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INTRODUCTION TO MARKET-BASED MANAGEMENT
With a Forward by
Charles G. Koch,
Chairman and CEO,
Koch Industries
ABOUT CHARLES G. KOCH
Charles G. Koch has served since 1967 as chairman and CEO of Koch Industries, Inc., a $20 billion petroleum, chemical, agricultural, and financial services company based in Wichita, Kansas. For the past 25 years, he has worked to improve Koch Industries' management systems by incorporating, insights from economics, philosophy, history, psychology, and other disciplines. In 1991, Koch first began describing his management philosophy as "market-based management," and Koch Industries is currently working to develop and apply further the basic market-based management framework to its various businesses.
About the AuthorsFrom 1991 to 1993, Dr. Wayne Gable was managing director for federal affairs and management research at Koch Industries, where his duties included helping to apply market process concepts to the development of management systems. In 1993, he became president of the Center for Market Processes, which has launched a major program to help organizations understand market-based management and develop their own market-based management systems.
Dr. Jerry Ellig, a professor at George Mason University's Program on Social and Organizational Learning, spent part of 1992 and 1993 at the Koch Management Center in Wichita, Kansas, where he researched market-based management ideas and helped develop programs for teaching market process analysis to upper and middle managers. Ellig teaches graduate courses at George Mason University on Market-Based Management and Economic Regulation.
Copyright 1993, by the Center for Market Processes. All rights reserved.
FOREWORD Twenty-five years ago, Koch Industries was a small company compared to what we are today. We had fewer than 700 employees, about 1,000 miles of pipeline, and operations focused on Kansas and Oklahoma. Since then, we've established a consistent record of profitable growth significantly above the industry average. We now have approximately 13,000 employees, our pipeline network exceeds 35,000 miles, and our revenues have grown a hundred-fold. We handle several million barrels of hydrocarbons daily, and we have operations in several countries around the world.
Because we've had consistently strong performance over the years, many people have looked at Koch Industries and asked, "How did they do it?" They found that a lot of the usual explanations fail to account for our success. We did not perform better because we had better assets than the competition. In fact, 25 years ago Koch's assets were quite modest compared to many of our competitors. Nor was it because we were smarter than our competitors; if anything, the bigger oil companies' well-known names gave them an edge in attracting people with the greatest potential. We are convinced that Koch Industries' success stems primarily from our management philosophy, which we call "market-based management."
I have personally practiced this philosophy for the past 25 years at Koch Industries. For much of this time the philosophy was more implicit-guiding my business decisions and those in which I was directly involved. The business and management decisions in which I was not directly involved were often market-based as well, but more through our shared values, culture and business analysis techniques than through a well-articulated management philosophy. Then, several years ago, we recognized that in order for Koch Industries to continue to succeed we needed to take full advantage of this powerful approach to management. Our entire management team, and eventually our entire organization, needed to understand the framework of market-based management and strive to operate within it. We therefore undertook an initiative with three complementary objectives:
(1) to articulate the conceptual framework and principles of market-based management in a manner that could be understood by the entire organization,
(2) to educate Koch management and eventually the entire organization about these concepts and philosophies, and
(3) to examine all facets of Koch Industries-our values, organizational structure, incentive systems, and other practices-to ensure that each was consistent with the principles of market-based management.
We have made good progress toward the first objective, and this booklet covers most of the principles we believe are important. We have not progressed as far toward the second and third objectives, but where we have applied the framework the results have been powerful enough to convince us we are on the right path.
Our experience has shown that market-based management is a framework within which we can analyze, and even improve upon, other management concepts such as Total Quality Management and Re-Engineering. By testing these ideas and programs against the principles of market-based management, we are better able to discern which parts truly add value and then apply them in a manner that is consistent and complementary with our other ongoing efforts. This helps us avoid the "false start" and "flavor of the month" problems that have plagued so many other companies and management approaches.
For Koch Industries-and, I believe, for most businesses-constant rethinking and improvement are now more important than ever. The entire business world faces a revolution that will redefine the role of managers, companies, and entire industries. Developments of new technology and changes in consumer desires have always meant change for corporations, but the change occurring today is more fundamental, more rapid, and potentially more devastating than at any time since the industrial revolution. American industry must now deal with massive increases in regulation and other government-imposed burdens. In addition, computer and telecommunications technology have created an explosion of information available to consumers and a wide variety of new means for satisfying consumer desires. This information explosion has redefined the products and services customers want and the forms in which they want them.
Nor is this unprecedented scope and rate of change limited to the information technology industry. America's most traditional industries-from automobiles, to steel production, to retailing are experiencing it, and there is no end in sight. Business firms must respond more rapidly than ever to changing customer values and to the rapid innovations of competitors.
This kind of rapid response requires new ways of anticipating, discovering and communicating customer desires to everyone in the organization, from the sales force to the accounting staff. Finns also need improved ways of mobilizing everyone's talents, abilities, and knowledge to serve the customer better. These needs require us to constantly redefine the way work is done. It is no longer enough for employees to come to work every day and work hard at assigned tasks; each day, each person needs" to ascertain what he or she can do that creates the most value for customers. In the new environment, only the best managed companies will be able to survive and thrive.
At Koch Industries, we believe market-based management provides a framework that better enables us to meet these requirements. We strive to improve our approach by further educating ourselves about market concepts and by developing market-based solutions to problems common to all organizations. The co-authors of this booklet have both played a role in helping us develop our market-based management ideas. They and other researchers at the Center for Market Processes are well suited to develop further and communicate market-based management to a wider audience in business, nonprofit institutions, and academia.
The power of using the market system as a model for management systems has been only partially tapped, even by companies like ours that have been working on it for many years. I believe there are tremendous opportunities to develop and apply market-based management, and I hope this booklet will generate a greater understanding of the concepts involved. The challenge to improve has never been greater than in today's competitive environment. And while the exact solution is different for each organization, our experience -indicates that market-based management is an excellent framework for anyone working to meet that challenge.
-- Charles G. Koch
Chairman and CEO, Koch Industries
Wichita, Kansas
WHY MARKET BASED MANAGEMENT?1
The past decade has witnessed a dramatic change in both the business world and our broader society. From the Soviet Union to IBM, massive institutions that seemed permanent stumble- or even crumble-in the face of constantly changing political forces, business conditions and information technology.2
Now more than ever, business managers must struggle to coordinate the knowledge and decisions of tens of thousands of employees from all walks of life. Traditionally, many people have thought that business coordination problems could be solved by hiring better brains at the top of the organization. These "experts" would carefully analyze the company's situation and prepare detailed plans for everyone to implement. This type of solution rests on a boundless optimism that superior minds can foresee every major contingency and find a course of action that is best for all.
In company after company, this approach has failed miserably. It has failed not because business managers were inept or corrupt, but because they overlooked a fundamental reality: the knowledge needed for sensible business decisions is inherently dispersed among many people, and much of it cannot be communicated to a central location for use by "experts." As a result, attempts to centrally plan a complex organization fail when confronted by competing firms that develop better ways to mobilize the knowledge of their people.
But how can an organization tap the knowledge and coordinate the decisions of thousands of employees, if not through command-and-control management?
Contemporary political and economic events suggest an answer. Most economists recognize that the Soviet and Eastern European economies failed because a command-and-control system cannot coordinate the millions of economic decisions needed to produce adequate amounts of consumer goods, even simple ones like bread and shoes.3 In other words, centralized planning of national economies failed for the same reasons that authoritarian business strategies failed: both approaches overlook the severe limitations to any individual's knowledge.4 While executives are beginning to realize this fact, most corporations still look much more like centrally planned economies than market systems.
Centrally planned economies suffer from what Nobel prizewinning economist Friedrich Hayek called the "Fatal Conceit."5 This conceit is the belief that leaders or technical experts know what is best for everyone, and that they can effectively manage society while ignoring what most individuals in society actually know and think. Whenever this philosophy has been tried in practice, it has led to disaster, because no person or committee can have all of the knowledge needed to plan a complex society. The conceit is indeed fatal, because centralized economic planning condemns most individuals in society to poverty, greater risk of disease, shorter life spans, and less fulfilling lives.
Free societies, on the other hand, have produced the greatest increases in living standards in the history of humanity, because free markets allow individuals to act on their own dispersed knowledge. For striking examples, contrast Hong Kong and the People's Republic of China, or West and East Germany, as shown in the accompanying table on page 8. In both cases, the people share a common history and similar ethnic backgrounds; the principal difference is the economic system. For years, people risked their lives escaping from East to West Germany, and from China to Hong Kong, in search of a better life. These examples demonstrate the superiority of market-oriented systems.
Historical experience shows that market economies, which rely on the dispersed knowledge and independent judgment of numerous consumers and producers, consistently provide a dramatically higher quality of life than centrally planned economies. Given that reality, it makes sense to examine how market economies coordinate human activity, in order to glean lessons for improving business management. Unfortunately, many analysts in business and academia resist this approach, out of a belief that market concepts apply only "out there," beyond the boundaries of the firm. In this view, the principles of a free society apply in the external market, but the firm's internal affairs are the province of brilliant planners making command decisions.
