Where should employees be located in matrix organization: co-located with project manager or with head of their department?
If you talk about matrix organisations, you have to differ between the different kind of matrix organisations (see answer to What are differences between Project Manager, Project Expeditor and Project Coordinator?).
One of the motivations of strong matrix organisations is to concentrate domain specific knowledge, e.g. functional safety or how to create software architectures. Therefore it is necessary to share the specialists among different projects, otherwise they won't be able to keep their knowledge due to the fact that is is demanded during the project for a specific / short time only. If the specialist are located in a project independent department:
- Their knowledge could be provided to several projects
- They could share knowledge among specialist of the same domain which are also located in their department
- Further education could be organised in a common way
- Similar organisational aspects (payment, working hours, etc.) are concentrated
If the demand for highly specialised employees is very high, they should be organised around their functional manager, e.g. when their influence on project success is very high and their temporal assignment is short.
But be aware of the fact that you need a "critical mass" of projects demanding the special capability. Otherwise you might run better using subcontractors.