CHAPTER ONE

The Theoryof the Business

Not in a very long time--not, perhaps, since the late 1940s orearly 1950s--have there been as many new major management techniques as thereare today: downsizing, outsourcing, total quality management, economic valueanalysis, benchmarking, reengineering. Each is a powerful tool. But, with theexceptions of outsourcing and reengineering, these tools are designed primarily todo differently what is already being done. They are "how to do" tools.

Yet "what to do" is increasingly becoming the central challenge facingmanagements, especially those of big companies that have enjoyed long-termsuccess. The story is a familiar one: a company that was a superstar onlyyesterday finds itself stagnating and frustrated, in trouble and, often, in aseemingly unmanageable crisis. This phenomenon is by no means confined to theUnited States. It has become common in Japan and Germany, the Netherlands andFrance, Italy and Sweden. And it occurs just as often outside business--in laborunions, government agencies, hospitals, museums, and churches. In fact, it seemseven less tractable in those areas.

The root cause of nearly every one of these crises is not that things are beingdone poorly. It is not even that the wrong things are being done. Indeed, in mostcases, the right things are being done--but fruitlessly. What accounts for thisapparent paradox? The assumptions on which the organization has been built andis being run no longer fit reality. These are the assumptions that shape anyorganization's behavior, dictate its decisions about what to do and what notto do, and define what the organization considers meaningful results. Theseassumptions are about markets. They are about identifyingcustomers and competitors, their values and behavior. They areabout technology and its dynamics, about a company's strengths andweaknesses. These assumptions are about what a company gets paid for.They are what I call a company's theory of the business.

Every organization, whether a business or not, has a theory of thebusiness. Indeed, a valid theory that is clear, consistent, and focused isextraordinarily powerful. In 1809, for instance, German statesman andscholar Wilhelm von Humboldt founded the University of Berlin on aradically new theory of the university. And for more than 100 years, untilthe rise of Hitler, his theory defined the German university, especially inscholarship and scientific research. In 1870, Georg Siemens, the architectand first CEO of Deutsche Bank, the first universal bank, had an equallyclear theory of the business: to use entrepreneurial finance to unify a stillrural and splintered Germany through industrial development. Within 20years of its founding, Deutsche Bank had become Europe's premierfinancial institution, which it has remained to this day in spite of two worldwars, inflation, and Hitler. And, in the 1870s, Mitsubishi was founded on aclear and completely new theory of the business, which within 10 yearsmade it the leader in an emerging Japan and within another 20 years madeit one of the first truly multinational businesses.

Similarly, the theory of the business explains both the success ofcompanies like General Motors and IBM, which have dominated the U.S.economy for the latter half of the twentieth century, and the challengesthey have faced. In fact, what underlies the current malaise of so manylarge and successful organizations worldwide is that their theory of thebusiness no longer works.

Whenever a big organization gets into trouble--and especially if ithas been successful for many years-people blame sluggishness,complacency, arrogance, mammoth bureaucracies. A plausibleexplanation? Yes. But rarely the relevant or correct one. Consider thetwo most visible and widely reviled "arrogant bureaucracies" among largeU.S. companies that have recently been in trouble.

Since the earliest days of the computer, it had been an article of faith atIBM that the computer would go the way of electricity. The future, IBMknew, and could prove with scientific rigor, lay with the central station, theever-more-powerful mainframe into which a huge number of users couldplug. Everything--economics, the logic of information, technology--led tothat conclusion. But then, suddenly, when it seemed as if such a central-station,mainframe-based information system was actually coming intoexistence, two young men came up with the first personal computer. Everycomputer maker knew that the PC was absurd. It did not have the memory,the database, the speed, or the computing ability necessary to succeed.Indeed, every computer maker knew that the PC had to fail--the conclusionreached by Xerox only a few years earlier, when its research team hadactually built the first PC. But when that misbegotten monstrosity--first theApple, then the Macintosh--came on the market, people not only loved it,they bought it.

