Review of 'The Science of Success'
How free-market ideas helped building one of the biggest privately held companies
Charles Koch, an accomplished businessman, one of the world's wealthiest people, and a supporter of many free-market-oriented organizations, wrote 'The Science of Success’ to introduce the management philosophy that his company uses. It’s called Market-Based Management (MBM for short) and is rooted in free-market principles and ideas.
The author believes that principles that make societies more prosperous are also applicable to organizations:
I came to realize that there were, likewise, laws that govern human well-being... It seemed to me that these laws are fundamental not only to the well-being of societies, but also to the miniature societies of organizations.
The MBM is a constellation of mental models grouped around five dimensions: vision, virtue and talents, knowledge processes, decision rights, and incentives. A reader familiar with economics will surely find many familiar ones among them (such as creative destruction, opportunity costs, time preference, subjective value, dispersed knowledge, and many others). But occasionally the author offers an interpretation or application of a familiar concept that provides better insight into the life of the organization. For example, freedom of speech as a vehicle to tap into employees' knowledge or thinking of salary as an advanced payment for the value that employee will be creating. Below I will focus on some of the points that the author raises.
The most insightful were the chapters dedicated to the knowledge process and decision rights. Others I'll touch only briefly.
Vision
One can think about the vision as a mission statement. The only additional spin in this book is the mindfulness of creative destruction. Whatever is the way the business delivers value to the customers now, it will become obsolete with time either because the customers won't value it anymore or there will be more efficient ways to deliver similar value. So the vision should not be only about how the company is delivering value to its customers but also how it will be continuously reinventing itself to offset the creative destruction.
Virtue and Talents
This chapter offers a fairly typical exploration of the topics like soft skills and hard skills, values, culture, hiring with cultural fit in mind, and performance review. Majority of these ideas one can find elsewhere in the leadership literature.
Knowledge Processes
This part is influenced by Hayek's seminal work on dispersed knowledge. Information that is required to understand to what usage the resources should be directed cannot be possessed by one person. Bits of this information are spread between people who, through market interactions, make this information explicit via the prices, profit, and loss. Here’s Charles Koch:
To succeed in an uncertain future, a company must draw on the knowledge dispersed among its employees… A market-based knowledge process coordinates dispersed knowledge, applying it at the appropriate time and place to enable the company to profitably satisfy changing needs. Mechanisms for coordinating knowledge are indispensable for bringing about the spontaneous order necessary for creating superior value.
Thus freedom of speech becomes crucial.
The quality of this process depends on a willingness to respectfully engage in open, honest and objective debate, to challenge the status quo, and to consider humbly any challenges to our own beliefs, proposals and actions.
Without this kind of organizational freedom of speech the company can become too ossified to register the looming creative distraction.
To drive the process of creative destruction internally, nothing can be immune to challenge. Each of us must help foster an open environment that invites challenge and embraces change. If you find that your views are rarely challenged, or that you rarely challenge the views of others, something is wrong.
Also not all the data is created equal. Market-generated knowledge is superior to whatever is generated inside the company by internal accounting because it taps into the dispersed knowledge of market participants. Therefore market data must take precedence:
When a business sells products or services to external customers, the prices reflect economic reality. When transferring products internally, prices should also reflect the market alternative. As such, the internal price should represent the weighted average market price… Transferring products using a cost-based system leads to faulty profit signals and bad decisions.
Decision rights
The tragedy of commons can plague companies the same way it plagues communities. The MBM's antidote to that is to emulate the role property rights play in society with decision rights:
Clear decision rights allow employees to allocate, consume or conserve the company’s resources as they attempt to create value. They also enable employees to know what they are responsible for and to be held accountable, just like owners.
It’s also interesting how these decision rights are acquired. It’s not proximity to the process or the best knowledge about it that gives an employee decision rights. Instead, the author uses David Ricardo’s concept of comparative advantage.
An employee has a comparative advantage among a group of employees when he or she can perform an activity more effectively at a lower opportunity cost than others...
I hardly can imagine the process or calibration they use to measure opportunity cost in this context. So what's actually meant by that? It seems what's meant here a more a less a track record of success
Decision rights expand for those who consistently make sound, value-adding decisions and contract for those who do not.
Years of experience, credentials or titles have not proven to be reliable predictors of good decision-making ability. Only demonstrated success in decisionmaking reveals an individual’s decision-making ability, and then, only for that type of decision.'
Potentially that may present a chicken-and-egg problem here. If one first needs to consistently make good decisions to get the decision rights, how is one to make a first good decision without having the decision rights first? Most likely, some decisions are made even before an individual attains certain decision rights (a loan of a kind if we assume that decision rights are approximations for rights) but nothing is said explicitly about that.
Incentives
Most of the discussion of the incentives goes in line with what can be found elsewhere in leadership literature. That is, managers should build trust to understand what people reporting to them value (their subjective value) and incentivize them accordingly.
