The Theory of the Business (Harvard Business Review Classics)

1. Every organization operates on a "theory of the business" that shapes its behavior

These assumptions are about markets. They are about identifying customers and competitors, their values and behavior. They are about technology and its dynamics, about a company's strengths and weaknesses. These assumptions are about what a company gets paid for. They are what I call a company's theory of the business.

Guiding assumptions. Every organization, whether a business or not, operates based on a set of assumptions about its environment, mission, and core competencies. These assumptions form the organization's "theory of the business," which dictates its decisions, actions, and definition of meaningful results.

Powerful impact. A clear, consistent, and focused theory can be extraordinarily powerful, as demonstrated by examples like the University of Berlin, Deutsche Bank, and Mitsubishi. These organizations built their success on well-defined theories that guided their strategies and operations for decades.

Consequences of misalignment. When an organization's theory no longer fits reality, it can lead to crisis and failure, even for previously successful companies. This misalignment explains the challenges faced by giants like General Motors and IBM, whose long-standing theories became outdated as market conditions changed.

2. A valid theory of the business has clear assumptions about environment, mission, and core competencies

The assumptions about environment define what an organization is paid for. The assumptions about mission define what an organization considers to be meaningful results; in other words, they point to how it envisions itself making a difference in the economy and in the society at large. Finally, the assumptions about core competencies define where an organization must excel in order to maintain leadership.

Three key components. A valid theory of the business consists of three interconnected parts:

• Environment: Assumptions about society, market, customers, and technology
• Mission: The organization's specific purpose and how it creates value
• Core competencies: The essential skills and capabilities needed to fulfill the mission

Alignment and clarity. These assumptions must be clearly defined, mutually consistent, and aligned with reality. For example, Marks and Spencer's theory combined assumptions about changing British society, its mission to be a classless retailer, and core competencies in merchandise identification and development.

Evolution over time. Developing a clear, consistent, and valid theory often takes years of hard work, thinking, and experimenting. However, this effort is crucial for an organization's success and ability to adapt to changing circumstances.

3. Successful theories become obsolete as external realities change

That is precisely what happened to those on which the great U.S. businesses of the 1920s were built. It happened to the GMs and the AT&Ts. It has happened to IBM. It is clearly happening today to Deutsche Bank and its theory of the universal bank. It is also clearly happening to the rapidly unraveling Japanese keiretsu.

Inevitable obsolescence. Even the most powerful theories of the business eventually become outdated as the external environment evolves. This process is accelerating in today's rapidly changing business landscape.

Examples of obsolescence:

• GM's theory about homogeneous market segments and mass production
• IBM's assumption about centralized computing
• AT&T's mission of universal telephone access
• Deutsche Bank's concept of the universal bank

Consequences of clinging to outdated theories. Organizations that fail to recognize and address the obsolescence of their theories often face severe challenges, loss of market position, and potential failure. The first reactions are typically defensive, such as denying changes or attempting to patch the existing theory, which rarely succeeds in the long term.

4. Organizations must constantly test and update their theory to remain effective

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.

Continuous evaluation. Organizations must treat their theory of the business as a hypothesis that requires ongoing testing and validation. This process involves regularly challenging assumptions about the environment, mission, and core competencies.

Adapting to change. As society, markets, customers, and technology evolve, organizations must be prepared to modify their theories accordingly. This adaptability should be an integral part of the theory itself, ensuring the organization can respond effectively to new realities.

Overcoming resistance. Many organizations struggle to question and update their theories, especially when they have been successful for a long time. However, failure to do so can lead to stagnation and eventual crisis. Leaders must foster a culture of continuous learning and adaptation to maintain their organization's relevance and effectiveness.

5. Preventive care through abandonment and studying non-customers is crucial

There are only two preventive measures. But, if used consistently, they should keep an organization alert and capable of rapidly changing itself and its theory. The first measure is what I call abandonment. Every three years, an organization should challenge every product, every service, every policy, every distribution channel with the question, If we were not in it already, would we be going into it now?

Systematic abandonment. Organizations should regularly challenge their existing products, services, policies, and distribution channels. This process forces the organization to reconsider its assumptions and adapt to changing circumstances before crises occur.

Studying non-customers. The most important indicators of fundamental change often appear first among non-customers. By focusing on this larger group, organizations can identify emerging trends and opportunities that may not be visible when looking only at existing customers.

Examples of preventive care:

• Questioning accepted policies and routines
• Analyzing why previously promising initiatives didn't work
• Paying attention to changes in the broader market, not just current customers
• Allocating resources to new opportunities rather than defending the status quo

6. Early diagnosis of an obsolete theory requires attention to warning signs

To diagnose problems early, managers must pay attention to the warning signs. A theory of the business always becomes obsolete when an organization attains its original objectives. Attaining one's objectives, then, is not cause for celebration; it is cause for new thinking.

Key warning signs:

• Achieving original objectives
• Rapid growth
• Unexpected success (own or competitor's)
• Unexpected failure (own or competitor's)

Proactive response. When these warning signs appear, organizations must take them seriously and use them as catalysts for reassessing their theory of the business. This proactive approach can help prevent more severe crises in the future.

Learning from success and failure. Both unexpected success and failure provide valuable information about the validity of an organization's theory. Leaders should treat these events as opportunities to challenge assumptions and consider new directions, rather than dismissing them or becoming complacent.

7. Rejuvenating an organization's theory is a systematic process, not a miracle

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

Systematic approach. Successful CEOs who have changed their organization's theory of the business rely on a systematic process rather than charisma or vision alone. This process involves:

• Starting with diagnosis and analysis
• Accepting that growth and success require rethinking the theory
• Treating unexpected failures as symptoms of systemic issues
• Viewing unexpected successes as challenges to assumptions

Continuous improvement. Rejuvenating a theory of the business is an ongoing responsibility of leadership, not a one-time event or the result of a miraculous intervention. It requires consistent effort, attention to detail, and a willingness to challenge long-held beliefs.

Cultural shift. To effectively update and maintain a relevant theory of the business, organizations must foster a culture that values:

• Continuous learning and adaptation
• Open-mindedness to new ideas and perspectives
• Willingness to question assumptions and challenge the status quo
• Embracing change as an opportunity for growth and improvement

Last updated: August 19, 2024