Theory of the Business

By Peter Drucker in Harvard Business Review 1994 (Sept. – Oct.): 95 – 104; Reprint 94506

Research on the value of Drucker’s thoughts in his seminal paper was reported here.

A clear, consistent, and focused theory of business is extraordinarily powerful. Successful companies are theories that work; troubled companies are theories that do not. A common trap is to identify the symptoms of the trouble, not the cause: a theory that does not work.  

Like Cicero’s Gaul, the assumptions in the theories of business are divided into three parts: 1) The business environment: society, the market, customers and technology; 2) the mission of the organisation: what it wants to become and 3) the capabilities and resources required for achievement of the mission. These assumptions influence the organisation’s behaviours, decisions, and the definition of success. So, when is a theory of business valid?

  1. The key assumptions fit reality.
  2. The assumptions are coherent and congruent, i.e. they fit and work together – they do not conflict.
  3. The theory is understood by everyone in the organisation.
  4. The theory has been tested constantly. Given the flux in the business environment, it is unlikely that any one theory will fit reality forever, although some may last a long time.

Prevention: Every 3 – 5 years, a company should go through a process of abandonment. If these products, services, channels, customers, policies were not here now, would we start with them again, now? If the answer is no, an investigation into the reasons is pursued until there is a deep understanding. Failure to follow this process and to respond appropriately means that scarce resource will continue to be invested in what is not consistent with the current reality. The next preventative measure is to develop a profound understanding of non-customers … why are they not customers and what will convert them?

Early diagnosis: Testing the theory is painful, but necessary. Defensiveness is a common reaction. Early diagnosis is possible by regularly monitoring lead indicators (early warning signs, such as loss of customers). Always try to understand unexpected success or failures, one’s own or one’s competitors … they reflect the success of the business theory.

Cure: The appropriate response to diagnosis is deep thought about the three fundamental assumptions, early diagnosis, changes to the assumptions and then decisively to give effect to these (it is a re-invention of the business). Patching here and there does not work.

Comment: Drucker’s insights are as valid today as they were two decades ago. Strategies emerge from the convergence of the three circles of influence: 1) the company’s world view, in particular the paradigms of its business and of success: its value in society; 2) its business model (the narrative and numbers about delivering its value proposition and making an economic profit in a way that resonates with society; and 3) its understanding of the environmental context (transactional and contextual) within which it operates.

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