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Abbyy SEPTEMBER-OCTOBER 1994 ^ "I The Theory of the Business orei by Peter R Drucker N ot in a very long time-not, perhaps, since the late 1940s or early 1950s-have there heen as many new major man- agement techniques as there are today: downsizing, out- sourcing, total quality management, economic value analysis, henchmarking, reengineering. Each is a powerful tool. But, with the exceptions of outsourcing and reengineering, these tools are designed primarily to do differently what is already heing done. They are "how to do" tools. Yet "what to do" is increasingly becoming the central challenge facing managements, especially those of hig companies that have enjoyed long-term success. The story is a familiar one: a company that was a superstar only yesterday finds itself stagnating and frus- trated, in trouble and, often, in a seemingly unmanageable crisis. This phenomenon is hy no means confined to the United States. It has hecome common in Japan and Germany, the Netherlands and France, Italy and Sweden. And it occurs just as often outside husi- ness-in labor unions, government agencies, hospitals, museums, and churches. In fact, it seems even less tractahle in those areas. The root cause of nearly every one of these crises is not that things are being done poorly. It is not even that the wrong things are being done. Indeed, in most cases, the right things are being done-but fruitlessly. What accounts for this apparent paradox? The assumptions on which the organization has been huilt and is heing run no longer fit reality. These are the assumptions that Peter F. Drucker is the Clarke Professor of Social Science and Manage- ment at the Claremont Graduate School in Claremont, California, where the Drucker Management Center was named in his honor. This is Drucker's thirty-first article for HBR. icies HARVARD BUSINESS REVIEW September-October 1994 95 THEORY OF THE BUSINESS What underlies the malaise of so manv large and successful organizations worldwide is that their theory of the business no longer ivorks. shape any organization's hehavior, dictate its decisions about what to do and what not to do, and define what the organization considers meaningful results. These assumptions are about mar- kets. They are about identifying customers and competitors, their values and hehavior. They are about technology and its dynam- ics, about a company's strengths and weaknesses. These assump- tions are about what a company gets paid for. They are what I call a company's theory of the business. Every organization, whether a husiness or not, has a theory of the husiness. Indeed, a valid theory that is clear, consistent, and focused is extraordinarily powerful. In 1809, for instance, German statesman and scholar Wilhelm von Humboldt founded the Uni- versity of Berlin on a radically new theory of the university. And for more than 100 years, until the rise of Hitler, his theory defined the German university, especially in scholarship and scientific research. In 1870, Georg Siemens, the architect and first CEO of Deutsche Bank, the first universal hank, had an equally clear the- ory of the husiness: to use entrepreneurial finance to unify a still rural and splintered Germany through industrial development. Within 20 years of its founding, Deutsche Bank had hecome Eu- rope's premier financial institution, which it has remained to this day in spite of two world wars, inflation, and Hitler. And, in the 1870s, Mitsubishi was founded on a clear and completely new the- ory of the business, which within 10 years made it the leader in an emerging Japan and within another 20 years made it one of the first truly multinational businesses. Similarly, the theory of the husiness explains both the success of companies like General Motors and IBM, which have dominat- ed the U.S. economy for the latter half of the twentieth century, and the challenges they have faced. In fact, what underlies the cur- rent malaise of so many large and successful organizations world- wide is that their theory of the husiness no longer works. Whenever a hig organization gets into trouhle-and es-pecially if it has been successful for many years -people hlame sluggishness, complacency, arrogance,mammoth bureaucracies. A plausihle explanation? Yes. But rarely the relevant or correct one. Consider the two most visible and widely reviled "arrogant hureaueracies" among large U.S. companies that have recently been in trouble. Since the earliest days of the computer, it had been an article of faith at IBM tbat the computer would go the way of electricity. The future, IBM knew, and eould prove with scientific rigor, lay with the central station, tbe ever-more-powerful mainframe into which a buge numher of users could plug. Everything-economies, the logic of information, technology-led to that conclusion. But then, suddenly, when it seemed as if such a central-station, main- frame-hased information system was actually coming into exis- tence, two young men came up with the first personal computer. Every computer maker knew that the PC was absurd. It did not have tbe memory, the database, the speed, or the computing ahili- ty necessary to succeed. Indeed, every computer maker knew that the PC had to fail - the conclusion reached by Xerox only a few years earlier, when its research team had actually built the first PC. But when that misbegotten monstrosity-first the Apple, then HARVARD BUSINESS REVIEW Sept ember-October 1994 the Macintosh-came on the market, people not only loved it, they bought it. Every big, successful company throughout history, wben con- fronted with such a surprise, has refused to accept it. "It's a stupid fad and will be gone in three years," said the CEO of Zeiss upon seeing the new Kodak Brownie in 1888, when the German compa- ny was as dominant in the world photographic market as IBM would be in the computer market a century later. Most mainframe makers responded in the same way. The list was long: Control Data, Univac, Burroughs, and NCR in the United States; Siemens, Nixdorf, Machines Bull, and ICL in Europe; Hitachi and Fujitsu in Japan. IBM, the overlord of mainframes with as mucb in sales as all the other computer makers put together and with record prof- its, could have reacted in the same way. In fact, it should have. In- stead, IBM immediately accepted the PC as the new reality. Al- most overnight, it brushed aside all its proven and time-tested policies, rules, and regulations and set up not one but two compet- ing teams to design an even simpler PC. A couple of years later, IBM had become tbe world's largest PC manufacturer and the in- dustry standard setter. Tbere is absolutely no precedent for tbis acbievement in all of business bistory; it hardly argues bureaucracy, sluggishness, or ar- rogance. Yet despite unprecedented