We believe that this point of view misses several elements essential to understanding organizations. The belief that market principles apply only outside the firm resembles the belief that market principles work in international trade, but not for a national economy. The Soviet experience readily calls this claim into question. The problem with formerly socialist economies was not that they refrained from external trade, but that they failed to implement market principles internally. Similarly, we believe firms that fail to learn and adapt market principles internally will one day find themselves distant competitors to firms that do.
The experience of Koch Industries, a firm with which we are quite familiar, shows the power of a more market-based approach. A small crude oil gathering company 25 years ago, Koch's current annual revenues-around $20 billion-rank behind only Cargill's among privately held American companies. During the past few years, while the major oil companies laid off thousands of workers, Koch Industries was one of the few large companies in this industry to expand.
Koch has also pioneered attempts to turn market principles into a management philosophy. Throughout this booklet, we will employ Koch Industries as a case study in market-based management. Koch's executives would be the first to agree that their ideas are not the last word on the subject, but this company provides the best example we know of a large company that has tried to implement market-based management as a consistent framework.6 We hope these examples will pique the interest of executives in other companies who are looking for innovative ways to mobilize each employee's unique knowledge and abilities.
FREEDOM WORKS
For years, people fled from East to West Germany, and from the People's Republic of China to Hong Kong, in search of both freedom and prosperity. In both cases, people sought to escape the results of a command-based society in order to enjoy the fruits of a more market- based system. The data below show dramatic differences in physical well-being in countries that shared virtually identical cultures, educational levels, and ethnic heritages before adopting different economic systems. Over time, greater reliance on free markets in Hong Kong and West Germany produced huge differences in human well-being, Not only were living standards dramatically higher in the two market-oriented cases, but less measurable aspects of human well being, such as individual freedom and human rights, were clearly far more desirable as well. Markets and individual freedom made a profound difference in economic and social well-being.
GDP per capita (1988) |
Hong Kong |
People's Republic of China |
West Germany | East Germany |
Number of people per* |
$9613 | $301 | $19,743 | $5256 |
| - Telephone | 2.2 | 149.8 | 1.6 | 4.3 |
| - Television | 4.2 | 100.7 | 2.4 | 5.8 |
| - Car | 29.8 | 1093.3 | 2.2 | 4.8 |
| Life Expectancy: | ||||
| - Women | 79 | 71 | 78 | 76 |
| - Men | 73 | 68 | 72 | 70 |
Source: The Economist Book of Vital World Statistics (Times Books, 1990).
*These statistics do not adjust for product quality, which is much higher in West Germany and Hong Kong than in East Germany or China.
WHY IS MARKET-BASED MANAGEMENT DIFFERENT?
On the surface, market-based management shares some similarities with total quality management, just-in-time inventory control, and other currently popular management practices. Like market-based management, these programs help organizations tap the dispersed and tacit knowledge of many employees. Tapping the creativity and knowledge spread throughout an organization is essential, yet extremely difficult in practice, as indicated by the growing number of companies that have abandoned total quality management in frustration.
Market-based management gives us more than a list of additional management tools. It provides an overall framework-a "paradigm" for understanding organizational problems. The market-based management framework helps us examine and evaluate the tools of just-in-time inventory, total quality management, and other ideas for improving organizational performance.
The paradigm underlying market-based management is a method of understanding human action and interaction called "market process analysis." Market process analysis helps us understand how free societies organize themselves to allow people to live and work in harmony, while increasing the wellbeing of the entire society. The market process allows vast amounts of human activity to be undertaken independently, yet coordinated with the activities of others. This coordination, referred to by Adam Smith in the Wealth of Nations as the "invisible hand" and by Nobel laureate EA. Hayek as "spontaneous order," is responsible for the vast increase in living standards that has occurred in many societies since the industrial revolution. This increase in human well-being resulted from the unleashing of individual initiative rather than from the actions of governments. The market system enabled people to create and distribute wealth on a scale never imagined by previous generations.7
A business firm is not just a piece of society, but a mini-society in its own right. Like societies that adopt market-based rules and cultures, organizations can vastly increase their effectiveness by using the market system as a guide for redesigning their own systems. In fact, during the past several decades, many of the most forward-looking management thinkers have de-emphasized hierarchy, authority, and other "command-oriented" management techniques that became common during the first half of this century. Early management thinkers tended to follow the command-oriented "scientific management" school of thought championed by Frederick Taylor.8 The similarities between the Taylorist approach to management and Soviet-style "economic planning" are uncanny, and they are not coincidental. Both approaches arise from the same framework: a framework that can understand order and coordination only as the deliberate product of some planner's design. As a result, both Taylorism and centralized economic planning depend on the ability of a central authority, whether economy-wide or organization-wide, to accumulate, process, and act on vast amounts of knowledge.9 And experience has proven both wrong.
Even the long-time defenders of Soviet-type systems have now declared them a massive failure. It is widely recognized that, no matter how intelligent and well-meaning the "authorities" are, and no matter how sophisticated their planning tools, there is simply no way for a government to "run" an economy. Many recent developments in management theory suggest that the same is true for organizations. Rather than emphasizing authority, hierarchy, management information, and "planning," more and more management thinkers are emphasizing decentralization, empowerment, organizational learning, cross-functional teams, consumer sovereignty, and other concepts that don't fit the "scientific management" mold.
In focusing on these concepts, executives knowingly or unknowingly incorporate key elements of a free society into their corporate cultures, informal rules, organizational structures and incentive systems. We believe there is a discernible evolution away from "scientific" management toward a more effective approach -- market-based management. Market-based management is based on a fundamental understanding of how the market system enables a group of people to achieve cooperatively results that far exceed what they could have achieved separately.
To avoid misunderstanding, we should note some misconceptions that often come with the name " market-based management." First, market-based management does not mean a mindless copying of external market practices inside the firm. A key difference between the business firm and our broader society is that the business firm exists to accomplish some specific mission, whereas a free society exists only as a means of allowing individuals to accomplish their own goals. Market-based management focuses on discovering organizational structures, responsibilities, values, and incentives that motivate people to advance a common mission. It does not mean merely turning everyone in the firm loose to do whatever they think will make money.
Second, market-based management does not mean simply being "responsive to the market." In our discussions with business leaders, we frequently hear, "Of course we're market-based; we respond to our customers." Any effective management system should help a firm respond to its customers, but market-based management is much more than responding to customers.
Market-based management is also different from various proposals for "industrial democracy" and "participative management." It shares with these approaches a skepticism of centralized management, but offers different solutions to the managerial coordination problem. The goal of many democratic and participative systems is to give every employee a voice in major decisions, either directly or through elected representatives. This approach relies on everyone being well enough informed to contribute to most decisions-- a situation just as unlikely as one person having sufficient knowledge to make most decisions. Market-based management, in contrast, seeks to divide up decision making, so that the person or team with the requisite knowledge and the right incentives makes each decision and bears ongoing responsibility for the outcome.
Finally, it would be a mistake to identify market-based management merely with the creation of competitive bidding or spot markets inside the firm. This misconception stems from a view of markets as nothing more than a sea of rivalrous, atomistic competition.10 In reality, markets are a complex blend of competition and cooperation. Likewise, a market-based firm should promote cooperation while channeling competition into activities that actually promote the common mission.11
SIX KEY SYSTEMS IN MARKETS AND ORGANIZATIONS
The market-based approach to management draws heavily on lessons learned from market process analysis. Markets facilitate economic growth and social progress through a highly complex process. To provide a workable framework for understanding the implications for organizations, we have focused on six key elements of the market system: division of labor, property rights, rules of just conduct, the price system, free flow of ideas, and market incentives.
Within the firm, each of these concepts has a parallel element in management practice, as illustrated by the table on page 15. The Mission System helps identify and keep everyone focused on the things that this particular organization does particularly well. A well-defined system of Roles and Responsibilities functions like property rights in the market. They link independent judgment with proper accountability, both for business units and for individuals. An organization's Values and Culture establish a framework that helps guide people in making decisions, just as laws and cultural norms guide behavior in the broader society. In the marketplace, the price system summarizes a tremendous amount of knowledge about the relative scarcity and demand for resources; similarly inside the firm, Internal Market give people access to crucial information that they have no other way of obtaining. People also acquire critical information through discourse, and Open Communication is as critical inside the firm as in a free society. Finally, in a free market, profit and loss indicate value added and provide incentives for improvement; the firm's Compensation and Motivation system should provide similar incentives.
When all six of these systems function well in a society, the results are truly dramatic. Societies that have these six systems have achieved tremendous increases in human well-being by successfully utilizing the knowledge that is spread out among all of their people. We can refer to these results broadly as "social earning." Similarly, when the analogous systems function well inside the firm, "organizational learning" occurs; the firm finds more effective ways to mobilize the knowledge of its people in pursuit of its mission.
Six Key Systems in Market Economies and Organizations| Market Economy | Organization |
| Division of Labor | Mission System |
| Property Rights | Roles and Responsibilities |
| Rules of Just Conduct | Values and Culture |
| Price System | Internal Markets |
| Free Flow of Ideas | Open Communication |
| Market Incentives | Compensation and Motivation |
More and more organizations are realizing that, regardless of what businesses they are in, they must also be in the "knowledge business." They must focus on generating and mobilizing the knowledge of their employees.12 To survive and thrive in today's business environment, an organization must be able to learn, adapt, and improve itself continuously. If it does not, its competitors will soon leave it far behind. While each of the six systems is critical for the market-based organization to develop and improve, managers should remember that the systems are highly interrelated. Attempts to improve organizational performance by focusing on only one system probably won't work.
