The Decline and Rise of IBM

IBM is making a comeback. Although many observers had counted the company out — “It’s a dinosaur, an implosion, a wreck,” various commentators said — its revival was probable, even predictable, because cycles of decline and revitalization have been the company’s pattern through many decades.

Part of the pattern has been its slow confrontation of new technological approaches. Successful in its established ways, IBM finds innumerable reasons to deceive itself about the need to change. In times of major technological transition, it has had to jettison its top leadership to bring in people who are willing to break with the past.

Again, the pattern has repeated itself. A new chairman and a new top management team are redirecting the company. IBM is embracing an innovative approach to computing — networks — and bringing out products and services that fit into the new model. As Lou Gerstner, IBM’s chief executive officer, recently commented, “We are completely transforming the business to address the market for networked computer systems.”

But, significantly, Gerstner has not taken IBM on a new course as much as he is returning it to its roots. For decades, IBM had a strategy of supplying one-stop shopping for information services to large firms — a strategy I call “singleness.” The company strayed from that strategy in the 1980s, confused and angered its customers, and has now returned to it. G. Richard Thoman, IBM’s chief financial officer, talks of a strategy of breadth, of being a full-service provider for customers, and managing technological integration for them. This is the singleness strategy revised for today’s IS environment.

To say that IBM’s recovery was predictable and that it has followed traditional paths is not to belittle the achievement of its managers. The IBM that existed when Lou Gerstner became CEO was bloated with excess bureaucracy and cost, and its people were demoralized. Initially, Gerstner’s top management team cut costs and downsized. Profitability returned, but not growth. How much of the company’s muscle was cut with the fat? How much of the company’s future was mortgaged to squeeze out short-term profits? Could Gerstner return the company to growth? If not, IBM would become a shell of its former self, destined to decline slowly and die.

But growth has returned in virtually all segments of the company. In 1995, IBM’s sales reached almost $72 billion, up more than 12 percent from 1994. For this, Gerstner and his team deserve great credit. Profitability was also up by 42 percent. And shareholders were richly rewarded: earnings per share rose by 44 percent. Even the mainframe market, the heart of IBM in the 1970s and 1980s that critics pronounced dead in the early 1990s, has recovered, with new mainframe computers bringing in substantial profit margins.

Clearly, IBM has turned around but is not out of the woods. Sales of mainframes depend on the business cycle in the economically developed world, but growth is slowing. The company has improved its position in other hardware areas but faces slow growth in personal computers and minicomputers. IBM’s new service units have smaller profit margins than the hardware businesses that previously provided its profitability. And IBM has yet to restore the customer and employee confidence that was so badly damaged in the early 1990s.

So IBM is recovering. But how could the world’s most admired company have slipped into massive losses and layoffs in just a few years? What do IBM’s experiences mean for other large corporations? Each of us has grown up with an image of IBM: once the world’s most admired corporation, it stumbled badly in the late 1980s and early 1990s. The causes of IBM’s difficulties constitute a warning and a source of insight.1

A Failure at Fundamentals

In the 1980s, IBM’s profit margins suffered a steep decline. Because the company’s costs remained level, profits dropped. Critics of the company have widely attributed IBM’s decline to two factors. During this period, IBM became a follower of technological development, more so than in the past. Such a change was marked because, in the 1960s, IBM had led the information technology industry with a grand innovation — the 360 Series of computers. Also, the company displayed a surprising naiveté in its partnering strategies, giving Microsoft and Intel extremely profitable portions of the industry while choosing to retain less profitable portions for itself.

Though these factors are very important, they are not the root causes of IBM’s difficulties. For example, the decline of profit margins was a result of falling customer interest in mainframe computers. That IBM executives failed to foresee this was the result of two more basic factors. First, IBM’s enormous R&D effort of the 1970s should have been directed at the microcomputer, which was about to burst onto the technological scene bringing a future full of personal computers, networks, and computer servers. Instead, the company squandered R&D on building a larger mainframe. Second, IBM shifted its relationships with customers and lost touch with their interests and concerns. Thus a partial explanation of IBM’s difficulties is that its profit margins on mainframes declined precipitously. What we need to understand is why.

