The Importance of Theory of the Business


This article is a summary of a classic by the father of modern business management Peter Drucker on the need to test business model assumptions. In the source article IBM and GM are used as examples of the need to refresh the “Theory of the Business”.

The Central Challenge

– “what to do” is increasingly becoming the central challenge facing managements
– The root cause of nearly every one of many business 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.
– Every organization, whether a business or not, has a theory of the business. Indeed, a valid theory that is clear, consistent, and focused is extraordinarily powerful.

Theory of Business Assumptions

A theory of the business has 3 parts which are assumptions about:
1. the environment of the organization: society and its structure, the market, the customer, and technology.
2. the specific mission of the organization.
3. the core competencies needed to accomplish the organization’s mission.

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.

Specifications for a Valid Theory of Business

There are 4 specifications of a valid theory of the business:
1. The assumptions about environment, mission, and core competencies must fit reality.
2. The assumptions in all three areas have to fit one another.
3. The theory of the business must be known and understood throughout the organization.
4. The theory of the business has to be tested constantly.

Time for a Change

When a theory shows the first signs of becoming obsolete, it is time to start thinking again, to ask again which assumptions about the environment, mission, and core competencies reflect reality most accurately—with the clear premise that our historically transmitted assumptions, those with which all of us grew up, no longer suffice.

Theory of Business Update Needs

1. There is a need for preventive care—that is, for building into the organization systematic monitoring and testing of its theory of the business.
2. There is a need for early diagnosis.
3. Finally, there is a need to rethink a theory that is stagnating and to take effective action in order to change policies and practices, bringing the organization’s behavior in line with the new realities of its environment, with a new definition of its mission, and with new core competencies to be developed and acquired.


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