DIVISION OF LABOR AND THE MISSION SYSTEM
Free societies generate wealth by facilitating an ever more complex division of labor and knowledge. Such specialization enhances productivity, because it allows each person to focus on the activities that create the most value at the least cost. A firm's mission system helps identify the activities in which it should specialize for maximum long-term profitability. In addition, when a firm understands its own "core competencies," it then has a much better idea of how its various divisions or profit centers should interact in order to accomplish its overall mission. To see in greater detail how an organization can identify its core competencies, we need to see how the division of labor works in a market economy.
Division of Labor and Comparative Advantage
Division of labor increases productivity by allowing each person or firm to exploit a "comparative advantage." To understand the role of comparative advantage in creating wealth for society, think about two farmers: an Idaho potato grower and a Louisiana rice grower. They can produce more potatoes and rice if each specializes in one crop than if each tries to be self-sufficient in both crops. To see why, imagine what would happen if the Idaho farmer tried to grow rice. Because the Idaho climate is better for potatoes, the farmer would give up a lot of potatoes to grow just a little rice. Idaho-grown rice would be very expensive, because customers would have to offer the farmer a high price for rice to make up for the lost income from potatoes. Similarly, the Louisiana farmer would give up a lot of rice in order to grow just a few potatoes in a swampy rice paddy. Potatoes grown in Louisiana rice paddies would be expensive, because it would take a very high potato price to replace the income that the farmer could have earned from growing rice.
In economist's jargon, the Idaho farmer has a "comparative advantage" in growing potatoes, and the Louisiana farmer has a comparative advantage in growing rice. Both farmers are better off if they grow the crop for which they have a comparative advantage, then trade for the other things they need. The rice farmer gets cheaper potatoes, and the potato farmer gets cheaper rice.
David Ricardo, a 19th-century economist, first developed the concept of comparative advantage to explain international trade. In reality, the principle is much broader than that, because it explains why different people specialize in producing some things and then buy whatever else they need from other people. An auto worker who buys vegetables at the grocery store, visits the doctor for a prescription, and rents videos for entertainment is practicing the principle of comparative advantage.
People and organizations can have comparative advantages for many reasons besides climate and soil. Individuals are born with different types of abilities, and so there would be gains from specialization even if we all lived in the same climate. Experience and education can generate comparative advantage, as people invest in developing skills that let them do new things with less time and effort.
While the specialization of different people in different activities is good for the people themselves, it is also good for society in general. If lots of Idaho farmers "wasted" resources growing rice and Louisiana farmers wasted resources growing potatoes, all of society would suffer the consequences. As a society, we should want farmers to grow the things they are best suited to grow, so we can use our limited resources to produce other things we need. Societies with market systems out-perform societies run by command, in part because the market system applies the principle of division of labor across the entire economy.
The Comparative Advantage of a FirmOrganizations too can possess comparative advantages, because groups of people can jointly develop capabilities to do certain things particularly well. Wal-Mart, for example, has excelled by developing superior communication and transportation links between individual stores, warehouses, and suppliers; the company has a comparative advantage in getting customers the merchandise they want quickly and efficiently.13 But having a comparative advantage in something also implies comparative disadvantages in other activities. If Wal-Mart stopped running retail stores and went into the oil drilling industry, it would probably lose money, because its communication and transportation skills might not be very useful in oil drilling. Thus, Wal-Mart and other companies have a strong incentive to concentrate their efforts in those areas in which they can contribute most to society.
A firm, like an individual, makes the most profits over the long term when it specializes in activities that create the most value for customers at the least cost. The firm's mission system helps promote long-term profitability by identifying the organization's comparative advantages, enabling each employee to focus on enhancing them, and giving employees a better means of measuring whether their efforts have been successful.
As the Wal-Mart example suggests, the process of developing and enhancing comparative advantage is complex. Physical assets and technical skills are important, but equally important are systems that enable everyone in the organization to combine their skills and abilities to deliver value in ways that competitors cannot match. Organization, values, and communication all play a crucial role in the creation of comparative advantage. The firm's mission, therefore, should provide a basis for evaluating and improving all of these aspects of the organization.
What happens when a company chooses to specialize in activities in which it doesn't have a comparative advantage? The market system gives it clear feedback in the form of sustained losses. Competitors who do have a comparative advantage in the business will emerge, and the errant company will eventually be forced to improve or exit the business. Although this process may sound cruel, it is actually quite humane. A corporation that decides to specialize in a business in which it lacks a comparative advantage is actually wasting resources. The resources available for investment in productive activity are limited, and when a firm uses up more resources than necessary to create a given level of value for consumers, the extra resources it used are gone forever. The additional value they could have provided for consumers will never be seen by anyone.
Koch Industries' Mission System The concept of comparative advantage has played a large role in guiding business leaders at Koch Industries. One senior executive often comments, "We used to think we were in the oil business; it turned out that we're in the purchasing, transportation, processing, sales, and trading businesses." When Koch's managers began to view the company's expertise as transportation and processing, they started doing a number of things differently. Koch exited the retail gasoline business years ago, because it believed that retailing requires expertise quite different from that required in other businesses. Similarly, the company does a very limited amount of oil exploration and production-and only when these activities clearly complement the core businesses.Koch Industries has developed a methodology for discovering its comparative advantages, organizing activities, and measuring success. The Koch "mission system" is an ongoing process in which employees systematically improve their understanding of the firm's capabilities and markets, define goals, plan ways to achieve the goals, and monitor progress. Many firms have mission statements that are intended to inspire employees to work toward common goals. At Koch, the mission statement is used more for strategic planning than for motivational inspiration. A mission statement is just one aspect of the mission system, and it continually changes as employees' understanding of the firm's competitive position changes.
Koch Industries divides its mission system into four key elements. The first element, Understanding the Business, involves deciding what is realistically possible given the nature of the markets, the competition, the firm's resources, and its capabilities. This understanding comes from knowing the business, its history, relevant economic theory, management tools, and the firm's competitive advantage.14 Relevant questions that help refine this understanding include:
The second element, deciding What to Do, is fairly self explanatory. Many company missions are too general, emphasizing factors like growth or improvement without an understanding of whether they are desirable or feasible, and without specifying the most profitable ways to target the firm's efforts. To create a mission, a business must really understand where it can create the most value at the least cost. The mission must also be realistic and specific enough that the business can measure its performance against the resulting price, quality, and service goals.
Planning How to Do It involves enunciating the concrete steps to accomplish the goals. Without this aspect of the mission system, the mission is just empty words that do nothing to help coordinate activities. The planning process should include strategies to advance the mission for each part of the business, including each division, product, facility, operation, and function.
The fourth element, Monitoring Progress, is extremely easy to do poorly but extremely important to do well. For each goal, businesses and individuals need to develop measures of progress in advancing the mission. That imperative places a premium on measuring results, not activities, and on defining quality before measuring quantity. In addition, all measures need to be related to the broad goal of providing the most value at the least cost. Business history is full of examples of firms that achieved poor results-or even failed-because they measured the wrong things. It is all too easy to measure the things that are easily measurable, rather than measuring the things that actually provide guidance in advancing the mission.
Paradoxically, the quest for meaningful measures may be most important in businesses where it is the most difficult. This is true because a thorough search for measures will often lead to a greater understanding of the business even if it fails to yield perfect measures. The more difficult a business is to define and measure, the more important a keen understanding of that business becomes.
The monitoring process must provide feedback that is accurate, timely, and in a form that can guide actions. In particular, businesses and individuals should be evaluated on measures that they can actually affect. A welder in an auto plant, for example, should be evaluated primarily on her activities that have the strongest impact on profitability. All too often, people like the welder are implicitly measured and rewarded according to criteria they cannot directly affect, such as the gross profit margin on cars or the total volume of cars sold, with little emphasis on individual performance. Measurement systems should evaluate contributions to both local and organizationwide performance, and rewards should be based on clearly understood criteria.
Earlier we described Adam Smith's concept of the "invisible hand," a metaphor for the way that people mutually adjust their decisions and activities to fit with those of others. It is useful to think of an organization's mission system as a "visible hand," which gives employees important information they need to work as a team in accomplishing common goals. Through a well-developed and well-defined mission system, an organization can achieve a harmony of interests among its employees very similar to the harmony of interests that exists in a market economy. This requires educating all employees on the organization's mission, helping them understand how it is relevant to them, and encouraging them to develop personal missions that support the common mission. Ultimately, each person's mission should answer the question, "What can I do to promote long-term profitability, consistent with the firm's overall mission?"
SUMMARY: DIVISION OF WORK AND THE MISSION SYSTEM
| SOCIETY | ORGANIZATION | |
M |
|
|
PROPERTY RIGHTS, ROLES, AND RESPONSIBILITIES
In a market economy, the institution of private property plays a key role in promoting productive activity. Private property has three fundamental characteristics: individuals can decide how to use their property, they can earn income from it, and they can freely sell their property to someone else. Each of these aspects has a significant social role. Independent judgment harnesses the specific knowledge of time, place, and circumstances that no planner (or CEO!) can possibly possess. Income from private property gives the owner continuous feedback on how well he is satisfying customers. And the sale of property capitalizes the value of future earnings, so that people take into account the long-term consequences of their decisions.15
Independent Judgement Harnesses KnowledgeEvery social system provides some means of organizing resources to satisfy human wants and needs. No mind or committee can possibly know the intensity of everyone's desires for various goods and services or all of the possible ways of providing them. But each person in society has important knowledge, especially about his own desires and abilities. Private property harnesses this knowledge by allowing people to make independent decisions about the uses to which resources will be put.