Similarly, how did IBM squander the technological leadership it had achieved in the 1960s and become a follower for a brief but crucial period in the 1980s? After decades of making sharp business deals and building a reputation as the best managed firm in the industry —many said in any industry — why did IBM executives suddenly make blunder after blunder in dealing with partners and competitors?

IBM’s success was based on two commitments; they were not formal contracts but understandings based on repeated assertions. To its customers, IBM had promised effective, high-quality technology and service support, maintained by a close, continuing relationship. IBM rented equipment to customers and was their partner in data processing and office work. For a large company wanting to ensure that its information systems were up-to-date (though not necessarily state-of-the-art) and reliable, IBM was the answer. When in doubt, a chief information officer could buy IBM and be confident that the choice would not be challenged.

To its employees, IBM had promised employment security. Once a person had a job with IBM, he or she was set for life. Benefits were good, the salaries competitive, and the working environment excellent. Customers were happy, and employees were productive. IBM was successful.

Breaking Two Promises

During the late 1980s and early 1990s, IBM abrogated its contract with both its customers and its employees. Although IBM had assured its customers a partnership, it broke that promise in order to finance a substantial expansion. At the time, top executives didn’t realize that the company was altering its contract with customers. When they later realized it, they didn’t care. When the expansion failed to materialize, IBM broke its promise of security to employees in order to bail out its shareholders. Both factors doomed IBM’s business to stagnation in the first half of the 1990s and left its business prospects uncertain for the remainder of the decade.

When IBM defaulted on its commitments to customers, they grew angry at its arrogance — for giving them equipment that did not work properly, was delivered late, or did not meet expectations in other ways — and at its failure to keep up with emerging technology from other vendors. The company was even castigated for failures in its service, something that was previously unheard of.

When IBM defaulted on its commitments to its employees, many became disillusioned and ineffective. Managers had let thousands believe that employment security had little connection with performance. In attitude surveys, top performing IBM employees complained bitterly that the company’s management was far too tolerant of poor performers. Had managers dismissed ineffective employees at less than half the rate that is common in other computing firms, IBM’s massive financial losses in the 1990s for early retirements and layoffs could have been significantly reduced.

How then can I summarize IBM’s failures? First and foremost, IBM’s difficulties reflected a failure to manage fundamentals. Any business depends on two relationships: those with customers and those with employees. Everything else, no matter how significant — including shareholder relations — just gets in the way. Every executive decision should be made in a context of satisfying customers and employees.

A Failure in Strategic Planning

The sequence of events in which IBM executives created the company’s financial disaster in the early 1990s began a decade earlier. In 1980, IBM executives reviewed current trends and made one of the largest miscalculations in business history. They concluded that IBM should continue building itself to support $100 billion in sales by fiscal 1990. This target represented a doubling of then-current revenues but was seen as an “aggressive but achievable” ten-year target for a business then enjoying a recovery from the 1979 “oil shock” recession in mainframe sales, the restoration of margins that had collapsed in the wake of the 4300 pricing fiasco, and the end of computer rentals — a decision that forced customers to buy machines outright.

At a dinner after a board of directors meeting in 1980, then chairman John Opel noted that, in the previous year, IBM’s rise in revenues was as big as Digital itself and as big as IBM’s other major competitors combined. Every year, he remarked, IBM would grow by an amount the size of Digital. IBM’s only real threat, Opel said, came from Japanese competitors who, with the help of their government, would copy IBM’s products. To beat them, IBM would have to be the low-cost producer, which meant that it had to have large new capacity for mainframe computers.

Opel felt that if IBM had the best products and manufacturing, it would win in the marketplace. He saw huge barriers to entry in semiconductor manufacturing in the form of hundreds of millions of dollars for plant and equipment. IBM, with its size and financial strength, would have a big advantage. It could manufacture at low cost through capital investment. It began to see sales and marketing as a necessary evil. IBM, which had been a marketing company, now began its unhappy transformation into something else.

In 1980, IBM’s first published corporate strategy had several key elements: to grow the business, to be the most profitable firm in the industry, and to compete where it chose (that is, not to be all things to all customers). That none of these items focused on the customer symbolized the company’s growing hubris. It would do business on its own terms, not on those of the customer or the marketplace.

