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...