Voluntary trade involves not just an exchange of money and property, but an exchange of knowledge. For example, someone with 50 cents buys an apple because he values the apple more than the 50 cents. By paying the 50 cents, that person is declaring to the store owner, "This apple is more valuable to me than to you, and the 50 cents is more valuable to you than to me." Conversely, the store owner makes the trade if he values the 50 cents more than the apple; he is telling the customer, "I agree; the apple is more valuable to you, and the 50 cents is more valuable to me." If customers could just walk into stores and take apples without paying for them, we would never know who placed more value on the apple. Voluntary exchange ensures that resources do not change hands unless the person acquiring them values them more than the person giving them up.16 Taken as a whole, the system of voluntary exchange enables millions of transactions of this type to generate knowledge about the most valuable use of resources in society.
Profit and Loss Provide FeedbackVoluntary exchange and private property provide strong incentives for businesses to serve consumers and strong feedback on the quality of service. In a free exchange, each person gains control over more valuable resources by giving the other something he wants more. This illustrates a fundamental principle of economics: to profit in a truly free market, firms have to find ways of delivering more value to customers while using fewer resources than their competitors. Once again, Adam Smith's "invisible hand" leads the profit seeker to act in ways that benefit society. "Total quality" gurus like Deming and Juran, who speak of defining quality in terms of customer desires, have rediscovered the "invisible hand." In a free market system, profits are the rewards for success in serving customers.
Profits earned in the marketplace signify that an enterprise has made a valuable contribution to society. Profits also give entrepreneurs with good judgment control over more resources so they can try creating value on an even larger scale. On the other hand, losses indicate that the firm has taken important resources and diminished their value. Losses also help separate people with poor judgment from the control of resources. One of the market's greatest strengths is its ability to match greater control over society's resources with those who have the best ability to make decisions. For centuries, social thinkers have misunderstood the role of profit in the market, yet no one has been able to design a social planning system which even comes close to performing as well.
Purchase and Sale Capitalize Future EffectsTo see how the right to sell property makes people accountable for the long-term effects of their actions, think about contemporary situations where property is not private, and so people cannot profit from preserving the value of resources. The air is regarded as public property, and the government feels compelled to regulate air pollution precisely because there is no owner who bears responsibility for keeping the air clean. Similarly, many American rivers became choked with pollution because no one owned them; no one had a strong enough incentive to preserve their future value by preventing pollution. Ecologists call this type of situation "the tragedy of the commons," because when a resource is considered public or "common" property, no one has a strong incentive to conserve and protect it.
Private ownership, on the other hand, creates strong incentives to preserve the value of resources. In Scotland, for example, the water in privately owned streams is crystal clear. Why? Because the stream owners have a legal right to limit water pollution, and they do so in order to protect the revenues they earn from selling fishing licenses.
If the environmental examples sound too far-fetched, think of the different habits we often associate with homeowners and renters. Homeowners plant trees, install roofs that will last for 20 years, and buy long-lived, heavy appliances in part because these investments all increase the value of the home when it is sold. Renters, on the other hand, often have to place a deposit up front to cover any damage they might do to the property. Without the deposit, renters would have less incentive to care about the condition of the property after they leave; the deposit is a way of inducing them to act more like owners.
It is important to understand that, in describing the important roles played by the institution of private property and the system of profit and loss, we are not claiming that all profits are socially "deserved." Profits promote a harmony of interests between the individual and society in free markets that have not been politicized. But companies can also make huge profits when legal or regulatory barriers prevent effective competition, as in the case of a government-granted cartel or monopoly. This allows the corporation to replace market competition-producing greater value using fewer resources with what might be called "political" competition. Individuals or companies can also profit through government subsidies. Here the value judgments (and resources) of consumers are replaced by the value judgments of the government and the resources of the taxpayer. In these cases, the profit-and-loss system is not allowed to function effectively.
Profits earned by creating value for consumers stem from the creation of wealth for society. Profits acquired through government stem from redistribution of wealth that someone else has created. Historian Franz Oppenheimer referred to the second strategy as the "political means" of profit.17 Oppenheimer distinguished the political means from what he called the 64economic means"-creating greater value for customers while using fewer resources than competitors. The possibility of profiting from the political means, and the extensive resources devoted to this strategy, make it difficult for us simply to look at the most profitable companies and conclude that they are necessarily superior to all others at creating value for society.
Implications for Business UnitsTo devise a market-based organizational structure, executives need to understand the beneficial characteristics of private property. The goal is not simply to copy the external market; we do not necessarily advocate making all workers buy their own tools or letting middle managers sublease their offices to outside customers. Rather, the goal is to understand the crucial functions played by private property in a market economy, and then allocate rights and responsibilities in ways that harness independent judgment, provide continuous feedback, and capitalize the future impact of current decisions.
At the business unit level, a firm can facilitate profit-and-loss calculation through the creation of profit centers. A profit center is a definable unit within a business, created from any set of activities for which financial statements can be prepared. Unlike independent firms, however, profit centers operate within the context of a larger organization. It would be a mistake simply to turn profit centers loose to do whatever makes profits, for then there is little reason for having them in the same firm. But how, then, does a company decide when to create a distinct profit center within the larger organization and when to spin it off as a totally separate entity?
Koch Industries tries to answer this question by evaluating profit centers not just on their own profitability, but also on the external benefits or costs they create for other profit centers. A business engaged in activities in which the company has a comparative advantage naturally falls within the company's "core." Other, noncore businesses are evaluated based on their positive or negative impact on the core businesses. For example, Koch retains some profit centers not because of their inherent profitability for the company, but because of their positive net impact on what Koch views as its core businesses. Similarly, parts of the company that are not profit centers at all, such as accounting and other "support" groups, are evaluated primarily on the value they create for the profit centers. This type of structure makes evaluation more difficult for Koch businesses than for independent firms in the marketplace. But complex and decentralized evaluation procedures are crucial for reaping the benefits of teamwork across multiple profit centers.
Implications for IndividualsProfit centers make separate pieces of the organization accountable for their actions, but to reap the full benefits of a market-based system, accountability must extend to the level of the individual. For individuals, well-defined roles and responsibilities inside the firm play a role similar to that of private property, and for many of the same reasons. Like private property, roles and responsibilities define the area within which a person or team is free to utilize local knowledge, make judgments, and bear the consequences.
All too often, things fail to get done in business organizations because everyone thought it was someone else's responsibility. The similarity between this situation and the "tragedy of the commons" is obvious. In effect, the activity in question was turned into public property. Since no one "owned" it, no one followed up to make sure it was done. Well-defined roles and responsibilities can prevent this type of problem by assigning a kind of "ownership" for every activity, action, and result.
In the free market, profit and loss continually reallocate control over resources to those skillful enough, or lucky enough, to please the customer more effectively than competitors. Like a society, an organization needs some way of assigning and reallocating roles and responsibilities. Koch Industries tries to reallocate roles and responsibilities based on an employee's demonstrated ability to make good decisions and satisfy customer needs.
Each person enters the company with control over a significant asset: his or her own abilities. Employees are expected to think in terms of the company's long-term profit and loss when deciding how to use their time. As people demonstrate sound judgment and good stewardship of corporate resources, they receive expanded authority to commit corporate resources to projects. This authority system applies both to internal resource allocation and external purchase decisions, and it has allowed Koch to abolish centrally approved budgets. In place of command-and-control budgeting, Koch tries to approximate the market's allocation through profits and losses. If a manager makes consistently poor business decisions over time, his authority to make future decisions eventually shrinks.
Well-defined roles should not be confused with detailed job descriptions. Historically, job descriptions in business have consisted of task lists. At their worst, these job descriptions have undermined teamwork and productivity-as when a store cashier refuses to sweep the floor because, "It's not in my job description." Roles and responsibilities, on the other hand, continually change as the external market, business mission, and employee's knowledge and capabilities change.
What should a market-based system of roles and responsibilities look like? While it would be impossible to define an exact system for all organizations, we can identify several appropriate characteristics:
1. An individual's roles and responsibilities should be based on the individual's mission, developed within the context of the relevant business unit and overall organizational mission.
2. Roles and responsibilities should be developed with an understanding of the individual's knowledge base and incentive structure. The individual should be allowed to make decisions or take actions which he or she is better qualified to make than anyone in the organization, and his or her compensation should be based on effectiveness in that role.
3. Specific roles and responsibilities should be determined (and changed when necessary) for articulated and well-understood reasons.
4. New situations are likely to arise over time, so there should be a clearly understood process for addressing and resolving questions of overlapping roles or gaps between roles. Incentive compensation should be based on an employee's contribution to working out conflicts in a positive way as well as on working within the current system.