To fund the new capacity, IBM needed more investment dollars. It accelerated its move from rentals to sales. Specifically, it pushed sales financed by leases to its customers from IBM or from financial institutions. Before the end of the 1980s, U.S. firms did not have to consolidate their leasing/finance subsidiaries (even if wholly owned), so that the corporation could account for the leased equipment as sales. Thus the shift from rentals to leases was shown as an increase in sales. This decision, seen as a financial move to raise cash for investment, had an enormous adverse impact on IBM’s relations with its customers.

IBM managers responded to the forecast and related growth plan by hiring tens of thousands of employees and adding billions of dollars in plant and equipment to IBM’s balance sheet. In retrospect, they were wildly optimistic, even negligently so. Building and equipment contractors recall IBM’s lavish spending, which marked a great capacity build-up. In Fishkill, New York, IBM quickly built, at enormous cost, semiconductor plants with the super-clean rooms needed for manufacturing. Two years after they opened, the plants were shut down. In California, laboratories were built at breakneck speed. They were opened, then closed, dismantled, and rebuilt. Mistakes costing tens of millions of dollars were made.

To finance such extravagance, IBM accelerated a transition that, over almost two decades, took it from a revenue stream that generated 85 percent by renting (it had been 95 percent) to one of 12 percent renting and 88 percent customer purchases. The company was abandoning the foundation of guaranteed revenue: the rental base.

In 1985, a peak year for IBM’s revenue and profits, few recognized that the strong performance was largely a bubble from the sell-off of rental equipment. The continuous revenue stream from renting had shrunk to only about 12 percent of the total. Added to this was another 30 percent of revenue from contract maintenance, so that some 42 percent remained secure from the need to be recreated by sales each year. By the early 1990s, renting was only about 4 percent, and maintenance, about 29 percent. IBM had converted its stable revenue stream to one that fluctuated with the economy and with the intensity of industry competition. The customer loyalty to IBM that renting had maintained and the stable revenue stream that cushioned the firm’s finances through the business cycle were both cast aside. In effect, through the 1980s, IBM managers sold off one of its greatest business assets, its rental base, and deluded themselves into thinking that business had never been better. They liquidated the company without realizing it.

Both the revenue forecast of 1980 and subsequent growth plan were seriously flawed; they went badly awry in the transition from mainframes to networked microcomputers. Instead of a steady rapid rise in mainframe sales, there was general stagnation; the growth in IT revenues came in microcomputer hardware, software, and service sales. By 1990, IBM’s annual sales were about $68 billion, not $100 billion, and the firm was struggling with resource imbalances among its business segments.

The strategic plan in 1980 led IBM up a hill of additional capacity and down again. First, it spent money to build capacity and add people; then it spent money to dismantle capacity and shed people. This dynamic was the source of the huge financial write-offs that crushed the firm’s profitability in the early 1990s.

Under the terms of IBM’s full employment practice, literally tens of thousands of staff hired for IBM’s mainframe operations had to be kept on or bought out with costly severance packages. The need to keep people gainfully occupied so that layoffs could be avoided may also have caused some managers to do unnecessary work in order to utilize people without incurring retraining and relocation costs. This prevented corrections from being made sooner. On the other hand, the surging microcomputer sector could not be fully supported by sufficient growth in the firm’s infrastructure; its assets were tied up in mainframes.

A major forecasting error can seriously cripple a company — especially a company that attempts to provide lifetime employment. Growth planning is normally done cautiously and deliberately, a process that seems to have failed at IBM. As IBM built capacity, it promised investors great returns. Instead, they got losses and a collapsing share price. It’s no wonder that, by the early 1990s, investor analysts believed that the company’s executives had lied to them. Wall Street ceased to listen to the company’s management, and IBM’s executives entered a black hole in which nothing they could say would favorably affect the company’s fortunes.

Crucial Questions about IBM’s Experience

Was IBM a victim of its own success? The answer is certainly yes. Intoxicated with good fortune, the company overreached in the 1980s and paid a bitter price in the 1990s.

