, lower-level employees are givenexplicit permission to develop new business ideas and the right to lobby top managers for the funds to develop those ideas. Such decentralization of strategy making would not be found in firms operating in a more stable and predictable environment, such as the automobile industry.

A vivid example of the costs of making the wrong choice between centralization anddecentralization occurred in 2005, when the Federal Emergency Management Agency (FEMA) had to respond to the devastating impact of Hurricane Katrina on New Orleans. The hurricane flooded much of New Orleans and resulted in a mandatory evacuation of the city. FEMA, the federal agency responsible for disaster response, was widely criticized for being very slow to help the hundreds of thousands of mostly poor people who had been made homeless.

For several days while thousands of homeless people huddled in the New Orleans Superdome, lacking food and adequate sanitary facilities, FEMA was nowhere to be seen. Later analysis revealed that one reason for FEMA’s slow response was that the once autonomous agency had been placed under the direct supervision of the Department of Homeland Security after September 11, 2001. FEMA officials apparently felt that they had to discuss relief efforts with their superiors before proceeding. This cost the agency crucial hours in the early part of the disaster, which significantly slowed its response and meant that the relief effort was less effective than it might have been.


A second aspect of vertical differentiation refers to the number of levels in an organization’s hierarchy. Tall hierarchies have many layers of management; flat hierarchies have few layers. Most firms start out small, often with only one or at most two layers in the hierarchy. As they grow, however, managers find that there is a limit to the amount of information they can process and the control they can exert over daily operations.

To avoid being stretched too thin and losing control, they tend to add layers to the management hierarchy, hiring more managers and delegating some decision-making authority to them. In other words, as an organization gets larger it tends to become taller. In addition, as organizations grow they often start to undertake more activities— expanding their product lines, diversifying into adjacent activities, vertically integrating, or expanding into new regional or national markets. This too creates problems of coordination and control, and once again these are often solved by adding layers to the management hierarchy.

For example, consider the history of a business founded by the father of this chapter’s author. The business was a small factory that made wood products for the construction industry, such as doors, window frames, and stairs.

Initially the factory had just one manager, who was also the CEO (the author’s father), and 10 employees. At this point the CEO performed multiple functions—managing employees, planning production, going on sales calls, doing the books, purchasing lumber, and so on. The firm was soon successful and business grew, so the CEO hired more employees. Soon he was too busy to perform all the tasks he had been doing.

At this point he hired help—a factory manager to supervise employees and plan production, a sales manager and three other salespeople to seek business, an accounts manager to manage the books, and a purchasing manager to buy lumber. This freed the CEO to concentrate on bigger strategic issues. In effect, the CEO added another layer to the management hierarchy to cope with growth.

The process did not stop here. Over time the CEO decided to enter other businesses that were related to the wood products industry, including home building, a brickmaking business, and a construction equipment rental company. With more businesses to manage the CEO found that he was once again stretched, so he created four divisions: the wood products factory, the home builder, the brick factory, and the equipment rental company.

To run each division he appointed a general manager. The CEO then managed the general managers and focused his attention on issues that cut across businesses, while the general managers manage people within their businesses. In effect the CEO added a third layer to the management hierarchy.To better manage growth and diversification of the firm, he made the hierarchy taller.


As this example illustrates, growth in the number of layers in a hierarchy is driven by the size of an organization and the number of different activities it undertakes. Adding more levels in the hierarchy is a response to the problems of control that mount when a manager has too much work. How many layers are added is also partly determined by the span of control managers can effectively handle.

Span of Control The term span of control refers to the number of direct reports a manager has. At one time it was thought that the optimal span of control was only about six subordinates. 10 The argument was that a manager responsible for more than six subordinates would soon lose track of what was going on. Now we recognize that the relationship is not this simple.

The number of direct reports a manager can handle depends on the nature of the work being supervised, how visible the performance of subordinates is, and the extent of decentralization within the organization. Generally if the work being performed by subordinates is routine, if the performance of subordinates is visible and easy to measure, and if the subordinates are empowered to make many decisions by themselves, managers can operate with a wide span of control.

How wide is the subject of some debate, but it seems that good managers can effectively handle as many as 20 direct reports if the circumstances are right.In sum, as organizations grow and undertake more activities, the management hierarchy tends to become taller. How tall depends on the span of control that is feasible, which in turn depends on the nature of the work, the visibility of subordinate performance, and the extent of decentralization within the organization.

Note that managers can influence the visibility of subunit performance and the extent of decentralization through organization design, thereby limiting the impact of organization size and diversity on the size of a management hierarchy. This is significant because we know that although adding layers to an organization can reduce the workload of higher-level managers and attenuate control loss, tall hierarchies have their own problems.