5. Expectations of performance, including the measures to be used, should be communicated and clearly understood.
SUMMARY: PROPERTY RIGHTS, ROLES AND RESPONSIBILITIES| Society | Organization | |
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RULES, VALUES AND CULTURE
In every society, various written and unwritten rules of just conduct provide guidelines for acceptable behavior. Some societies have rules that reward hard work, innovation, and service to others; other societies have rules that reward indolence, conflict, and power-seeking. It's not hard to predict which of these societies have been more successful in increasing the well-being of their members. Sensible rules also make people's behavior more predictable to others, and this predictability helps all people accomplish their different goals.
Rules that Promote ProsperityA society's rules of just conduct can be divided into the formal and the informal. Formal rules are written laws, such as those against murder and theft. For these rules to be effective, most people must accept and follow them voluntarily. The gang wars during Prohibition and riots in Los Angeles illustrate what happens when a sizable number of people choose not to accept formal rules of just conduct.
If law-breaking becomes widespread, it is much harder for people to accomplish their goals, because the behavior of other people is too unpredictable. An urban storeowner faced with the threat of looters, for example, will try to protect himself from this uncertainty by carrying a smaller stock of merchandise and charging higher prices to pay for a security system. As a result, the threat of looting harms not just the storeowner, but all of the customers in the surrounding community.
Beyond the formal rules are informal rules of just conduct. These are the customs, codes of decency, and culture that exist in society. For example, most people try to give accurate directions to strangers who ask for directions. But if a substantial number of people enjoy giving out wrong directions-or just guess at the directions because they don't want to admit that they don't know-travelers find it harder to get to their destinations in a reasonable time. Few places have formal laws about giving directions, but there is an unspoken norm that says we should be honest when someone asks. Similarly, some companies' informal rules of just conduct include honoring their agreements, but others will break agreements if they can get away with it. Adherence to commonly acknowledged business ethics makes us all wealthier by reducing the amount of resources we have to devote to contract negotiation and enforcement.
Over time, a large number of rules and norms have evolved in our society.18 Concepts like honesty, respect for private property, and keeping one's word play a significant role in advancing our standard of living, because they promote the types of long term investment and risk-taking that enhance human welfare. A corn farmer, for example, fully plants his acreage because he knows where the boundaries are, and he knows others will respect them. If the boundaries are in dispute on one quarter of the property, he probably will not invest as much time and money in planting that area as he would in the areas where his property rights are certain. If a gang periodically burns his crop or if the government periodically confiscates it, he will invest less time and money in developing that farm. Many people in the modern world, from residents of America's inner cities to inhabitants of war-torn countries, are in a position little better than the farmer beset by bandits- and for similar reasons. Prosperity slips away when the rules of just conduct break down, because people lack the predictability needed to make long-term plans and investments.
Just as scientific progress changes our understanding of the physical world, learning and experience gradually change people's ideas about the appropriate rules of just conduct. Formal rules are subject to change by government, of course, but informal rules constantly evolve as well. Customs regarding smoking are a good example. It used to be considered impolite to ask someone to put out a cigarette; now, it's considered impolite to light up without asking if the smoke will bother anyone.
Corporate Values and CultureRules defining acceptable behavior make the actions of others in society more predictable and beneficial. Similarly, a company's values and culture can guide employees' actions in ways that advance the common mission. In emphasizing values and culture, we explicitly reject the popular idea that there exists a conflict between what is profitable and what is moral. In society and in organizations, moral principles serve the crucial function of guiding our decisions in ways that promote our long-term welfare. The relevant tradeoff is not what is right versus what is profitable; it is between long-term and short-term profitability. If an organization's moral principles are sound, doing the right thing also enhances profitability over the long term.
For an illustration of rules of just conduct, we turn again to Koch Industries. Some key concepts in Koch's written statement of corporate principles are humility, intellectual honesty, openness, receptiveness to new ideas, treating others with dignity and respect, recognizing and using everyone's unique knowledge and abilities, and instilling a commitment to the common mission.
Of course, any organization can pay lip service to these types of principles, and putting principles on paper but not in practice can seriously damage a corporation's underlying culture. But when actually followed in practice, principles like these can promote the trust and openness that allow organizations to tap tremendous employee knowledge and creativity. Employees who exhibit humility recognize that they do not have all the answers, and probably never will. Without humility, individual and organizational learning is difficult if not impossible. Intellectual honesty means people admitting what they don't know, acknowledging mistakes, and searching for evidence that contradicts their positions with as much vigor as they search for evidence that confirms their positions.
When principles like these are not followed, a corporate culture develops in which "information is power," and those who collect and hoard key information are rewarded with positions of greater authority. It is easy to see the damage that such a culture can do to an organization that needs to tap and integrate the dispersed knowledge of all its employees. Finding solutions to complex problems is all but impossible if an organization depends on one person collecting the relevant information. A culture of genuine humility and honesty must be established in order to achieve organizational learning and profitability.
The Koch principles may sound like common sense, but they contrast sharply with the informal culture in many organizations. Managers often face strong pressure to appear competent and put a positive spin on every development, even if it was a genuine mistake. When mistakes occur, people often ask, "How can we avoid blame?" instead of asking, "What can we learn?" Edgar Schein, an organizational learning specialist at MIT, has noted that even in organizations that encourage people to learn from mistakes, there is often an unspoken prohibition on making the same mistake more than once.19 In such an environment, managers may analyze past mistakes, but the main thing they learn is to avoid activities that carry some risk of repeating a mistake. As a result, people shy away from taking healthy risks, and they lose the opportunity to recognize patterns of events that repeatedly generate the same types of mistakes.
A company's actual values and culture also exercise a heavy influence on managers' attitude toward change. If followed consistently, principles like humility, intellectual honesty, and receptiveness to new ideas encourage people to embrace change as an opportunity for improvement, instead of avoiding it as a threat. Yet in many organizations, people spend a great deal of time and effort resisting change, under the guise of weeding out "unwise" change. Values that promote openness to change are now more important than ever, because in the modern business environment to resist change is virtually to guarantee failure.
SUMMARY: RULES, VALUES, AND CULTURE| SOCIETY | ORGANIZATION | |
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THE PRICE SYSTEM AND INTERNAL MARKETS
In a society of independent decision makers, people need some means of coordinating their decisions with those of others. A free society lets millions of individuals simultaneously try to accomplish their various goals. Yet at the same time, people cooperate harmoniously to accomplish their goals better than they could by acting alone. Market prices play a large role in providing both the information and the incentives that make this mutually beneficial activity possible. Guided by prices, both business and consumers weigh alternatives and make choices in ways that take other people's plans and desires into account.20
The Power of PricesThe absence of gasoline lines during the Persian Gulf war powerfully demonstrates the price system's ability to promote coordination. When Saddam Hussein invaded Kuwait, a portion of the world's oil supply was temporarily cut off, and many people expected the Gulf war to reduce supply further. With less oil available, it was only sensible for people to conserve. The oil price increase following the invasion accomplished this conservation with a minimum of disruption. Millions of people simply looked at the higher price of gasoline, and they decided that some of their driving was not worth the increased cost. Each person decided whether and how much to conserve, and each person who conserved decided which activities to curtail. We did not need ration coupons, a national oil allocation scheme, or presidential speeches urging us to save energy-, people just responded sensibly to the signal conveyed by prices.
Contrast this to America's experience during the Arab oil embargo of the 1970s, when government-imposed price controls prevented pump prices from rising to reflect the reduced supply of oil. Without a reliable price signal, American families had no way of knowing how much they should conserve, and they had much less incentive to conserve. Instead of conserving, many people wasted time and millions of gallons of gasoline waiting in line at filling stations for fuel that was sold at an artificially low price. Price controls prevented Americans from adjusting to the reality of a temporarily reduced oil supply. The price system facilitates amazing coordination in a market economy. Every day, millions of people make all manner of decisions by comparing the prices they see with the benefits they expect from products or services. Not even the most powerful computer could make all of these decisions for society, but ordinary people can make decisions for themselves when aided by the information summarized in prices.
Bringing Prices Inside the FirmThe size and complexity of resource allocation decisions within firms sometimes rival the size and complexity of decisions in the external marketplace. Yet the typical business firm employs the price system only sparingly. Many companies do establish transfer prices for products that move between internal divisions, but the vast pool of resources known as "corporate overhead" usually carries no internal price. Indeed, a recent survey by Price Waterhouse revealed that most companies are only just beginning to tackle the problem of internal pricing for corporate services.21 In many companies, resource allocation for services is managed by corporate bureaucracies that more closely resemble Soviet planning boards than entrepreneurial businesses.
During the past ten years, though, some firms have made major strides in developing internal market systems to guide internal resource allocation decisions.22 The creation of internal markets stemmed from the realization that many "corporate overhead" functions have traditionally been treated like government-run utilities. Instead of receiving resources from customers who voluntarily decided to buy, these groups frequently received budgets from top management. To cover these costs, profit centers then paid arbitrary "overhead" allocations that bore little relationship to their actual use of corporate services, much less the value created by such services for the corporation. As a result, profit centers had every incentive to use as many corporate services as they could-even if a given project consumed more resources than the value it created. This overuse of corporate services often created the impression that services were undersupplied-an impression that could be used to argue for spending even more on overhead services in the future. The predictable result was often a corporate overhead cost spiral, which many companies addressed through "across-the-board" budget cuts. Across-the-board cuts, arbitrary by their very nature, fail to take the relative value of particular corporate services into account. Yet without some kind of market-type evaluation system, most alternatives are relatively arbitrary.
