Year-end is often seen, understandably if somewhat arbitrarily, as a time for reflection. Actually, in my book there’s never a bad time for reflection, so I’ll take an arbitrary peg over no peg.

I hope you share my core belief in the power of standing back for a good, hard, intellectually demanding fresh look—the kind that children would say makes their brains hurt. (As C.G. Jung supposedly said, “Thinking is difficult; that’s why most people judge.”)

Which brings us to today’s topic: Peter Drucker’s timeless 1994 Harvard Business Review article, “The Theory of the Business.” In it, Drucker sets out to explain what underlies the familiar phenomenon of companies that have enjoyed long-term success who find themselves “stagnating and frustrated, in trouble, and often, in a seemingly unmanageable crisis.” Here’s what he thinks is going on:

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 built and is being run no longer fit reality.

These assumptions are what Drucker encapsulates in the phrase, “a theory of the business,” and they have to do with such fundamentals as markets, customers and competitors, values and behavior, strengths and weaknesses, and what the firm gets paid for. Drucker doesn’t subscribe in the least to the commonplace that when successful firms get into trouble it can be laid at the feet of slackness, complacency, or hubris. Those can all befall firms, of course, but Drucker finds it rarely “the relevant or correct” explanation.

As all too familiar examples, Drucker cites IBM’s being blindsided by the rise of the PC, and GM by first the Japanese and then the fragmentation of the US car market from a predictable staircase of brands driven by rising household incomes in the post-WWII era to a market segmented by lifestyles and car buyers choosing vehicles based on more intangible concepts of self-expression and identification. “Put another way reality has changed, but the theory of the business has not changed with it.”

Drucker enumerates what goes into the “theory of the business:”

A theory of the business has three parts. First, there are assumptions about the environment of the organization: society and its structure, the market, the customer, and technology.

Second, there are assumptions about the specific mission of the organization. […]

Third, there are assumptions about the core competencies needed to accomplish the organization’s mission.

The environment—society, the market, clients—dictates what the firm can and will be paid for. The firm’s mission determines such critical values as what constitutes quality in the eyes of the firm, what its contribution to society and the economy should be, and what kind of results and outcomes count as meaningful. Finally, identifying core competencies leads to key decisions about where the firm must excel, where good enough is good enough, and where it chooses not to play at all.

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