flexibility, agility, and humili- ty, IBM was floundering a few years later in both tbe mainframe and tbe PC business. It was suddenly unable to move, to take deci- sive action, to cbange. Tbe case of GM is equally perplexing. In tbe early 1980s-tbe very years in wbicb GM's main business, passenger automobiles, seemed almost paralyzed-the company acquired two large busi- nesses; Hughes Electronics and Ross Perot's Electronic Data Sys- tems. Analysts generally considered both companies to be mature and chided GM for grossly overpaying for them. Yet, witbin a few sbort years, GM bad more tban tripled tbe revenues and profits of tbe allegedly mature EDS. And ten years later, in 1994, EDS had a market value six times the amount that GM had paid for it and ten times its original revenues and profits. Similarly, GM bougbt Hughes Electronics - a huge but profitless company involved exclusively in defense-just before the defense industry collapsed. Under GM management, Hughes bas actually Increased its defense profits and bas become tbe only big defense contractor to move successfully into large-scale nondefense work. Remarkably, the same bean counters who had been so ineffectual in tbe automobile business-30-year GM veterans who had never worked for any otber company or, for that matter, outside of fi- nance and accounting departments-were tbe ones wbo achieved tbose startling results. And in the two acquisitions, they simply applied policies, practices, and procedures tbat bad already been used by GM. Tbis story is a familiar one at GM. Since the company's found- ing in a flurry of acquisitions 80 years ago, one of its core compe- tencies bas been to "overpay" for well-performing but mature businesses-as it did for Buick, AC Spark Plug, and Fisher Body in tbose early years-and then turn them into world-class champi- ons. Very few companies bave been able to matcb GM's perfor- mance in making successful acquisitions, and GM surely did not One oJGMls core competencies has been to ''overpay^ for well- performing but mature businesses and then turn them into world- class champions. HARVARD BUSINESS REVIEW Scpi cm her-Octoher 1994 97 THEORY OF THE BUSINESS The assumption that a computer is a computer-OK more prosaically, that the iiidustryis hardware driven - paralyzed IBM. accomplish those feats hy heing hureaucratic, sluggish, or arro- gant. Yet what worked so heautifully in those husinesses that GM knew nothing about failed miserably in GM itself. What can explain the fact that at hoth IBM and GM thepolicies, practices, and behaviors that worked for de-cades-and in the case of GM are still working wellwhen applied to something new and different - no longer work for the organization in which and for which they were developed? The realities that each organization actually faces have changed quite dramatically from those that each still as- sumes it lives with. Put another way, reality has changed, hut the theory of the business has not changed with it. Before its agile response to the new reality of the PC, IBM had once before turned its hasic strategy around overnight. In 1950, Univac, then the world's leading computer company, showed the prototype of the first machine designed to be a multipurpose com- puter. All earlier designs had been for single-purpose machines. IBM's own two earlier computers, huilt in the late 1930s and 1946, respectively, performed astronomical calculations only. And the machine that IBM had on the drawing hoard in 1950, intended for the SAGE air defense system in the Canadian Arctic, had only one purpose: early identification of enemy aircraft. IBM immediately scrapped its strategy of developing advanced single-purpose ma- chines; it put its hest engineers to work on perfecting the Univac architecture and, from it, designing the first multipurpose com- puter ahle to he manufactured (rather than handcrafted) and ser- viced. Three years later, IBM had become the world's dominant computer maker and standard-bearer. IBM did not create the com- puter. But in 1950, its flexibility, speed, and humility created the computer industry. However, the same assumptions that had helped IBM prevail in 1950 proved to he its undoing 30 years later. In the 1970s, IBM as- sumed that there was such a thing as a "computer," just as it had in the 1950s. But the emergence of the PC invalidated that as- sumption. Mainframe computers and PCs are, in fact, no more one entity than arc generating stations and electric toasters. The lat- ter, while different, are interdependent and complementary. In contrast, mainframe computers and PCs are primarily competi- tors. And, in their hasic definition of information, they actually contradict each otber: for the rnainframe, information means memory; for the hrainless PC, it means software. Building gener- ating stations and making toasters must he run as separate husi- nesses, but tbey can he owned by the same corporate entity, as General Electric did for decades. In contrast, mainframe comput- ers and PCs prohahly catinot coexist in the same corporate entity. IBM tried to combine the two. But hecause the PC was the fastest growing part of the husiness, IBM could not suhordinate it to the tiiainframe business. As a result, the company could not op- timize the mainframe business. And hecause the mainframe was still the cash cow, IBM could not optimize the PC business. In the end, the assumption that a computer is a computer-or, more pro- saically, that the industry is hardware driven-paralyzedlBM. GM had an even more powerful, and successful, theory of the husiness than IBM had, one that made GM the world's largest and HARVARD BUSINESS REVIEW September-October 1994 most profitable manufacturing organization. The company did not have one sethack in 70 years-a record unmatched in business history. GM's theory comhined in one seamless web assumptions ahout markets and customers with assumptions about core com- petencies and organizational structure. Since the early 1920s, GM assumed that the U.S. automohile market was homogeneous in its values and segmented hy ex- tremely stahle income groups. The resale value of the "good" used car was the only independent variable under management's con- trol. High trade-in values enahled customers to upgrade their new- car purchases to the next category - in other words, to cars with higher profit margins. According to this theory, frequent or radical changes in models could only depress trade-in values. Internally, these market assumptions went hand in hand with assumptions ahout how production should be organized to yield the biggest market share and the highest profit. In GM's case, the answer was long runs of mass-produced cars with a minimum of changes each model year, resulting in tbe largest numher of uni- form yearly models on tbe market at the lowest fixed cost