Frequently, business leaders and economists dismiss internal market ideas with a brusque statement that firms exist to minimize transaction costs. Administrative fiat supposedly reduces transaction costs, and so there is seemingly no place for the price system inside the firm. But these objections ignore the "costs" of making decisions without the knowledge provided by prices. No one disputes the notion that, at some level, internal pricing creates more transaction costs than are profitable.23 But some innovative companies have achieved tremendous increases in productivity by organizing internal service providers as business units charging explicit prices for specific services.
Koch Industries' internal market system provides an interesting example. Services provided under Koch's internal market system include accounting, training, government affairs, information services, legal, environmental compliance, and a variety of other functions. When confronted with explicit prices linked to discrete choices, business leaders face strong incentives to "buy" only those specific "overhead" services that are really worth the cost. During the past two years, a number of Koch corporate service groups have made major revisions in the types of services they offer, because internal markets have forced them to provide services that internal customers perceive as valuable.
Examples of these services include development of certain reports and studies requested by senior management. In the absence of prices for research and reports, top executives asked for a lot of information on sundry topics; various departments dutifully supplied them, assuming that management knew the costs and had decided the activity was worth the cost. In reality, executives had little idea what the company paid to generate these reports. When prices for these services were presented to management, it quickly scaled back its requests, and some types of reports were eliminated entirely. On the other hand, several new reports were developed jointly by the report "suppliers" and their "customers" in management. These documents now provide managers with much more useful information, such as information on business unit profitability rather than raw data. Yet they would probably not have been developed without the incentives created by the internal market system.
Like Koch's profit centers, its internal service providers are not merely freed to do whatever they think will produce revenue for themselves. They are currently nonprofit entities whose survival depends on their ability to offer services that internal customers are willing to buy. Initially, most of Koch's internal service providers did not have to compete with outside vendors. But as the internal market system has evolved, more and more outside contracting has taken place. Currently, if an internal customer wants to purchase from an outside supplier, the internal service group acts as advisor and purchasing agent. The internal agent is always the "supplier" in this system, although it may not necessarily be the specific "generator" of the service. Even the corporate chairman's office is operated as a profit center, purchasing some services deemed essential to the well-being of Koch Industries as a whole.
Obviously, Koch Industries' implementation of internal markets differs from that of many other companies. Many proposals for internal markets sound like trust-busting gone wild; when the whirl of decentralization is finished, there seems little justification for keeping a bunch of independent business units inside the same firm. Koch's corporate services currently are nonprofit entities, not because the company's executives are certain that this is the best way of organizing internal markets, but because they are searching for a solution that captures the benefits of internal markets without sabotaging teamwork.
The transition to internal markets demonstrates some of the challenges Koch has encountered in implementing its management philosophy. Market-based management does not mean merely mimicking markets inside the firm. Rather, it requires managers to understand the major features of a market economy, then adapt these features as needed to improve management practice. Koch's combination of profit centers and nonprofit service groups, along with the evaluation criteria for managers, are an attempt to capture the benefits of a market economy while preserving the benefits of having these entities in one business firm.
SUMMARY: PRICE SYSTEM AND INTERNAL MARKETS| SOCIETY | ORGANIZATION | |
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GENERATION AND COMMUNICATION OF KNOWLEDGE
An effective organization must tap the vast and diffused knowledge held by its employees. Decisions must be made by certain people and should be based on the best available information. For many organizations, getting the right information into the hands of the right people can mean the difference between profitability and failure. Many companies now realize that, whatever other businesses they are in, they are also in a kind of "knowledge business." In the business of generating and communicating knowledge, market-based systems have major advantages over command-based alternatives.
The price system serves as a communication network that links and coordinates individual decisions in a market economy. Internal markets can help capture some of the benefits of the price system inside the organization. But in addition to prices, many other aspects of a free society also promote the generation and use of knowledge. Three important characteristics of knowledge help show the power of market-based management in generating and utilizing ideas: much knowledge is dispersed (or "local"), much knowledge is difficult to articulate (or "tacit"), and potential knowledge needs to be tested.
Much Knowledge Is "Local"Regardless of how decisions and information are communicated, a free society allows-and even requires-that key decisions be made by a vastly greater number of people than a command system. And since knowledge is, by its very nature, widely dispersed among individuals in society and organizations, a system that allows people with appropriate knowledge to make decisions also must permit fairly decentralized decision making. This does not mean that all systems that promote decentralized decisions are good, only that any system which cannot accommodate decentralized decision making fails to take full advantage of the knowledge contained in the system.
The power of the market system lies largely in placing decision making power in the hands of those with the appropriate knowledge. In a market economy, we see dramatic decentralization of decision making, but we also see some cases where one or a few people make decisions that affect vast collections of resources. In many cases, the appropriate level of decision making is much closer to the customer than to corporate headquarters. But it would be a mistake to view market-based management as always requiring more decentralized decision making. When decision making authority is placed at too local a level, the decision maker lacks the appropriate knowledge because he "can't see the forest for the trees." This kind of misplaced authority can be just as disastrous for an organization as having top management make all decisions.
The important point is that, where the critical knowledge is local, the market system permits decisions to be made at the local level. A market-based organization needs to approximate this distribution of authority to achieve its potential. But appropriate distribution of authority is not enough. Even a person with the appropriate knowledge won't make the best decisions unless he or she has the proper incentives to do so. For this reason, the organization's incentive system must be developed to maintain the harmony of interests between the individual decision maker and the organization.
Much Knowledge Is "Tacit"Much of the most important knowledge contained in societies and organizations is inarticulable-or what philosopher of science Michael Polanyi calls "tacit." One example is knowledge of how to ride a bicycle. While many people know how to ride one, no one could articulate this knowledge in any complete way. Polanyi captures this state of affairs by saying, "We know a great deal that we cannot tell."24 Another often-cited example of tacit knowledge is language. When we learn to talk as children, we also learn a complex set of grammatical rules that very few of us can articulate, but almost all of us use on a daily basis. Other direct examples from organization management might be the knowledge of how to achieve maximum output from an assembly line or get maximum quality from a given production procedure.
Management literature features plenty of examples of companies that have found ways to capture local and tacit knowledge. How? By permitting individual initiative, creativity, and experimentation. While a command system relies on an explicit, articulated set of regulations establishing which decisions will be made by which people (often even specifying the information on which the decision will be based), a more market based system permits flexibility and creativity in accomplishing the overall goal. The recognition that much of the crucial knowledge needed for maximum performance lies beyond the reach of the manager implies an entirely different approach to getting a particular job done.
An example from Koch Industries demonstrates what happens when an organization mobilizes the knowledge of its employees. At one processing unit, managers achieved a large increase in production simply by telling the unit operator to produce as much as he thought the unit could produce, within safety and legal tolerances. Formerly, he had explicit instructions to produce the maximum amount that engineers said the unit was designed to produce within the same tolerances. Koch management acted on the possibility that the unit operator might have superior knowledge in his area of expertise, and they were right. In this case, a seemingly small change had major results.
Much Knowledge Is UntestedHow an organization or a society deals with new and untested ideas can have a major impact on its performance. In fact, we believe that the way in which the former Soviet Union stifled creativity and innovation is directly linked to its eventual downfall. In a command economy, people fear speaking up, because they are often punished if they disagree with the official doctrine. This is an unavoidable feature of centralized economic planning, because ordinary individuals are not supposed to be able to improve on the government's economic plans. Such a system clearly limits the creation and communication of knowledge. For decades the Soviet Union discouraged (and often persecuted) individuals engaged in scientific inquiry that was not condoned by the government. The system was clearly based on the idea that the government "knew" what needed to be discovered, and any other intellectual pursuits ran counter to "progress."
As misguided as the Soviet system sounds, it is likely that the real problem was not irrational or stupid government officials, but rather the inevitable result of a command-based system. How different, in principle, was this system from a corporate system in which new ideas must be passed through multiple and hostile "channels" in order to be heard by top management? How likely are creative suggestions to occur in a company within which success comes from protecting divisional budgets, product "turf," or some other variable unrelated to tapping the knowledge of employees? And how many companies don't have at least some elements hostile to new and untested ideas? We believe no company is completely immune to Soviet-style suppression of new ideas, and it is therefore critical for each company to examine its own systems for finding and testing these ideas.
Does the common tendency for people to suppress new and threatening ideas imply that all new ideas should at least be tried? No. But the systems a company uses to generate new ideas and select those that will be tried should be designed to avoid as many command-based shortcomings as possible. For example, rather than designating a fixed "channel" through which an idea must pass (such as a specific person), a system of several possible avenues might be arranged. This would more closely approximate a market-type system, since the "idea entrepreneur" would be able to choose the reviewer least likely to be threatened by the new idea. The ideal idea reviewers would be people with credibility in the organization but who would be unlikely to behave as authoritarians.25 The reviewers would also be responsible for advancing the organization's mission by helping generate new ideas, and they would be rewarded based on their success in this area.
