Heavy Organizations
Why organizations exist and what determines their size?
POV: It’s the Monday after Diwali, the extended weekend’s inertia begs you to quit your job and permanently relocate to a beach somewhere but all you manage is an existential ‘why do I have to do this today?’ as you login for work. Welcome back to employment! In other news, the great resignation is well underway. So much so that new statistics about how many people are switching jobs don’t seem to surprise us anymore. While the FOMO is real, today we think it is worth taking a step back to answer these existential questions about how organisations originated, why they should / shouldn’t exist and how big or small they must be. While this has nothing to do with how or where to switch, we hope to deconstruct how we landed here and learn about some fundamental principles of organisation design along the way.
Nature of the firm
To make sense of the modern organisation, we have to go all the way back to 1937. Ronald Coase wrote The Nature of the Firm, the paper that would ultimately win him the Nobel prize in 1991. The paper remains foundational to our understanding of companies and helps define what determines their scope and scale. Economic theories before Coase argued that free markets and supply-demand curves alone would be able to dictate the flow of resources to the right places without the need for central planning (in the form of companies). Everyone believed that because markets are efficient, it would be easier to get work done contractually instead of building companies. Coase observed that this was contradictory to common practice because companies were very much existent. Coase then started wondering what makes an entrepreneur want to hire employees (and bring companies into existence) instead of contracting out work.
Coase identified two variables: Transaction costs and overhead / bureaucracy costs. The first variable creates firms and the second one determines the size of the firm. Let’s start with transaction costs. Coase noted that there are a number of costs involved in using the market. These go beyond the actual cost of goods / raw materials and comprise of searching / negotiation costs, enforcement costs, keeping trade secrets etc., that add to the cost of production. This explains why entrepreneurs hire people. Like imagine having to look for a manufacturing head every time you want increase supply and imagine the cost of enforcing confidentiality of sensitive information throughout this process.
Overhead and bureaucracy costs refer to the possible mistakes in resource allocation people managers can make as organisations get more complex. Think of all the meetings that could have been an email. Overall, Coase proposed that these two variables are in a state of dynamic equilibrium with each other and are in essence competing forces. Jobs to be done by the organisation increases transaction costs and the resulting organisation structure’s complexity (bureaucracy cost) counteracts to reduce the height of the firm. This explains the size of organisations from a macroeconomic perspective. Let’s get into reporting relationships at a team level to understand the forces that increase bureaucracy costs.
The origin of thicc structures
A good starting point within a team is to identify the number of team members that must report to a given supervisor / manager. This is called the span of control and can be a powerful indicator of whether the overall structure is top heavy or middle management heavy and so on. We have already learnt about the importance of managerial leverage. The span of control directly affects managerial leverage and hence the effectiveness of the team. For a manager whose work is largely supervisory, very low span of control (2-3) means poor utilisation and a very high span (10-12) would lead to a lack of individual focus. How should the span be determined then? Andy Grove has a simple rule of thumb for this and the answer depends on the number of working days in a week! He argues that a supervisory manager must effectively allocate half a day per week to each subordinate. This puts the ideal span of control at around 6-8. If the said manager is also a contributor themselves, this number would reduce accordingly. We have understood what span of control is, now let’s look at how it can cause problems.
Consider the mini org chart above. The one on the left has an exclusive engineering manager as well as a manufacturing manager whereas the one on the right has the plant manager acting as the engineering manager. In the former, the plant manager has a span of only 2 whereas on the right, the same person has a span of 5 and is better utilised. While it might seem obvious that we must organise our teams to optimise spans this way, it is rarely observed in practice. Obviously it is not always easy to find someone with the capabilities of a plant manager and that of an engineering manager (or whatever the case may be) but that’s the point. If it was easy, everyone would do it. To make things worse, consider what happens when one of these team members get promoted. There is now an even higher chance that that person’s span will be very short. This is the exact recipe for building a middle management heavy structure. The second order effects of not optimising spans would include poor division of labour amongst team members and lead to increase in the bureaucracy costs as discussed in the previous section.
Strategy vs Structure
The organisation design process can take a significant amount of time. It starts with identifying all the pain points in the current structure and then narrowing down on design principles that must guide the entire design process. Throughout this process it is important to recognise the role of the structure in facilitating the strategy of the organisation. This HBR article covers this topic really well and in fact our very first article on Ideal Gas was on how to align the business strategy with the HR strategy and it is one of our most read pieces till date:
We would like to leave you with the following thought: If an organisation’s structure is so hard to change and if it must be aligned to the strategy at all times, how should companies handle environments requiring a rapid change of strategy without being able to change the structure every single time? Well that’s a story for another day so stay tuned and…