The Firm: The Story of McKinsey and Its Secret Influence on American Business (3 page)

That’s pretty much all that is known about Mac McKinsey’s personal life. But a few points are worth reinforcing. First, McKinsey saw that a company’s secrets could be found in its accounting. He proudly wrote books about the minutiae of budgeting and forecasting, because he believed it was only through rigorous adherence to such “fact-based” analysis that a company could truly reach its potential. His protégé Marvin Bower, however, later distanced McKinsey & Company from this image of accounting, so much so that it came to define itself in opposition to the field. In Bower’s mind, accountants were drones bound by rules while consultants were free thinkers whose vision and creativity extended far beyond balance sheets. Bower’s McKinsey started with the numbers and then added perspective.

Second: With his own experience as proof of concept, McKinsey attracted a cohort that wanted to achieve in life the same things he did—rising above an often humble upbringing to become rich and important men. McKinsey pursued success by combining an ability to focus relentlessly with a knack for breaking rules. And he decided early on that he would gain power by speaking truth to it. “He was quite poised,” wrote William Newman, who worked with McKinsey in the 1930s. “No trace of Ozark poor farm boy, not the least. He’d had poverty in his childhood and I think that left its mark. He wanted to succeed, but he also wanted to have money, the satisfaction that he did have money and that he was free to spend it.”

In 1941 Time Inc. publisher Henry Luce coined the term “American Century” in a
Life
magazine editorial. He was describing the country’s
global economic and political dominance leading up to World War II. But Luce was also correct in the literal sense: The American Century had actually started several decades before.

The building of the railroads and coincident spread of the telegraph in the United States in the middle and second half of the nineteenth century helped create the world’s first truly “mass” markets. If an executive had ambition, his company didn’t have to serve just local customers. It could serve an entire continent and beyond, if it had the wherewithal to get the organization and logistics right.

The economic historian Alfred Chandler documented the momentous changes in what came to be known as the Second Industrial Revolution in his seminal book
Scale and Scope
—the title of which referred to the simultaneous revolutions in both scale (in manufacture) and scope (in distribution) in American enterprise. Those twin revolutions transformed the United States from an agrarian society to an industrial powerhouse in the span of a single generation. In 1870 the nation accounted for 23 percent of the world’s industrial production. By 1913 that proportion had jumped to 36 percent, exceeding that of Great Britain.
¹⁰

By 1920, when only a third of homes in the country had electricity and only one in five had a flush toilet,
¹¹
the country’s business establishment was embarking on a course of radical, unprecedented expansion. This brought with it a dilemma that has preoccupied business leaders ever since: how to grow big while maintaining control over the enterprise. Moving from a single-product, owner-run enterprise into a complex and large-scale national one is a difficult task. First, you have to build production facilities massive enough to achieve the desired economies of scale. Second, you have to invest in a national marketing and distribution effort to ensure that sales have a chance of matching that scaled-up production. And third, you have to hire, train, and
trust
people to administer your business. Those people are
called managers, and in the first half of the American Century, they were in very short supply.

The benefits to successful first-movers were gigantic. In industries where only one or two companies took the plunge early, they dominated their field for a very long time to come; this group includes well-known names like Heinz, Campbell Soup, and Westinghouse.
¹²
A ten-year merger mania, from 1895 through 1904, also brought the creation of a number of corporate entities the likes of which the world had never seen—1,800 companies were crunched into 157 megacorporations,
¹³
including stalwarts like U.S. Steel, American Cotton, National Biscuit, American Tobacco, General Electric, and AT&T.
¹⁴

The key business problem identified during this transition—and one that underwrote McKinsey’s success for several decades—was that a single, central office could no longer adequately administer such far-flung empires. Power had to be ceded to the extremities. The question was how. It was a quandary that beguiled some of the great thinkers of the time, including political scientist Max Weber, who argued that a systematic approach to marshaling resources through bureaucracy was a necessary and profound improvement over pure charismatic leadership.

In his book
American Business, 1920–2000: How It Worked
, Harvard professor Thomas McCraw pinpointed the issue: “In the running of a company of whatever size, the hardest thing to manage is usually this: the delicate balance between the necessity for centralized control and the equally strong need for employees to have enough autonomy to make maximum contributions to the company and derive satisfaction from their work. To put it another way, the problem is exactly where within the company to lodge the power to make different kinds of decisions.”
¹⁵

Companies such as DuPont, General Motors, and Sears Roebuck were the first to address this problem systematically. According to
Chandler, DuPont sent an emissary to four other companies experiencing similar issues—the meatpackers Armour and Wilson and Company, International Harvester, and Westinghouse Electric—to ask what
they
were doing.
¹⁶
And the answers were remarkably similar: The innovators moved from the centralized system to a multidivisional structure with product and geographic breakdowns. The concept left operating division chiefs with total control over everything except funding resources. Top managers took a more universal view of the business, monitoring the divisions and allocating capital accordingly.

The most successful companies of the era, such as General Electric, Standard Oil, and U.S. Steel, all employed some variant of this model. But by and large, they had developed these ideas on their own, a process of trial and error that was costly and time consuming. They would have much preferred hiring outside experts to help them with it, if only such experts existed. This was a huge commercial opportunity that called for an entirely new kind of service.

Unwittingly, the federal government did its part to create the modern consulting business. Starting in the last part of the nineteenth century, Washington made periodic regulatory efforts to curb the power of big business, including the 1890 Sherman Antitrust Act, the Federal Trade Commission Act and Clayton Act of 1914, and the Glass-Steagall Act of 1933. The intended effect of these measures was to prevent corporations from colluding with one another to fix prices and otherwise manipulate the markets. The unintended effect, according to historian Christopher McKenna, was to accelerate the creation of an informal—but legal—way of sharing information among oligopolists. Who could do that? Consultants.
¹⁷

Regulatory efforts paid another rich benefit to the likes of McKinsey: Restricted from cutting backroom deals with each other, firms were thus obliged to actually compete, which meant they needed to make their operations more efficient. Here again, consultants were the answer.