Freedom of expression, multiple idea filters, and mutually agreed upon standards of evaluation are positive features of a non-authoritarian scientific community described by Michael Polanyi as a "society of explorers."26 Polanyi contrasts this kind of society with what he calls a "dogmatic society," which corresponds to our concept of a command society. The society of explorers is not without standards for determining the quality of ideas, but it is without centrally directed standards and channels. The standards are mutually held and reinforced (and sometimes even changed) by the members of the society themselves. It is this kind of system that seems to produce the most innovative ideas and thinkers, and a market-based system of creating and communicating knowledge should take this ideal as a model.
SUMMARY: KNOWLEDGE GENERATION AND COMMUNICATION| SOCIETY | ORGANIZATION | |
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INCENTIVES, COMPENSATION, AND MOTIVATION The Social Role of Profit
The market system is critical if people are to receive rewards for helping others accomplish their goals. The prospect of profit motivates entrepreneurs to seek ways of delivering the most value to consumers for the least cost. Through their purchases, customers reward those who do a better job of satisfying their needs using fewer resources.
Some critics of the market object that the business leader's obsession with profitability prompts companies to pursue only short-term goals. This objection ignores the way markets capitalize future profits into the price of assets. In a market system, transferable property rights create powerful incentives to conserve and care for valuable resources. For example, when a corn farmer sells his farm, the price he gets depends on its condition. He has an incentive to ensure future productivity, so he leaves it in a condition that minimizes future costs and maximizes future revenues. In other words, by doing things that make the farm fetch a higher price today, he ends up taking the needs of future generations into account. In the case of a corporation, it makes much more sense to maximize the long-term net present value of the corporate income stream than to maximize short term earnings. The market system thus contains strong incentives to provide for the future.
In contrast, a farmer in a socialist system like the former Soviet Union received rewards for meeting his quotas, not for thinking about the future. He could use the land, but he could not sell it, and so he had little incentive to preserve or enhance the land's value for the future. Ultimately, he would leave the property in worse condition than when he received it. This principle explains why environmental problems in the formerly socialist countries dwarf those that we face in the West. In Eastern Europe, sulfur emissions from coal-burning factories have completely denuded some forests. Water in rivers is so loaded with toxic chemicals that it is not even fit for industrial use. These results stem directly from the incentive system: pushed to meet production quotas, people did the things they were rewarded to do and no more.
Personal Profit and LossPsychologists, economists, and others have produced mountains of theories and research about motivating people inside organizations.27 Market-based management adds not another theory of motivation, but a framework for integrating the existing research and deciding which ideas are most useful.
Inside the firm, an effective motivation system conveys market signals to each employee. To fully understand the implications of this statement, we need to remember that the profit-and loss mechanism accomplishes several things in our broader society. It offers the prospect of rewards, conveys information, and redistributes control over resources. Each of these elements has a parallel in an organization's motivation system.
Within organizations, no aspect of motivation generates as much controversy as the issue of rewards. Some people think of incentives in a very mechanical and superficial way, assuming that people are naturally lazy and that financial and material rewards are the main things that motivate them. The motivation issue then simply becomes a question of discovering the "right" amount of pay and perks to elicit the "right" amount of effort. Many authors and business leaders have reacted against this view, arguing that intrinsic motivation-the individual's desire to accomplish something-is the main force that drives achievement. Unfortunately, some take this sensible notion to the opposite extreme, asserting that material rewards do not matter much, as long as people have fulfilling work in a good environment. This notion sometimes surfaces in the political realm as well. It is used to justify a ideological agenda that seeks more egalitarian pay scales and more progressive income taxation.
Market-based management offers a third way, different from either of these two extreme views. In general, people do want to make a positive contribution and do the best job they can. In many cases, though, organizations give people incentives to do just the opposite, and it is an exceptional person who can resist these incentives for a long period of time. Nearly every organization has stories of heroic people who succeeded in doing their jobs in spite of the system. The goal of a market-based company should be to create a motivation and incentive system that will reinforce people's natural desire to do the right thing.
How does one decide what "doing the right thing" means? While we can't give blanket criteria, we can suggest the following:
Carefully developed measures are especially important in large organizations, where people may be quite insulated from direct contact with the external marketplace. It is here that the organization's incentive system, understood in the broadest possible sense, is most crucial as a means of conveying information. People in a big company may sincerely want to do their best to serve the customer, but they need meaningful feedback to guide them. Furthermore, verbal evaluation and discussion by themselves may not provide sufficient information to guide action, because "talk is cheap." When administered sensibly, tangible rewards-in the form of pay, bonuses, greater responsibility, or other benefits-help underscore the most important things an employee can do to serve customers.
There is a third, distinct reason that advancement and compensation should depend on results: the imperative of matching people with the most appropriate responsibilities. In the marketplace, a small business owner who successfully serves customers will often earn higher profits and have the opportunity to make even more resource allocation decisions in the future. This continual redistribution of resources serves the important social function of moving each decision into the hands of the person with the best knowledge and judgment. A career development and compensation system should attempt to replicate these aspects of the market economy. Employees who make greater contributions to profit should enjoy greater opportunities to determine their own work and make decisions about the use of company resources. Many psychologists have argued that this type of motivation system makes people work harder because they feel better about their work. just as important, it helps the organization allocate decision making authority to the right people.
SUMMARY: INCENTIVES, COMPENSATION, AND MOTIVATION| SOCIETY | ORGANIZATION | |
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THE RESULT: SOCIAL AND ORGANIZATIONAL LEARNING
Ultimately, a free economy generates vast wealth because it effectively uses individuals' knowledge in decisions. This 49social learning" is a crucial element in economic progress, because of the dispersed and tacit nature of economically useful knowledge. The more effectively a society uses knowledge, the higher its standard of living, because better know-how lets us satisfy more consumer desires using fewer resources.
Social LearningThe incentive problems in a command system are generally well recognized, but the knowledge problems of a command system are not. The market system has the highest rate of social learning of any economic system because its rules of just conduct and property rights systems help generate a rich flow of information from two important sources: verbal exchanges and market transactions. Markets promote learning because consumer choices determine rewards for entrepreneurship. Society benefits from the individual knowledge each consumer reveals in market exchanges. When competition forces firms to improve their ability to satisfy consumer needs, learning occurs. Without consumer choice, there would be much less learning or coordination in society. Command systems find it much more difficult to tap dispersed knowledge and "learn," which is a key reason why command systems fail. This failure of centralized planning also helps explain why large firms that use command systems are so inefficient. They fail to use everyone's knowledge, precisely because they are centrally controlled.
If planners impede market decision making, coordination must occur in some other way. The central authority typically tries to specify the quantity and quality of the things to be made. But typically, government planners find that their plans are unworkable because they lack the necessary knowledge. For instance, when Soviet planners expressed a nail factory's quota in tons of nails per month, the factory produced a glut of large nails but a shortage of small nails, because that was the easiest way to meet the quota. When the quota was set in numbers of nails per month, the factory produced millions of tiny nails but no large ones. Both of these results occurred because planners rewarded factory managers for meeting their quota, and so the managers found the least difficult way to achieve it. Even with quotas expressed in particular sizes of nails, there were shortages of some and surpluses of others-because the planners could not really know the total number of every type of nail that was needed.28
Even if the planners could have gotten everything exactly right once, neither consumer desires nor production technologies stand still. To plan an economy or an organization effectively, those in charge need to anticipate continual change and respond effectively. A market system, in contrast, does not require such an impossible collection of knowledge and power. Firms that are skilled at anticipating future trends reap profits, and the prospect of profit spurs business leaders to adjust to change.
Organizational LearningOrganizational learning is the business firm's counterpart to social learning. Great differences in the rates of learning among firms stem from organization and management, because organization and management determine how well the firm uses the knowledge of its people in decisions.29
The Japanese and American auto industries provide a well known case in point. Compared to U.S. auto firms in the 1980s, the Japanese were twice as productive, had one-third fewer defects, maintained less than eight percent of the inventory, and required half as many people in product development.30 Japanese firms achieved these results because they found better ways to marshal the knowledge of individual workers and work teams.
The Japanese emphasis on mobilizing the knowledge of workers, their rejection of the "scientific management, theories of Frederick Taylor, and their strong sense of the superiority of their techniques, all come through quite clearly in the following quotation from Konosuke Matsushita:
We will win and you will lose .... Your companies are based on Taylor's principles. Worse, your heads are Taylorized too. You firmly believe that sound management means executives on the one side and workers on the other, on the one side men who think and on the other side men who can only work. For you, management is the art of smoothly transferring the executives' idea to the workers' hands.
We have passed the Taylor stage. We are aware that business has become terribly complex. Survival is very uncertain in an environment filled with risk the unexpected, and competition.Therefore, a company must have the constant commitment of the minds of all of its employees to survive. For us, management is the entire work force's intellectual commitment at the service of the company....We know that the intelligence of a few technocrats --- even very bright ones-has become totally inadequate to face these challenges....Yes, we will win and you will lose. For you are not able to rid your minds of the obsolete Taylorisms that we never had.31
Mobilization of knowledge is critical in the Japanese systems. Strategies like just-in-time inventory management, pioneered by Toyota, can work only if companies organize work in ways that tap the dispersed knowledge of individual workers. Many Japanese auto firms accomplish this by making each worker or work team responsible for inspecting the parts they receive from the previous stage of production. When defects are discovered, the parts are returned to the previous stage for repairs- a significant form of immediate feedback. Since workers know that they will be held responsible for correcting problems appearing at their stage, they have strong incentives to minimize defects. Given this division of responsibilities, it is sensible for the individual worker to learn statistical process control and other techniques that enhance quality. But note that the result-low defect rates-stems from the definition of responsibilities, just as the productive results in a market economy stem from the underlying structure of property rights.