Did IBM outgrow the capacity of even the most capable managers to run it effectively? The answer is no. IBM’s top executives attempted to manage the corporation from the top, despite its great size and complexity, and in so doing exceeded their capabilities. But IBM is a closely integrated company, operates in only one industry, and has much synergy between its various businesses. It requires a high degree of central coordination and direction. It needs a judicious blend of decentralized operating management and centralized strategic direction. In the 1980s, IBM’s executives failed to get the mixture right.

Did IBM’s basic management techniques become obsolete in today’s work environment? The answer is yes. IBM’s lengthy study of decisions before they could be made, its emphasis on consensus, its interminable executive meetings that focused on ideas and plans, not operating results, its full employment practice that became a refuge for poor performers — all were rendered obsolete in a more competitive, rapidly changing business environment. But IBM’s basic business strategy of singleness and loyalty, properly administered, is valid today.

Is IBM the victim of a corporate culture that pushed the wrong type of executive to the top? Yes. IBM chief executives were too inbred, too steeped in the arrogance of success, and too certain of their own judgment in a time of challenge. IBM’s culture contributed greatly to each shortcoming.

Most of these failures were avoidable. Because IBM’s difficulties were largely the result of executive error, other large firms can hope that, with the right leaders, they can remain successful as they grow.

Prospects for the Future

IBM’s opportunities have never been greater. The global economy has recovered from deep recession, and the market for information technology is very strong. New technology offers exciting avenues for new product development. The large businesses that have traditionally been IBM’s best customers are now surprised by the complexity and cost of integrating systems themselves, so they are looking for a company to provide entire systems, not just elements. Also, IBM has established itself as a consulting company and entered several other new businesses. Its size and financial strength allow it to invest in new products and services.

Yet IBM is hobbled by its recent past. Customers are upset that IBM disregarded their concerns; employees are embittered by the continuing layoffs. IBM has so far failed to admit that it broke faith with customers and employees and has not begun to reestablish the necessary trust. The past casts a pall over IBM’s future prospects.

What is the long-term future of large corporations like IBM? To some, they seem relics of an age in which change was less rapid, competition less intense, and the economic world was national, not global. Recently, many old, well-established companies have fallen on hard times, and the media are full of reports of financial losses and staff down-sizings in large firms. As evidence mounts that links market-dominating scale with loss of competitiveness, it seems that large corporations are doomed. Ungainly dinosaurs are simply not suited to markets in which ideas appear one year, are brought to market the next, and become obsolete soon after. Linking small firms together in free-form alliances to tackle complex business opportunities seems to make more sense than relying on dinosaurs to mobilize resources on a grand scale. Big firms are advised to break themselves up into multiple smaller units. Large-firm executives envy the agility of smaller firms and try to mimic them.

No large firm embodies the hazards of large size more than IBM. Thus IBM’s experience has important implications for the future of large companies — especially its recent recovery of profitability. Scale, market power, and cash flow still count for a great deal in business; the advantages they give an organization are only blunted —not offset — by the bureaucratic rigidity that so often accompanies them.

Why have large companies like IBM been unable to convert the strengths of bigness into marketplace success?

1. They base overly optimistic strategies more on pride than on reality.
2. They focus on financials that inadvertently cripple other functions, including production and marketing.
3. Top executives of large firms believe that they can dictate what customers should buy, only to discover they cannot.
4. Large U.S. businesses have broken their pact with employees and, when they lose employee loyalty, can find nothing to replace it.
5. Top executives flee into reorganizations when faced with strategic crises, leaving the crises unresolved.

Virtually all these wounds are self-inflicted. A new generation of chief executives in large firms has assumed leadership — a generation schooled by past errors and committed to correcting them.

IBM’s experience shows that large companies with established customer bases will prosper only when they are responsive to the changing customer desires. Hence, companies must examine each decision in terms of its impact on customers, no matter how unrelated it may seem at first glance.

Because employee conduct is crucial to customer satisfaction — both in service and product — a company cannot destroy the loyalty of its employees without suffering serious repercussions. When loyalty has been lost, a company must revive performance by rewarding employees for success immediately, not in the long term as employment security did.

Large companies can survive and prosper only if they address these issues.