Every big, successful company throughout history, when confrontedwith such a surprise, has refused to accept it. "It's a stupid fad and will begone in three years," said the CEO of Zeiss upon seeing the new KodakBrownie in 1888, when the German company was as dominant in the worldphotographic market as IBM would be in the computer market a centurylater. Most mainframe makers responded in the same way. The list waslong: Control Data, Univac, Burroughs, and NCR in the United States;Siemens, Nixdorf, Machines Bull, and ICL in Europe; Hitachi and Fujitsu inJapan. IBM, the overlord of mainframes with as much in sales as all theother computer makers put together and with record profits, could havereacted in the same way. In fact, it should have. Instead, IBM immediatelyaccepted the PC as the new reality. Almost overnight, it brushed aside allits proven and time-tested policies, rules, and regulations and set up notone but two competing teams to design an even simpler PC. A couple ofyears later, IBM had become the world's largest PC manufacturer and theindustry standard setter.

There is absolutely no precedent for this achievement in all of business history;it hardly argues bureaucracy, sluggishness, or arrogance. Yet despiteunprecedented flexibility, agility, and humility, IBM was floundering a few yearslater in both the mainframe and the PC business. It was suddenly unable to move,to take decisive action, to change.

The case of GM is equally perplexing. In the early 1980s--the very years inwhich GM's main business, passenger automobiles, seemed almost paralyzed--thecompany acquired two large businesses: Hughes Electronics and Ross Perot'sElectronic Data Systems. Analysts generally considered both companies to bemature and chided GM for grossly overpaying for them. Yet, within a few shortyears, GM had more than tripled the revenues and profits of the allegedlymature EDS. And ten years later, in 1994, EDS had a market value six times theamount that GM had paid for it and ten times its original revenues and profits.

Similarly, GM bought Hughes Electronics--a huge but profitless companyinvolved exclusively in defense--just before the defense industry collapsed. UnderGM management, Hughes has actually increased its defense profits and hasbecome the only big defense contractor to move successfully into large-scalenondefense work. Remarkably, the same bean counters who had been soineffectual in the automobile business--30-year GM veterans who had neverworked for any other company or, for that matter, outside of finance andaccounting departments--were the ones who achieved those startling results. Andin the two acquisitions, they simply applied policies, practices, and proceduresthat had already been used by GM.

This story is a familiar one at GM. Since the company's founding in a flurry ofacquisitions 80 years ago, one of its core competencies has been to "overpay" forwell-performing but mature businesses--as it did for Buick, AC Spark Plug, andFisher Body in those early years--and then turn them into world-class champions.Very few companies have been able to match GM's performance in makingsuccessful acquisitions, and GM surely did not accomplish those feats by beingbureaucratic, sluggish, or arrogant. Yet what worked so beautifully in thosebusinesses that GM knew nothing about failed miserably in GM itself.

What can explain the fact that at both IBM and GM the policies, practices,and behaviors that worked for decades--and in the case of GM are still workingwell when applied to something new and different--no longer work for theorganization in which and for which they were developed? The realities that eachorganization actually faces have changed quite dramatically from those that eachstill assumes it lives with. Put another way, reality has changed, but the theory ofthe business has not changed with it.

Before its agile response to the new reality of the PC, IBM had once beforeturned its basic strategy around overnight. In 1950, Univac, then the world'sleading computer company, showed the prototype of the first machine designedto be a multipurpose computer. All earlier designs had been for single-purposemachines. IBM's own two earlier computers, built in the late 1930s and 1946,respectively, performed astronomical calculations only. And the machine thatIBM had on the drawing board in 1950, intended for the SAGE air defense systemin the Canadian Arctic, had only one purpose: early identification of enemyaircraft. IBM immediately scrapped its strategy of developing advanced single-purposemachines; it put its best engineers to work on perfecting the Univacarchitecture and, from it, designing the first multipurpose computer able to bemanufactured (rather than handcrafted) and serviced. Three years later, IBM hadbecome the world's dominant computer maker and standard-bearer. IBM did notcreate the computer. But in 1950, its flexibility, speed, and humility created thecomputer industry.