But perhaps the circumstance that most aided the creation of the consulting industry was the entry of a new, key player into business itself. Empire builders with names like Carnegie, Duke, Ford, and Rockefeller had built huge, vertically integrated companies, but they had neither the time, the talent, nor the inclination to create and carry out management systems for those entities. These were the conquerors of capitalism, not its administrators. And yet, as Chandler pointed out, “their strategies of expansion, consolidation, and integration demanded structural changes and innovations at all levels of administration.”
¹⁸

Into the breach stepped a new economic actor who was neither capital nor labor: the professional manager. Gradually, he replaced the robber baron as the steward of American business. Alfred P. Sloan, the legendary president of General Motors, was the first nonowner to become truly famous for his managing skills. His decentralized, multidivisional management structure gave GM the agility to outmaneuver the more plodding Ford Motor Company and snatch the industry lead. Ford may have revolutionized manufacturing, but Sloan realized that the car-buying market had become big enough to be segmented into people who bought Buicks, Cadillacs, Chevrolets, Oldsmobiles, and Pontiacs. By the late 1920s, the car market was maturing, and people wanted
choice
. Sloan also gave them the ability to buy a car on
credit
—a groundbreaking idea at the time. Before the decade was over, GM had surpassed Ford as the market share leader, a position it didn’t relinquish until the 1980s.

Sloan and his ilk were perfect customers for McKinsey: Lacking
the legitimization of actual ownership, professional managers felt great pressure to show they were using cutting-edge practices. And who better to bring those practices to their attention than consultants who were talking to everyone else? This was the beginning of a decades-long separation of ownership from control in corporate America, and the consultant was an able ally to the professional manager in this tug-of-war—an ally who wasn’t gunning for the manager’s job. Thus began the era of managerial capitalism.

For more than two centuries, economists had argued that companies operated in some sense at the mercy of Adam Smith’s “invisible hand” of the market. But the revolution in management thinking in the United States offered up an alternative idea: the “visible hand” of management, which made things happen, as opposed to merely responding to external market forces.

The academy helped move this ideology along. Before 1900, there was only one undergraduate business school in the country, the University of Pennsylvania’s Wharton School of Finance and Economy, founded in 1881 with a $100,000 donation from financier Joseph Wharton. The Tuck School of Business at Dartmouth followed in 1900. Over the next decade, pretty much every major institution started explicitly preparing its students for careers in management.

Although the rise of today’s industrial-farm-style MBA programs is really a postwar phenomenon, Harvard founded its Graduate School of Business Administration in 1908, with a second-year business policy course designed to give the student an integrative approach to addressing business problems, including accounting, operations, and finance.
¹⁹
The purpose of the course, according to the school, was to give the student an ability to see those problems from the top management point of view. Much of James McKinsey’s academic writing centered on this very issue and later informed the practice of his firm.

As a young academic, McKinsey was a prolific writer, if not an especially engaging one. His first four books were dry tomes on the nitty-gritty of accounting and taxes:
Federal Incomes and Excess Profits Tax Laws
(1918),
Principles of Accounting
(cowritten with A. C. Hodges, 1920),
Bookkeeping and Accounting
(1921), and
Financial Management
(1922). But with his fifth effort, he broadened his horizons significantly.
Budgetary Control
(1922)—the first definitive work on budgeting—turned accounting on its head, promoting it as an essential tool of managerial decision making. “Budgetary control involves the following,” McKinsey wrote. “1. The statement of the plans of all the departments of the business for a certain period of time in the form of estimates. 2. The coordination of these estimates into a well-balanced program for the business as a whole. 3. The preparation of reports showing a comparison between the actual and the estimated performance, and the revision of the original plans when these reports show that such a revision is necessary.”
²⁰

It seems commonsensical, but McKinsey’s new way of looking at the use of the budgeting process sparked nothing short of a revolution. “No other mechanism of management of similar scope and complexity has ever been introduced so rapidly,” wrote one commentator just ten years later. “It is estimated that 80 percent of budgets installed in industry have been put in since 1922.”
²¹

Up to that point, budgeting was a one-way exercise: Accountants added up all of a firm’s expenses and then tossed in a sales projection almost as an afterthought. In McKinsey’s view, companies should start by developing their business plan, figure out how to achieve it, and then estimate the costs of doing so. In this new context, budgeting wasn’t just a ledger activity; it could also be used to identify excellence in performance (i.e., those who outperform their budget), to spot
weaknesses (those who underperform), and to take corrective action. “[While] there are many who do not yet plan scientifically . . . ,” he wrote, “there are few who will deny the merits of the system.”

Two subsequent books fleshed out McKinsey’s ideas: 1924’s
Managerial Accounting
and
Business Administration
. The former taught students how accounting data could be used to solve business problems. Using the data of traditional recordkeeping, he suggested the possibility for much greater control over a company’s destiny, including the establishment of standard procedures (how things should be done and to whom information should be reported), financial standards (ways to judge operating efficiency), and operating standards (including nonfinancial measures, such as quality). To today’s business student, this kind of comprehensiveness seems obvious. But at the time, the idea of planning, directing, controlling, and improving decision making by means of regular and rigorous reporting of company results was novel. The latter book contained the seeds of McKinsey’s General Survey Outline—a thirty-page system for understanding a company in its entirety, from finances to organization to competitive positioning. It became part of his consultants’ toolkit sometime in the early 1930s.