Centralization or Decentralization

Published by MBA Skool Team, Published on August 12, 2011

What is decentralization? It is a tendency to disperse decision making authority in an organization structure. It is a process to delegate authority thorough out the organization to middle and lower level managers. On the other hand, centralization means retaining power and authority in the hands of higher level managers.

Centralization vs Decentralization

As the organization grows, it faces dilemma of centralizing the business units or verticals or departments. Should it combine some of the units to offer an integrated product? Consider a case of equipment manufacturer which has two business units, cutting and welding which operates independently but shares same brand. Both the units are decentralized having independent managers with power and authority. In this case, an integrated product range would make company’s offering more appealing to businesses that bought both types of equipments. The logical explanation is ‘you cut before you weld’.  If cutting is done with welding in mind then cost can be minimized. Now the decision to centralize the operations will depend on type of customers the company has and total revenue generated from them. If majority of customers bought both types of equipment and sales generated from these types of customers are high, then it is worth considering centralization. Any process of centralization or decentralization requires analytical approach. Many a times decision of centralization or decentralization is taken based on benchmarks, instincts or on the basis of competitor’s organization structure.

Before taking any decision it is essential to answer few questions analytically. First question is whether centralization is mandated. For example, it is required to publish annual reports in consolidated manner and must be signed by CEO. In this case it makes sense to centralize the finance operations. On the contrary, health and safety department can be decentralized as each business unit can manage its own compliance. Or for example HR function in a large IT organization like Infosys which is organized in various verticals like manufacturing, retail etc. In this case there is no need for centralization as each unit can have their own HR function. In the last two cases the answer is centralization is not mandated.

If the answer to the first question is no, then second question which is needed to be answered is whether centralization is adding significant value 8-10%. Value here means that organization set itself a hurdle high enough so that the benefits of centralization will probably far outweigh the disadvantages, making the risks worth taking. Hurdle can be whether the proposed initiative adds to ten percent to profits or improves operational efficiency by eight percent or increases market capitalization by ten percent.  The ten percent hurdle does not require fine grain calculations, what it requires is judgment about the significance of the activity.

The third question which is to be answered is whether the risks associated with centralization are low. The risks are reduced motivation levels, increased bureaucracy, and business rigidity. The proposal for centralization can go forward only if the risks are on the negative sides are low. It makes sense to centralize the payroll activity as cost can be saved through economies of scale and risks on the negative side are low. Managers will not feel demotivated by losing control of payroll.

So in order to for the organization to decide on the centralization, answer to the above questions will definitely help it in making the decision.

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