However, the same assumptions that had helped IBM prevail in 1950 proved tobe its undoing 30 years later. In the 1970s, IBM assumed that there was such athing as a "computer," just as it had in the 1950s. But the emergence of the PCinvalidated that assumption. Mainframe computers and PCs are, in fact, no moreone entity than are generating stations and electric toasters. The latter, whiledifferent, are interdependent and complementary. In contrast, mainframecomputers and PCs are primarily competitors. And, in their basic definition ofinformation, they actually contradict each other: for the mainframe, informationmeans memory; for the brainless PC, it means software. Building generatingstations and making toasters must be run as separate businesses, but they canbe owned by the same corporate entity, as General Electric did for decades. Incontrast, mainframe computers and PCs probably cannot coexist in the samecorporate entity.

IBM tried to combine the two. But because the PC was the fastest growing partof the business, IBM could not subordinate it to the mainframe business. As aresult, the company could not optimize the mainframe business. And because themainframe was still the cash cow, IBM could not optimize the PC business. In theend, the assumption that a computer is a computer--or, more prosaically, that theindustry is hardware driven--paralyzed IBM.

GM had an even more powerful, and successful, theory of the business thanIBM had, one that made GM the world's largest and most profitable manufacturingorganization. The company did not have one setback in 70 years--arecord unmatched in business history. GM's theory combined in one seamlessweb assumptions about markets and customers with assumptions about corecompetencies and organizational structure.

Since the early 1920s, GM assumed that the U.S. automobile market washomogeneous in its values and segmented by extremely stable income groups. Theresale value of the "good" used car was the only independent variable undermanagement's control. High trade-in values enabled customers to upgrade theirnew-car purchases to the next category--in other words, to cars with higher profitmargins. According to this theory, frequent or radical changes in models couldonly depress trade-in values.

Internally, these market assumptions went hand in hand with assumptionsabout how production should be organized to yield the biggest market share andthe highest profit. In GM's case, the answer was long runs of mass-produced carswith a minimum of changes each model year, resulting in the largest number ofuniform yearly models on the market at the lowest fixed cost per car.

GM's management then translated these assumptions about market andproduction into a structure of semiautonomous divisions, each focusing on oneincome segment and each arranged so that its highest priced model overlappedwith the next division's lowest priced model, thus almost forcing people to tradeup, provided that used-car prices were high.

For 70 years, this theory worked like a charm. Even in the depths of theDepression, GM never suffered a loss while steadily gaining market share. But inthe late 1970s, its assumptions about the market and about production becameinvalid. The market was fragmenting into highly volatile "lifestyle" segments.Income became one factor among many in the buying decision, not the only one.At the same time, lean manufacturing created an economics of small scale. It madeshort runs and variations in models less costly and more profitable than long runsof uniform products.

GM knew all this but simply could not believe it. (GM's union still doesn't.)Instead, the company tried to patch things over. It maintained the existingdivisions based on income segmentation, but each division now offered a "car forevery purse." It tried to compete with lean manufacturing's economics of smallscale by automating the large-scale, long-run mass production (losing some $30billion in the process). Contrary to popular belief, GM patched things over withprodigious energy, hard work, and lavish investments of time and money. Butpatching only confused the customer, the dealer, and the employees andmanagement of GM itself. In the meantime, GM neglected its real growth market,where it had leadership and would have been almost unbeatable: light trucks andminivans.

A theory of the business has three parts. First, there areassumptions about the environment of the organization: society and its structure,the market, the customer, and technology.

Second, there are assumptions about the specific mission of the organization.Sears, Roebuck and Company, in the years during and following World War I,defined its mission as being the informed buyer for the American family. A decadelater, Marks and Spencer in Great Britain defined its mission as being the changeagent in British society by becoming the first classless retailer. AT&T, again inthe years during and immediately after World War I, defined its role as ensuringthat every U.S. family and business have access to a telephone. An organization'smission need not be so ambitious. GM envisioned a far more modest role--asthe leader in "terrestrial motorized transportation equipment," in thewords of Alfred P. Sloan, Jr.

Third, there are assumptions about the core competencies needed to accomplishthe organization's mission. For example, West Point, founded in 1802, defined itscore competence as the ability to turn out leaders who deserve trust. Marks andSpencer, around 1930, defined its core competence as the ability to identify,design, and develop the merchandise it sold, instead of as the ability to buy.AT&T, around 1920, defined its core competence as technical leadership thatwould enable the company to improve service continuously while steadilylowering rates.

