The present paper has as a subject Kranworth Chair Corporation (KCC) management initiative of decentralization (authority for making decisions pushed down to lower levels) the transition from a functional organization structure to a product division structure and some aspects that derive from this decision. We will first present advantages and disadvantages of the new proposed Product Division Structure and how this new structure impact on the decision making process. We will identify the key recurring decisions that must be made effectively for Kranworth Chair Corporation to be successful and how the authority for making these decisions is shifting between the two organizational structures. Further we evaluate the proposed design for performance evaluation and incentive system linked with the new Product Division Organization Structure.
We will assess the alignment (congruence) of performance measurement system with the company’s strategy and strategic objectives and at the same time if meets the criteria of an effective system: controllability, precision, objectivity, timeliness and cost efficiency. Finally we will explore the alternative of further decentralize (give to the product divisions) the R&D function and asses if this decision will trigger changes to the design of KCC performance measurement and incentive system. We will analyze advantages and disadvantages of decentralization of R&D function and give our opinion as what will be the best decision for KCC. Company Overview
Kranworth Chair Corporation (KCC) was incorporated in 1987 by Weston Krantz and Kevin Wentworth. KCC is a manufacturing company, and is associated with the FOLD-IT! brand that includes the production of high-quality and fashionable portable, folding chairs and related products. The main manufacturing line was concentrated to produce (i) folding chairs (produced at several price points) and related products (tripod stools, ottomans, costs, and stadium seats) in Mexican and Chinese manufacturing facilities and (ii) custom-designed products in the Denver location. KCC’s main customers were:
Major retail chains (Wal-Mart, K-Mart, Target) that provided higher sales volumes, but with lower gross margins; Other retail chains (e.g. sporting goods); Corporations for custom-design product orders.
From the beginning of KCC’s activities, the Company had little competition and high margin rates. However, starting in 1999, the Company faced some cash and business issues related to a $30 million dollar loan to allow the owner’s to withdraw cash from the Company, the new competitors on the market and the worldwide recession.
At that point of time Kevin realized that in order to keep the business in good shape, new changes would be required. These changes had to solve the main strategic issues the company faced, which included: eroding profit margins, fierce completion, inventory spread amongst more than a thousand types of products and parts and rather tight financial situation. Kevin realized that to handle all these issues, the company needed to better understand customer requirements and believed that decentralization could help KCC to achieve success.
Key recurring decisions
New changes in the market that might result in high risk of losing market share and drop in profit caused top management to revise the Company’s business direction and structure. In order to reach the proposed objectives the new Company strategy consists in delegating some of the decisions from Top Management (TM) to Division Managers (DM). Table 1 shows how the existing decisions are split between TM and DM. However, considering the Company’s business direction, there would still be new work required to help draw a clearer line on decision-making with regards to important business decisions. For example, under the new structure, human resource (HR) decisions by top management do not specify if this included promotion of staff.
Under the functional organization (EXISTING) VPs of sales, supply chain and finance and administration, staff managers responsible for advertising and research and development reported to cofounders Krantz and Wentworth. Essentially, the main decisions were still made by the cofounders.
After the divisionalization (NEW), the main responsibilities are split between (i) top management and corporate staff and (ii) divisions’ management (i.e. Retail Product division and Custom Product division). The main goal is to give the Divisions’ management more responsibilities and focus over the control of costs and sale organization of specific line of products and strictly to follow the gross margin. These profit centers, strictly speaking, are incomplete profit centers since they are responsible for only several lines of costs in the income statement such as COGS, advertising and promotion, but not responsible for other lines of cost such as R&D, supply chain, etc.
With the transition to Product Division Structure the authority for making some decisions will be pushed down to divisions. Some of the key decisions worth analyzing are:
1. Investment decisions: What investments to make? How to finance the investments? What criteria the proposed investments will have to meet in order to be approved? The Product Divisions will function as profit centers with no authority on making decisions regarding the investments. Taking into account the considerable resources needed for investments it is wise for KCC top management to keep it under tight control.
2. Production decisions: What products to manufacture/develop? Under the new organizational structure the Divisions Managers have the authority to decide what products to manufacture. As stated in the case out of the 1500 SKU produced only 40SKU make up 85%-to 90% of sales. The divisions can concentrate on quality of sales and decide to produce the SKU that are best sold (great margins and big volume).
What inventory level to maintain? Product Division will decide on inventory levels needed based on production cycles and forecasted sales. Division will decide on the minimum inventory level for a purchase order to be initiated and a minimum level of available for sale products. This is applicable more for retail division. Custom division works with specific quantities and delivery terms.
3. Staffing Decisions: Divisions will have the authority to decide on staffing. How many employees needed and if on division advantage – services less costly or of superior quality the divisions have the authority to outsource.