Incentives, of course, need to be aligned with the company's interest in order to address the principal-agent problem. An interesting example was given about deriving bonuses for salespeople as a bigger percentage from the price above the cost rather than a smaller percentage from the total sale—the second can incentivize making bigger discounts.
The following is quite an unorthodox suggestion but makes total sense given that one of the values of the Koch Industries is ‘principled entrepreneurship’
no limit should be put on an employee’s compensation so employees will not put a limit on the value they create.
Also the author rightly criticizes some of quite common perverse incentives. Such as thinking in terms of budgets:
Some companies institute fixed budgets as a way of controlling costs. Under this system, profitable opportunities are often missed as managers reject profitable proposals that would cause their budgets to be exceeded… This practice usually results in removing profitable expenditures and people along with unprofitable ones, tending to make the company less rather than more profitable.
Or focus on the short-term market valuation that can affect publicly traded companies.
Opportunity cost
Opportunity cost is mentioned a lot in different sections of the book. It seems to take a very important place in the world of MBM mental models. One application of this concept is to constantly look for an alternative, more profitable usage of the resources, and mind you, profitable resources as well.
Working on a profitable activity is wasteful when there is another, even more profitable activity that could be performed instead. It sounds counterintuitive, but profit can be increased by eliminating some profitable, value-adding activities when doing so enables a business to capture higher-valued opportunities.
The below quotes suggest that there is some advanced way to use the concept of opportunity costs by accounting for forgone opportunities. But frankly, from these quotes it’s not very clear how exactly it’s done in practice. It would be great to see some examples.
To encourage entrepreneurship among our employees, including appropriate risk-taking, we began to consider the profit forgone from an opportunity missed to be equivalent to a book loss resulting from a failed venture
Prudent risk-taking should be encouraged by applying the concept of opportunity cost. Within limits, the profits forgone from a missed opportunity should be considered the same as losses from a failed venture. The value of missed opportunities, as well as other shortcomings, should be estimated, included in evaluations of the employee’s performance and communicated to the employee. This eliminates the incentive to forgo riskier opportunities that are in the company’s interest
The structure of the organization
An important question is what kind of structure is promoted by MBM in order to facilitate the economic calculation process? The author suggests that profit centers should be rendered as atomic as possible.
Identifying and efficiently creating profit centers at the lowest practical level can provide a substantial competitive advantage. Ideally, each plant should be a profit center and, if it makes more than one product, the profitability of each product should be tracked.
That allows market processes to function internally within companies
The purpose of internal markets is to provide internal signals, so that decision making can be based on this information. This framework ensures decisions are made on the basis of business profitability to the same extent as external purchases. Proper internal markets generate knowledge, guide decisions, reinforce ownership and accountability, encourage entrepreneurship and help eliminate waste.
Yet he doesn’t go as far as to offer individual PnL but suggests that an employee's marginal contribution should be estimated and contributed to his or her compensation.
[Marginal contribution] refers to the portion of value created that can be assigned to a specific change, factor or individual. Understanding an employee’s marginal contribution requires answering several questions: What results were achieved? Would the opportunity have been captured without the employee? What would the results have been without this individual? How did this employee contribute to our culture?
Also Koch doesn't support the idea of full decentralization and self-organization:
Those with local knowledge are often in a better position to solve the problem at hand. The ideas and creative energy of all employees should be leveraged, but universally decentralized decision-making has its own problems. Some decisions, if made at the local level, can be unprofitable because a broader perspective is required.
The author notices that in a suggested structure of atomic profit centers there are pockets that are not subjected to efficient internal market economic calculation
Such support services, without oversight, tend to maximize their services rather than maximize their contribution to profitability. To eliminate this problem wherever possible, put these services under the control of the relevant business, or use the internal market or other mechanisms and measures
The suggestion is to be very cautious about them and try to use whatever possible way to measure them, e.g. by benchmarking with the external market.1
Conclusion
What makes 'The Science of Success' particularly interesting is that it provides insight into how someone who is obviously well-versed in free-market economics and obviously immensely successful in business translates this knowledge into practice.
This book is short and accessible. On one hand, it could serve as an introduction to very basic economics. On the other hand, it can help a practitioner, a business owner or a manager, by enriching their thinking with insights tested by time and based on economic theory. And the framing of most of those insights is quite different from what you can find in other business and leadership literature.
Having said that, there there are two drawbacks I noticed. First, the book is quite uneven. Many pages are dedicated to quite generic leadership and management advice one can find elsewhere (for example, things like hiring with alignment to values in mind or having three different performance ratings for high-performance, solid performers, and underperformers) while others are extremely dense and unorthodox. And related to that is the second drawback--there is not enough time dedicated to the most complicated and novel ideas. Some of those I mention above.
The book is not a practical guide and it's quite short to go into much detail on all the topics it's dealing with. It's more of a teaser and the reader would need to fill in some gaps on his or her own to integrate the ideas and make them applicable. As a side note: perhaps some of the gaps are covered in another book that Charles Koch has written--'Good Profit' which I will be also reviewing.