The assumptions about environment define what an organization is paidfor. The assumptions about mission define what an organization considers to bemeaningful results; in other words, they point to how it envisions itself making adifference in the economy and in the society at large. Finally, the assumptionsabout core competencies define where an organization must excel in order tomaintain leadership.

Of course, all this sounds deceptively simple. It usually takes years of hardwork, thinking, and experimenting to reach a clear, consistent, and valid theory ofthe business. Yet to be successful, every organization must work one out.

What are the specifications of a valid theory of the business? There are four.

1. The assumptions about environment, mission, and core competencies must fit reality. When four penniless young men from Manchester, England, Simon Marks and his three brothers-in-law, decided in the early 1920s that a humdrum penny bazaar should become an agent of social change, World War I had profoundly shaken their country's class structure. It had also created masses of new buyers for good-quality, stylish, but cheap merchandise like lingerie, blouses, and stockings--Marks and Spencer's first successful product categories. Marks and Spencer then systematically set to work developing brand-new and unheard-of core competencies. Until then, the core competence of a merchant was the ability to buy well. Marks and Spencer decided that it was the merchant, rather than the manufacturer, who knew the customer. Therefore, the merchant, not the manufacturer, should design the products, develop them, and find producers to make the goods to his design, specifications, and costs. This new definition of the merchant took five to eight years to develop and make acceptable to traditional suppliers, who had always seen themselves as "manufacturers," not "subcontractors."

2. The assumptions in all three areas have to fit one another. This was perhaps GM's greatest strength in the long decades of its ascendancy. Its assumptions about the market and about the optimum manufacturing process were a perfect fit. GM decided in the mid-1920s that it also required new and as-yet-unheard-of core competencies: financial control of the manufacturing process and a theory of capital allocations. As a result, GM invented modern cost accounting and the first rational capital-allocation process.

3. The theory of the business must be known and understood throughout the organization. That is easy in an organization's early days. But as it becomes successful, an organization tends increasingly to take its theory for granted, becoming less and less conscious of it. Then the organization becomes sloppy. It begins to cut corners. It begins to pursue what is expedient rather than what is right. It stops thinking. It stops questioning. It remembers the answers but has forgotten the questions. The theory of the business becomes "culture." But culture is no substitute for discipline, and the theory of the business is a discipline.

4. The theory of the business has to be tested constantly. It is not graven on tablets of stone. It is a hypothesis. And it is a hypothesis about things that are in constant flux-society, markets, customers, technology. And so, built into the theory of the business must be the ability to change itself.

Some theories of the business are so powerful that they last for a long time.But being human artifacts, they don't last forever, and, indeed, today theyrarely last for very long at all. Eventually every theory of the business becomesobsolete and then invalid. That is precisely what happened to those on which thegreat U.S. businesses of the 1920s were built. It happened to the GMs and theAT&Ts. It has happened to IBM. It is clearly happening today to Deutsche Bankand its theory of the universal bank. It is also clearly happening to the rapidlyunraveling Japanese keiretsu.

The first reaction of an organization whose theory is becoming obsolete isalmost always a defensive one. The tendency is to put one's head in the sand andpretend that nothing is happening. The next reaction is an attempt to patch, asGM did in the early 1980s or as Deutsche Bank is doing today. Indeed, thesudden and completely unexpected crisis of one big German company afteranother for which Deutsche Bank is the "house bank" indicates that its theory nolonger works. That is, Deutsche Bank no longer does what it was designed to do:provide effective governance of the modern corporation.

But patching never works. Instead, when a theory shows the first signs ofbecoming obsolete, it is time to start thinking again, to ask again whichassumptions about the environment, mission, and core competencies reflectreality most accurately--with the clear premise that our historically transmittedassumptions, those with which all of us grew up, no longer suffice.

What, then, needs to be done? There is a need for preventive care--that is, forbuilding into the organization systematic monitoring and testing of its theory ofthe business. There is a need for early diagnosis. Finally, there is a need to rethinka theory that is stagnating and to take effective action in order to change policiesand practices, bringing the organization's behavior in line with the new realities ofits environment, with a new definition of its mission, and with new corecompetencies to be developed and acquired.