4. Purchasing decisions: What vendors to use? Supply Chain function under new organizational structure will still be a corporate function that will be shared be divisions. Supply Chain is responsible for obtaining and maintaining an adequate vendor group. The divisions had responsibility only for placing orders with the agreed vendors.
5. How to advertise? The product specific advertising will be decided at division level. The advertising of KCC brand “Fold-it!” and brand image creation will fall under the corporate responsibility.
6. Engineering Design and R&D: Decisions related to Engineering Design and R&D will be made at corporate level. “Although most ideas for new products come from division managers and their sales peoples in the field” nothing can be done without Ken Simons “blessing”. Divisions will share the function and expenses will be allocated based on some relevant cost drivers like number of hours of service.
7. Administrative decisions: Divisions will have the authority to decide on their administration. Development and implementation of budgets, controllership and accounting will be under Division care.
Conclusion: Bearing in mind Kevin’s initial motivation, there is still some work to be done in terms of empowering the divisions. Kevin made mention that “each entity would be dedicated to its focused core business, but their managers would be free to choose how they did business and what they incorporated into their business model.” However, we noticed that certain decisions such as the supply chain and quality have not been entrusted to the division managers. Taking into consideration that Kevin is worried that too much decision-making power will be delegated to division management after decentralization, some internal audit control should be put in place.
Scope and extent of decentralization
A Functional Organization is frequently adopted by new organizations and maintained over time by organizations that have a single major business, or several businesses that share the same technologies and have similar markets. KCC management took the right decision in decentralizing the corporation. Functional organizations are often not very responsive to changes in markets or customers’ needs. Moreover, as their level of specialization increases, individuals tend to develop narrower perspectives, and have difficulty in solving problems that require joint efforts with other groups.
Product Division Structure organizes on the basis of the service or product provided. The people within the group perform a variety of different tasks and activities, but they are all contributors to the same final output. Bearing in mind that since 1999 Kevin has been less interested in the business and more interested in his ranches and Weston too is rarely on the ground as he is often flying around, decentralization will help in quicker decision making. The current decentralization framework is designed to divide the divisions according to different customer characteristics and requirements. It has the following advantages: 1. Right people making right decisions at right time: Division management who are closer to customers now have decisions to make on overall vision and strategy for their relative markets. It empowers the right people to make the right decisions and enables rapid response to market demands.
2. Facilitate customer profitability analysis and customer relationship management: The company can now analyze customer profitability and purchasing history (e.g. price, costs analysis) and manage customer relationships accordingly. 3. Increased cost consciousness in divisions: After decentralization, divisions are responsible for issuing their own annual budget. This pre-action review and relevant measuring and rewarding system will enhance cost consciousness indivisions, making them focus more on the quality of sales rather than the mere growth of sales at any cost. 4. Motivate division management teams and improve their abilities: Giving the division management teams more power and responsibility motivates them to reach higher results, be more accountable and improve their management ability in all relevant fields (e.g. finance). 5. Maintain economies of scale and synergies: With HR, finance, R&D, supply chain and general advertising still centralized, the company can maintain economies of scale and synergies on these aspects.
However, the current framework also exhibits weaknesses and exposes the company to risks: 1. Inadequate decentralization: Centralization in R&D and supply chain has caused problems such as conflict in choosing which model has the priority in R&D: allocation of R&D costs, vendors’ late delivery and quality problems which caused missing sales, etc. 2. Loss of economies of scale: Duplication of organizations and each division’s separate purchase of goods or services such as advertising may cause loss in economies of scale. 3. Division managers’ lack of ability: Division managers’ lack of previous experience and professional knowledge in relevant fields such as finance put the division management at risk. 4. Conflict over investments: There may be conflicts between divisional interest and corporation interest such as investment in equipment.
If not controlled properly, division managers may make myopic decisions and sacrifice company benefit. Conclusion: At this primary stage when decentralization is regarded as a radical change to the company, despite some weaknesses and risks, the decentralization structure is still proper for the company and can help the company to solve major strategic issues. We also suggest that the company may consider more decentralization in R&D and supply chain in the future. This further decentralization can draw the line of responsibility more clearly and can decrease internal coordination/negotiation costs.
However, KCC must be aware of the danger of over-decentralizing, which could cause the Custom and Retail divisions to act as separate companies, and thus only in their own best interests and not for the best of the company as a whole. It is clear that there is likely a significant cost to further decentralizing and management must weigh the cost and benefits of decentralizing. Another alternative will be to come up with some agreed cost drivers (like number the hours worked for each product division) for allocating the R&D expenses. What’s more, to ensure the effectiveness of decentralization, proper internal controls, matching measurement and incentive systems must be in place. Proposed performance measurement system
Defining the right performance dimensions is challenging. It is critical to choose performance measurements that are congruent with the company’s objectives. The goals that are set and the measurements that are made will shape employees views of what is important. Good performance measurement should derive from the stated KCC objectives: focus more on quality of sales and not just quantity of sales, create value rather than merely growth and develop strong customer focus, to better understand customer’s needs and to increase customer service levels.
