Book: The Theory of the Business

This Harvard Business Review Classics article by Peter F. Drucker argues that the underlying cause of stagnation and crisis in successful, long-standing organizations is often not poor execution or even doing the wrong things, but rather the fact that their theory of the business – the fundamental assumptions upon which the organization is built and run – no longer aligns with reality. Drucker emphasizes that a clear, consistent, and focused theory of the business is crucial for success but must be continuously tested and adapted to remain valid.

Key Ideas and Facts:

1. The Central Challenge: "What to Do" vs. "How to Do": Drucker observes that while many new management techniques focus on efficiency ("how to do"), the more critical challenge for managements, particularly in large, historically successful companies, is determining "what to do". He states: "Yet 'what to do' is increasingly becoming the central challenge facing managements, especially those of big companies that have enjoyed long-term success."
2. The Theory of the Business Defined: Drucker introduces the concept of a "theory of the business," which he defines as: "The assumptions on which the organization has been built and is being run no longer fit reality. These are the assumptions that shape any organization’s behavior, dictate its decisions about what to do and what not to do, and define what the organization considers meaningful results." He further elaborates that these assumptions concern markets, customers, competitors, technology, a company's strengths and weaknesses, and what a company gets paid for.
3. Components of a Theory of the Business: According to Drucker, a theory of the business has three key parts:

• Assumptions about the environment: "society and its structure, the market, the customer, and technology."
• Assumptions about the specific mission of the organization: Defining what the organization considers meaningful results and its role in the economy and society. Examples include Sears' initial mission as "the informed buyer for the American family" and AT&T's goal of ensuring universal telephone access.
• Assumptions about the core competencies needed to accomplish the mission: Defining where the organization must excel to maintain leadership. Examples include West Point's focus on producing leaders who deserve trust and Marks & Spencer's shift towards designing and developing its own merchandise.

1. Specifications of a Valid Theory of the Business: Drucker outlines four specifications for a valid theory of the business:

• Fit with Reality: "The assumptions about environment, mission, and core competencies must fit reality." He uses the example of Marks & Spencer adapting to the post-World War I societal changes and developing new core competencies in product design.
• Internal Consistency: "The assumptions in all three areas have to fit one another." He highlights GM's strength in aligning its market assumptions with its manufacturing processes and developing financial control as a core competency.
• Organizational Understanding: "The theory of the business must be known and understood throughout the organization." He cautions that success can lead to taking the theory for granted, resulting in sloppiness and a focus on expediency over what is right.
• Continuous Testing: "The theory of the business has to be tested constantly." It should be treated as a hypothesis subject to the constant flux of society, markets, customers, and technology, requiring the ability to change itself.

1. Consequences of an Invalid Theory: Drucker argues that when a theory of the business no longer works, even doing the right things can be fruitless. He uses the examples of IBM's initial resistance to the personal computer and GM's struggles adapting to the fragmented automobile market despite their past successes. He notes: "What underlies the current malaise of so many large and successful organizations worldwide is that their theory of the business no longer works."
2. Preventive Measures: Drucker proposes two preventive measures to keep an organization alert and adaptable:

• Systematic Abandonment: Every three years, the organization should challenge every product, service, policy, and distribution channel with the question: "If we were not in it already, would we be going into it now?" This forces a re-evaluation of assumptions.
• Studying Noncustomers: Organizations should pay close attention to those who are not their customers, as the first signs of fundamental change often appear in this segment. He uses the example of U.S. department stores neglecting the time constraints of women in two-income families, leading to their decline. "But the first signs of fundamental change rarely appear within one’s own organization or among one’s own customers. Almost always they show up first among one’s noncustomers."

1. Early Diagnosis of an Obsolete Theory: Drucker identifies several warning signs indicating that an organization's theory of the business is no longer valid:

• Attainment of Original Objectives: Achieving long-term goals should trigger a reassessment of the theory.
• Rapid Growth: Significant increases in size can outstrip the existing assumptions and necessitate a re-evaluation of environment, mission, and core competencies.
• Unexpected Success: Whether one's own or a competitor's, unexpected success should be analyzed to understand if underlying assumptions are shifting. He cites Chrysler's unexpected success with Jeeps and minivans as a signal GM missed.
• Unexpected Failure: Similarly, unexpected failures, like Sears' venture into investment products, should be seen as potential indicators of a flawed underlying theory. "Unexpected failure is as much a warning as unexpected success and should be taken as seriously as a 60-year-old man’s first 'minor' heart attack."

1. The Cure: Rethinking and Decisive Action: Restoring a valid theory of the business is not about genius but about hard work and conscientiousness. It requires:

• Diagnosis and Analysis: Accepting that achieving objectives and rapid growth necessitate rethinking.
• Treating Failures as Systemic: Not dismissing unexpected failures as isolated incidents.
• Challenging Assumptions with Success: Not taking credit for unexpected success but using it to question existing beliefs.
• Decisive Action: Recognizing that an obsolete theory is a degenerative issue requiring prompt and effective change.

Conclusion:

Drucker's "The Theory of the Business" remains a highly relevant framework for understanding organizational success and failure. He compellingly argues that a clear and consistent set of assumptions about the environment, mission, and core competencies is foundational. However, these assumptions are not static and must be continuously monitored, tested, and adapted to the evolving realities of the business landscape. Failure to do so, even with efficient operations, inevitably leads to stagnation and crisis. The article provides practical guidance for preventing obsolescence and for taking decisive action when a theory no longer holds true.

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