Responsibility Centers, Decision Rights, and Synergies

Abstract

ABSTRACT We consider the optimal allocation of decision rights over noncontractible specific investments. Risk-averse business unit managers each engage in general (stand-alone) operations and invest in joint projects that benefit their own and other divisions. Which of the managers should have the authority to choose these investments? With scalable investments, we show that decision rights should be bundled in the hands of the manager facing the more volatile environment. With discrete (lumpy) investments, on the other hand, decision rights should be split between the managers, provided they face comparable levels of uncertainty in their general operations. Splitting decision rights better leverages the inherent investment complementarity, counter to conventional wisdom. Our model generates empirical predictions for the equilibrium association of organizational structure and managers' incentive contracts: bundling of decision rights results in pay-performance sensitivity (PPS) divergence across divisions; splitting them results in PPS convergence. JEL Classifications: M41; D23; D86.