It is tempting for management to adopt command practices when employees fail to do exactly what is expected of them. The easy response is to try to specify exactly what the people will do. However, giving orders and ignoring the knowledge of the people in the organization will generate the wrong decisions, will hamper employee motivation, and will likely produce results about as spectacular as those in the now-defunct Soviet Union.
CONCLUSION
Because the key systems of organizations discussed in this booklet are so heavily interdependent, we suspect that the principal elements of market-based management probably need to be implemented as a coherent system in order to achieve their full potential. This conjecture is certainly consistent with the experience of Koch Industries. An incentive system, for example, makes little sense unless people first understand the organization's mission.32 Similarly, an attempt to create internal markets without profit centers and carefully defined roles and responsibilities will create chaos.
Changing management approaches is one of the most difficult processes a corporation can initiate, and a transition from command-based to market-based management is as fundamental a change as an organization can make. Effective change requires a strong understanding of how the market process really works not just how it works in textbooks-combined with a sense of how people will react to different structures and incentive systems. One of the biggest challenges in this process is combining business expertise with a strong knowledge of economic concepts. This combination, though rare, seems essential for continued development of the market-based approach.
This realization has shaped our approach to developing market-based management at the Center for Market Processes. Market-based management is not an off-the-shelf program that business managers can buy and install. Rather, it is a perspective that permeates our approach to analyzing and improving major organizational systems. We invite interested executives to join with us in developing and applying market-based management, to help modem organizations fully tap the unique knowledge and expertise of all of their employees.
The nature of today's business environment shows that organizational change and improvement are not just smart choices they are necessary for survival. Command-based societies have found themselves unable to survive when faced with market based alternatives, and command-based companies will suffer the same fate when confronted with market-based competitors. It is no accident that today's most innovative and successful management techniques are those that mobilize the vast knowledge dispersed throughout organizations. Their success points to the need for an overall approach to management that continually uncovers and mobilizes this knowledge.
We believe the coming decades will see the paradigm of command and hierarchy replaced-in practice as well as in theory. The new paradigm will allow employees to apply their knowledge and skills with minimal "management" in the traditional sense. It may or may not be referred to as market-based management, but to work effectively it must be based on many of the principles described in this booklet. And while there is still much work to be done, market-based management clearly has the potential to serve as a guide for designing and building the organization of the future.
References
1The authors have spent several years discussing market-based management with, and learning from, Charles Koch, Richard Fink, and Paul Brooks at Koch Industries. We wish to acknowledge the major role played by them in developing the concepts and tools of market-based management, including much of the material covered in this booklet.
2For a sweeping analysis of these changes, see Richard McKenzie and Dwight Lee, Quicksilver Capital (New York: The Free Press, 1991).
3Don Lavoie, National Economic Planning: What is Left? (Cambridge, MA: Ballinger Publishing, 1985); Peter Boettke, Why Perestroika Failed (London: Routledge, 1992).
4Jerry Ellig and Don Lavoie, "Governments, Firms, and the Impossibility of Central Planning," in Paul Foss (ed.), Introduction to Organization Theory (Oslo: Norwegian University Press, forthcoming).
5Friedrich Hayek, The Fatal Conceit (Chicago: University of Chicago Press, 1990)
6See also Tyler Cowen and Jerry Ellig, "Market-Based Management at Koch Industries," Working Papers in Market-Based Management, Center for Market Processes (June 24, 1993).
7Adam Smith, An Inquiry Into the Nature and Causes of the Wealth of Nations (Chicago: University of Chicago Press, 1976 [19041); Friedrich Hayek Law, Legislation, and Liberty" (Chicago: University of Chicago Press, 1979).
8Frederick W. Taylor, Principles of Scientific Management (New York: Norton, 1911).
9In fact, two of the Soviet Union's "founding fathers," Lenin and Trotsky, admired the Taylorist system and saw centralized economic planning as a means of making all of society run as smoothly as a factory. See Peter Boettke, The Political Economy of Soviet Socialism (Boston: Kluwer Academic Publishers, 1990), pp. 105-6.
10The overemphasis on "competitive" relative to "cooperative" forces in the market process, and the analytical errors that result, are examined by Richard Fink, Price Theory and Pricing Practice (Routledge, forthcoming).
11We disagree with the notion that the essence of the firm is the substitution of command for market relationships. Readers concerned about this issue should see G.B. Richardson, "The Organisation of Industry," in Richardson, Information and Investment (Oxford: Clarendon Press, 1990).
12Peter Senge, The Fifth Discipline (New York: Doubleday, 1990).
13George Stalk, Philip Evans, and Lawrence Shulman, "Competing on Capabilities: The New Rules of Corporate Strategy," Harvard Business Review (March-April 1992).
14In this type of analysis, Koch executives have been influenced by Michael Porter, Competitive Advantage (New York: The Free Press, 1985), and Ludwig von Mises, Human Action, 3d Revised ed. (Chicago: Contemporary books, 1966).
15Randy E. Barnett, "The Function of Several Pr6perty and Freedom of Contract," Social Philosophy&Policy (1992), pp. 62-94.
16This value judgment is, of course, made in practice before the buyer consumes the product. The buyer may later regret his decision, but at the time of purchase the apple was worth more to him than the price.
17Franz Oppenheimer, The State (New York: Vanguard Press, 1914), pp. 24-27.
18Friedrich Hayek, The Fatal Conceit (Chicago: University of Chicago Press, 1992).
19Edgar Schein, "How Can Organizations Learn Faster? The Challenge of Entering the Green Room," Sloan Management Review (Winter 1993), pp. 85-92.
20Friedrich Hayek, "The Use of Knowledge in Society," in Hayek, Individualism and Economic Order (Chicago: University of Chicago Press, 1945).
21Daniel P. Keegan and Patrick D. Howard, "Making Transfer Pricing Work for Services," Journal of Accountancy (March 1988), pp. 96-103.
22William Halal, Ali Geranmayeh, and John Proudehnad, Internal Markets: Bringing the Power of Free Enterprise Inside the Organization (New York: Wiley, 1993).
23For a detailed analysis of transaction cost and pricing issues, see Jerry Ellig, "Internal Pricing for Corporate Services," Working Papers in Market-Based Management, Center for Market Processes (Sept. 17, 1993).
24Michael Polanyi, The Tacit Dimension (New York: Doubleday, 1983), p. 61.
25Don Lavoie and Bill Tulloh, "The Use of Knowledge in Organizations," Working Papers in Market-Based Management, Center for Market Processes (forthcoming 1994).
26Michael Polanyi, The Tacit Dimension (New York: Doubleday, 1983), p. 83.
27For example, see Frederick Herzberg, "One More Time: How Do You Motivate Employees?," Harvard Business Review (Sept.-Oct. 1987), pp. 109-120, and George P. Baker, Michael C. Jensen, and Kevin J. Murphy, "Compensation and Incentives: Practice vs. Theory," Journal of Finance (July 1988), pp. 593-616.
28Thomas Sowell, Knowledge and Decisions (New York: Basic Books, 1980).
29Ray Stata, "Organizational Learning: The Key to Management Innovation," Sloan Management Review (Spring 1989), pp. 63-74.
30James P. Womack, Daniel T. Jones, and Daniel Roos, The Machine That Changed the World (New York: Rawson Associates, 1990).
3lKonosuke Matsushita, "The Secret is Shared," Manufacturing Economics (February, 1988), p. 15.
32Acceptance of an incentive system can also depend on the organization's values and culture. For an example, see Kenneth W. Chilton, "The Double-Edged Sword of Administrative Heritage: The Case of Lincoln Electric" (St. Louis: Center for the Study of American Business, July 1993).
About the Center for Market Processes
The Center for Market Processes is a nonprofit research and education organization affiliated with George Mason University in Fairfax, Virginia. The Center's program on market-based management is designed to develop and apply market-based solutions to critical management problems faced by today's organizations. Toward this end, the Center produces educational publications and conducts research projects, case studies, and management workshops. The Center also offers consulting services to help organizations improve their profitability by developing and implementing market-based management systems.
For more information on the Center's products and service please contact us at:
Center for Market Processes
4084 University Drive, Suite 208
Fairfax, Virginia 22030-6815
Phone: 703-934-6970
Fax: 703-934-1578
Internet: cmbm@gmu.edu
| "This booklet applies market process theory to the internal operation of the firm in a way that is comprehensible to the layman and useful to the practicing manager." Jack High Harvard Business School |
| "Introduction to Market-Based Management is well thought-out and right on the money as far we are concerned." Joel J. Bleth President, Pump Systems, Inc. |
| "Market-Based Management is one of the main sources of Koch Industries' success. We believe that any business can benefit tremendously from the principles outlined in this booklet." Charles G. Koch Chairman and CEO, |
Center for Market Processes 4084 University Drive, Fairfax, VA 22030
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