----------Preventive Care

There are only two preventive measures. But, if used consistently, they shouldkeep an organization alert and capable of rapidly changing itself and its theory.The first measure is what I call abandonment. Every three years, an organizationshould challenge every product, every service, every policy, every distributionchannel with the question, If we were not in it already, would we be going into itnow? By questioning accepted policies and routines, the organization forces itselfto think about its theory. It forces itself to test assumptions. It forcesitself to ask: Why didn't this work, even though it looked so promisingwhen we went into it five years ago? Is it because we made a mistake? Is itbecause we did the wrong things? Or is it because the right things didn't work?

Without systematic and purposeful abandonment, an organization will beovertaken by events. It will squander its best resources on things it should neverhave been doing or should no longer do. As a result, it will lack the resources,especially capable people, needed to exploit the opportunities that arise whenmarkets, technologies, and core competencies change. In other words, it will beunable to respond constructively to the opportunities that are created when itstheory of the business becomes obsolete.

The second preventive measure is to study what goes on outside the business,and especially to study noncustomers. Walk-around management becamefashionable a few years back. It is important. And so is knowing as much aspossible about one's customers--the area, perhaps, where information technology ismaking the most rapid advances. But the first signs of fundamental change rarelyappear within one's own organization or among one's own customers. Almostalways they show up first among one's noncustomers. Noncustomers alwaysoutnumber customers. Wal-Mart, today's retail giant, has 14 percent of the U.S.consumer-goods market. That means 86 percent of the market is noncustomers.

In fact, the best recent example of the importance of the noncustomer is U.S.department stores. At their peak some 20 years ago, department stores served 30percent of the U.S. nonfood retail market. They questioned their customersconstantly, studied them, surveyed them. But they paid no attention to the 70percent of the market who were not their customers. They saw no reason whythey should. Their theory of the business assumed that most people who couldafford to shop in department stores did. Fifty years ago, that assumption fitreality. But when the baby boomers came of age, it ceased to be valid. For thedominant group among baby boomers--women in educated two-income families--itwas not money that determined where to shop. Time was the primary factor, andthis generation's women could not afford to spend their time shopping indepartment stores. Because department stores looked only at their owncustomers, they did not recognize this change until a few years ago. Bythen, business was already drying up. And it was too late to get the babyboomers back. The department stores learned the hard way that althoughbeing customer driven is vital, it is not enough. An organization must bemarket driven too.

----------Early Diagnosis

To diagnose problems early, managers must pay attention to the warningsigns. A theory of the business always becomes obsolete when anorganization attains its original objectives. Attaining one's objectives,then, is not cause for celebration; it is cause for new thinking. AT&Taccomplished its mission to give every U.S. family and business access tothe telephone by the mid-1950s. Some executives then said it was time toreassess the theory of the business and, for instance, separate localservice--where the objectives had been reached--from growing and futurebusinesses, beginning with long-distance service and extending into globaltelecommunications. Their arguments went unheeded, and a few yearslater AT&T began to flounder, only to be rescued by antitrust, which didby fiat what the company's management had refused to do voluntarily.

Rapid growth is another sure sign of crisis in an organization's theory.Any organization that doubles or triples in size within a fairly short periodof time has necessarily outgrown its theory. Even Silicon Valley haslearned that beer bashes are no longer adequate for communication once acompany has grown so big that people have to wear name tags. But suchgrowth challenges much deeper assumptions, policies, and habits. Tocontinue in health, let alone grow, the organization has to ask itself againthe questions about its environment, mission, and core competencies.

There are two more clear signals that an organization's theory of thebusiness is no longer valid. One is unexpected success--whether one'sown or a competitor's. The other is unexpected failure--again, whetherone's own or a competitor's.