We can see that proposed performance measurement “controllable return” is based only on quantitative indicators. The desired improvement in customers’ satisfaction and creation of value should also be part of the measurement system. The proposed system fails to incorporate measurements for this important objective. Some basic indicators that can be used: number of complaints, % of returned items and % of returning customers (customer retention). In addition to being congruent and controllable, results measures should be precise, objective, timely, understandable and cost efficient in order to be effective. Further, we will analyze if KCC performance measurement system meet the above criteria.
Controllable: Division Managers (profit center managers) can influence and thus be held responsible for: All profit and loss items generated directly by the profit center; Any expense incurred outside the center at head-quarters or other units for which the center can be billed directly; An expense equal to the controllable working capital.
Divisions have about 85% control over P&L results. Some items that Division Managers can argue about not being able to control will be the R&D expenses that get allocated 50/50 and some other expenses that the corporate staff negotiated for the divisions (insurance). Supply Chain is still responsible for maintaining vendor group. The divisions are responsible only for placing purchasing orders; they cannot negotiate contracts (prices) with vendors.
Precise: Regarding precision, inventory items will be the only item subject to using estimates in valuation of work in progress inventory(this will most probably not make a difference; proportion in denominator insignificant). Objective: To be objective a measure must be free from bias. Some bias may occur in valuation of inventory (estimating the labour cost included in work in progress). Understandable: The controllable return formula might not be so easily understood by everyone. Employees need clear goals to strive for. Division managers will have to set up operating targets for departments. Timelines: can be assured using the information system.
Cost Efficiency: Accounting measures of performance are in common use particularly because at minimal incremental cost they provide a useful summary of the results of many actions and decisions that managers take.
Many companies use systems developed by Du Pont and General Motors in the 1920s. They expressed future profit objectives in terms of return on divisional assets and began to base projected performance on past results. Return on investment is a valid technique for measuring past profitability. It is a technique that allows a company to compare profitability among organizations or investments, but it is not a valid way to set future objectives, because the historical costs of assets—on which it is based—are meaningless in planning future action. The failure to make this distinction—between measuring the past and projecting the future—is the principal reason that companies continue to use ROI to measure the financial performance of their managers.
Companies should express profit objectives for both the profit center and its manager in terms of absolute dollars of profit, which are based on the projected potential of existing resources to generate cash flow. The methods used to measure managers affect the way they act. If companies measure return on assets, their managers will do all they can to optimize the ratio, and that may result in suboptimal decisions (Management myopia and sub optimization). Proposed changes to performance measurement and incentive system. To motivate employees and for alignment purposes bonuses should follow below structure:
For Division Managers
Bonuses to be based 85% Retail Division and 80% Custom Division on targeted controllable return and Introduction of qualitative dimension relating to value creation and customer satisfaction. This is very important especially for Custom Division (20%) where the weight should be higher than in Retail Division (15%). For the alignment reasons, managers assigned to a division, bonuses would be based 75% on division performance and 25% on corporate performance.
For Corporate Managers bonuses would be based solely on corporate performance and will follow the same structure as above.
R&D function decentralization
As for investment decisions, we believe that at present it is better for the company to keep R&D under corporate management. Since the divisions are responsible for their own performance and are already incurring the costs of corporate R&D, moving these responsibilities to the divisions would only allow for further control of R&D output and costs. Thus, the division managers would be able to focus dollars on R&D that they feel would generate the most revenues and since they would control the costs, no performance management or incentive changes would be required. However, considering that unsolved issues still exists between R&D and the divisions, some of internal R&D changes should be implemented. Clear and detailed R&D cost allocation for each division, consequently each Division Manager will be sure that no other “foreign” expenses are allocated to his division Nature of R&D requirements to be strictly defined by Division Mangers by issuing new internal policies that R&D Department has to follow.
Consequently, communication and organization issues might be mitigated. Conclusion: Taking into account the size of the Company and the fact that only two divisions exist, the decentralization of the R&D department would generate more costs and the Company’s objectives would not be further achieved. Consequently, R&D should follow the corporate business strategies with reasonable adjustments to divisions’ requirements. Impact of R&D decentralization on performance measurement system R&D department decentralization will have no impact on performance measurement system. The only thing that will change will be the calculation of R&D employee’s bonuses. R&Ds being assigned to divisions the bonuses will be calculate as 75% division performance and 25% corporate performance versus 100% corporate performance for functions not assigned to divisions.