Problems in Tall Hierarchies Several problems can occur in tall hierarchies that may result in lower organizational efficiency and effectiveness. First, there is a tendency for information to get accidentally distorted as it passes through layers in a hierarchy. The phenomenon is familiar to anyone who has played the game “telephone.” In this game players sit in a circle; somebody whispers a message to the next person, who then whispers the message to the next person, and so on around the circle.

Problems in Tall Hierarchies

By the time the message has been transmitted by a number of people, it becomes distorted and the meaning starts to change (this can have amusing consequences, which of course is the point of the game). Human beings are not good at transmitting information; they tend to embellish or miss data, which distorts the information. In a management context, if crucial information has to pass through many layers in a tall hierarchy before it reaches decision makers, it may get distorted in the process. So decisions may be based on inaccurate information, and poor performance may result.

There is also the problem of deliberate distortion by midlevel managers who are trying to curry favor with their superiors or pursue some agenda of their own. For example, the manager of a division might suppress bad information and exaggerate good information in an attempt to window-dress the performance of his or her unit to higher-level managers and win their approval. By doing so the manager may get access to more resources, earn performance bonuses, or avoid sanctions for poor performance.

Other things being equal, the more layers there are in a hierarchy, the more opportunities there are for people to deliberately distort information. To the extent that information is distorted, senior managers will make decisions on the basis of inaccurate information, which can result in poor performance. Economists refer to the loss of efficiency that arises from deliberate information distortion for personal gain within an organization as influence costs, and they argue that influence costs can be a major source of low productivity.

A third problem with tall hierarchies is that they are expensive. The salaries and benefits of multiple layers of midlevel managers can add up to significant overhead, which can increase the cost structure of the firm; unless there is a commensurate benefit, a tall hierarchy can put a firm at a competitive disadvantage. A final problem concerns the inherent inertia associated with a tall hierarchy. One cause of inertia in organization is that to protect their turf and perhaps their jobs, managers often argue for the maintenance of the status quo. In tall hierarchies there is more turf (more centers of power and influence) and thus more voices arguing against change. Thus tall hierarchies tend to be slower to change.

Delayering: Reducing the Size of a Hierarchy Given the disadvantages associated with tall hierarchies, many firms attempt to limit the size of the management hierarchy. During the last 15 years or so, delayering to reduce the number of levels in a management hierarchy has become a standard component of many attempts to boost firms’ performance. Delayering is based on the assumption that when times are good, firms tend to expand their management hierarchies beyond the point of efficiency.

The bureaucratic inefficiencies associated with a tall hierarchy become evident only when the competitive environment becomes tougher, at which time managersseek to delayer the organization. Delayering, and simultaneously widening spans of control, is also seen as a way of enforcing greater decentralization within an organization and reaping the associated efficiency gains.

The process of delayering was a standard feature of Jack Welch’s tenure at General Electric, during which he laid off 150,000 people, reduced the number of layers in the hierarchy from nine to five, and simultaneously increased General Electric’s profits and revenues. Welch believed that GE had become too top-heavy during the tenure of his successors. A key element of his strategy was to transform General Electric into a leaner and faster-moving organization—which required delayering. Welch himself had a wide span of control, with some 20 subordinates reporting directly to him, including the heads of GE’s 15 top businesses.

Similarly, Jeffery Immelt, the head of GE’s medical systems business under Welch, had 21 direct reports (Immelt replaced Welch as CEO). 13 Delayering has also been prompted by the realization that large firms can function withrelatively flat structures if their organization architecture is designed correctly. Nucor, forexample, has only four layers in its hierarchy, yet it is the largest steelmaker in the United States.

As at Nucor, achieving a flat hierarchy requires decentralization of responsibility for many decisions to lower-level managers who run autonomous self- contained units (in Nucor’s case, individual steel plants). If these units are managed on an arm’s-length basis, with topmanagement intervening in subunit operations only when performance goals are not met, the top managers can handle a wide span of control, which makes a flat organization feasible.

Nucor, for example, has 25 divisions. The general manager of each reports directly to the CEO, which implies that the CEO has a very wide span of control (probably close to 30 if other corporate executives such as the COO are included).

Although performance benefits are often associated with moving to a flat structure, the process of delayering is not an easy one; and research shows that delayering can cause significant stress and poor morale among managers if the process is not handled correctly. Jack Welch believed that the key to successful delayering is to move fast (thereby eliminating lingering uncertainty among managers concerning their job security) and to reward and promote managers who thrive within the new structure, thereby indicating the management style that will be favored

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