At the same time that Japanese automobile imports had Detroit's BigThree on the ropes, Chrysler registered a totally unexpected success. Itstraditional passenger cars were losing market share even faster than GM'sand Ford's were. But sales of its Jeep and its new minivans--an almostaccidental development--skyrocketed. Atthe time, GM was the leader of the U.S. light-truck marked andunchallenged in the design and quality of its products, but it wasn'tpaying any attention to its light-truck capacity. After ail, minivans andlight trucks had always been classified as commercial rather thanpassenger vehicles in traditional statistics, even though most of them arenow being bought as passenger vehicles. However, had it paid attentionto the success of its weaker competitor, Chrysler, GM might have realizedmuch earlier that its assumptions about both its market and its corecompetencies were no longer valid. From the beginning, the minivan andlight-truck market was not an income-class market and was little influencedby trade-in prices. And, paradoxically, light trucks were the one area inwhich GM, 15 years ago, had already moved quite far toward what we nowcall lean manufacturing.

Unexpected failure is as much a warning as unexpected success andshould be taken as seriously as a 60-year-old man's first "minor" heartattack. Sixty years ago, in the midst of the Depression, Sears decided thatautomobile insurance had become an "accessory" rather than a financialproduct and that selling it would therefore fit its mission as being theinformed buyer for the American family. Everyone thought Sears wascrazy. But automobile insurance became Sears's most profitable businessalmost instantly. Twenty years later, in the 1950s, Sears decided thatdiamond rings had become a necessity rather than a luxury, and thecompany became the world's largest--and probably most profitable--diamondretailer. It was only logical for Sears to decide in 1981 thatinvestment products had become consumer goods for the American family.It bought Dean Witter and moved its offices into Sears stores. Themove was a total disaster. The U.S. public clearly did not consider itsfinancial needs to be "consumer products." When Sears finally gave upand decided to run Dean Witter as a separate business outside Searsstores, Dean Witter at once began to blossom. In 1992, Sears sold it at atidy profit.

Had Sears seen its failure to become the American family's supplier ofinvestments as a failure of its theory and not as ail isolated incident, itmight have begun to restructure and reposition itself ten years earlier thanit actually did, when it still had substantial market leadership. For Searsmight then have seen, as several of its competitorslike J.C. Penney immediately did, that the Dean Witter failure threw intodoubt the entire concept of market homogeneity--the very concept on which Searsand other mass retailers had based their strategy for years.

----------Cure

Traditionally, we have searched for the miracle worker with a magicwand to turn an ailing organization around. To establish, maintain, and restore atheory, however, does not require a Genghis Khan or a Leonardo da Vinci in theexecutive suite. It is not genius; it is hard work. It is not being clever; it is beingconscientious. It is what CEOs are paid for.

There are indeed quite a few CEOs who have successfully changed their theoryof the business. The CEO who built Merck into the world's most successfulpharmaceutical business by focusing solely on the research and development ofpatented, high-margin breakthrough drugs radically changed the company's theoryby acquiring a large distributor of generic and nonprescription drugs. He did sowithout a "crisis," while Merck was ostensibly doing very well. Similarly, a fewyears ago, the new CEO of Sony, the world's best-known manufacturer ofconsumer electronic hardware, changed the company's theory of the business. Heacquired a Hollywood movie production company and, with that acquisition,shifted the organization's center of gravity from being a hardware manufacturer insearch of software to being a software producer that creates a market demand forhardware.

But for every one of these apparent miracle workers, there are scores of equallycapable CEOs whose organizations stumble. We can't rely on miracle workers torejuvenate an obsolete theory of the business any more than we can rely on themto cure other types of serious illness. And when one talks to these supposedmiracle workers, they deny vehemently that they act by charisma, vision, or, forthat matter, the laying on of hands. They start out with diagnosis and analysis.They accept that attaining objectives and rapid growth demand a seriousrethinking of the theory of the business. They do not dismiss unexpected failure asthe result of a subordinate's incompetence or as an accident but treat it as asymptom of "systems failure." They do not take credit for unexpected successbut treat it as a challenge to their assumptions.

They accept that a theory's obsolescence is a degenerative and, indeed,life-threatening disease. And they know and accept the surgeon's time-testedprinciple, the oldest principle of effective decision making: A degenerative diseasewill not be cured by procrastination. It requires decisive action.

Excerpted from Peter Drucker on the Profession of Management by Drucker Peter F.. Copyright © 2003 by Drucker Peter F.. Excerpted by permission of Harvard Business School Press.
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