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Rosenzweig CMR Prepdf Su07 Misunderstanding the Nature of Company Performance: THE HALO EFFECT AND OTHER BUSINESS DELUSIONS Phil Rosenzweig n February 2005, Dell Computer was ranked #1 among the World’s Most Admired Companies by Fortune magazine. Just two years later, in February 2007, amid slumping performance, Michael Dell removed I CEO Kevin Rollins and took over the reins to revive the company. What had gone wrong? Observers were quick to offer their views. According to Business Week, “Dell succumbed to complacency in the belief that its business model would always keep it far ahead of the pack.” It had been “lulled into a false sense of security.” An unsuccessful acquisition was said to be evi- dence of “hubris.”1 In Leadership Excellence, a management consultant explained that Dell “got stuck in a rut” and became “reluctant to change.” When rivals had matched Dell’s strategy of customization, managers “fell back on an old practice: they cut costs to maintain market share.” The Financial Times quoted a business school professor at the University of Maryland who opined: “[Dell has] forgotten how to make customers happy. I have to believe the problems with the company are cultural and they begin at the top.”2 Dell’s misfortunes made for an irresistible story—How the mighty have fallen. The reasons that were advanced—complacency, hubris, reluctance to change, and poor leadership—all sounded reasonable. They offered explanations that most readers would find sensible and satisfying. On closer inspection, however, the coverage of Dell illustrates some of the common errors that distort our under- standing of company performance. Start with the suggestion that Dell had been “complacent.” It’s easy to infer from Dell’s slowing performance that it must have been “complacent,” but the claim doesn’t stand up to closer scrutiny. In fact, as far back as the late 1990s, Michael Dell and his top managers knew that their dominance wouldn’t last forever. They identified new growth opportunities, seeking to build upon 6 CALIFORNIA MANAGEMENT REVIEW VOL. 49, NO. 4 SUMMER 2007 Misunderstanding the Nature of Company Performance Dell’s core strength—a disciplined fast-cycle manufacturing process. High on their list were related hardware products where they might apply this capability, such as computer storage, printers, and televisions. Dell also acquired a com- pany—ConvergeNet—that promised a sophisticated new storage product. None of these actions are evidence of complacency. Further, Dell responded to renewed competition by finding new ways to lower costs, hardly evidence of an unwillingness to change. A fair-minded assessment suggests that for Dell, extending its manufac- turing model into related products was a sensible strategy. Suppose that Dell had never tried to expand into new fields—that might be grounds to charge it with “complacency.” Or suppose that Dell had ventured into entirely different businesses, such as software or consulting, or into a very different product seg- ment—that might be evidence of “hubris.” Such a choice would have been much less sensible, and if things had gone badly, the press would have hammered Dell for abandoning its core strength in pursuit of an impossible dream. Michael Dell would have been accused of arrogance and derided for a naïve belief that he could succeed in very different markets. The Halo Effect and the Problem of Data Independence The story of Dell is an example of errors we commonly make in explain- ing company performance. Today, knowing that Dell’s performance faltered, it’s easy for pundits and professors to claim that someone blundered. Decisions that turned out badly are castigated as bad decisions. However, these sorts of judg- ments are erroneous, made retrospectively in light of what we know to have happened subsequently. These errors are surprisingly widespread in the business world. They affect not only journalistic accounts about specific companies, but also undermine the data used for large-scale studies about company perfor- mance. They lead to a broad misunderstanding of the forces that drive company success and failure. As we will see below, some of the most popular business studies in recent years are undermined by fundamental problems of data integrity. One of the root causes is the halo effect. First identified by American psy- chologist Edward Thorndike in 1920, the halo effect describes the basic human tendency to make specific inferences on the basis of a general impression.3 How is the halo effect manifested in the business world? When a company is doing well, Phil Rosenzweig is a Professor of Strategy and with rising sales, high profits, and a surging International Management at IMD in Lausanne, Switzerland, and author of The Halo Effect: . stock price, observers naturally infer that it has and the Eight Other Business Delusions That a smart strategy, a visionary leader, motivated Deceive Managers (Free Press, 2007). employees, excellent customer orientation, a <[email protected]> vibrant culture, and so on. When that same company suffers a decline—when sales fall and profits shrink—many people are quick to conclude that the company’s strategy went wrong, its people became complacent, it neglected its customers, its culture became stodgy, and more. In CALIFORNIA MANAGEMENT REVIEW VOL. 49, NO. 4 SUMMER 2007 7 Misunderstanding the Nature of Company Performance fact, these things may not have changed much, if at all. Rather, company perfor- mance creates an overall impression that shapes how we perceive its strategy, leaders, employees, culture, and other elements. The halo effect helps explain the way that Dell’s performance was described. As long as Dell was successful, observers marveled at its strategy, its focus on customers, its disciplined operations, and its execution skills. When performance began to falter, those same things were seen in a different light. Very much the same thing happened at Cisco Systems, which was praised in the late 1990s for its brilliant strategy, its superb management of acquisitions, and its laser-like customer focus. When the tech bubble burst, Cisco was sud- denly derided for a flawed strategy, sloppy acquisition management, and poor customer relations. In fact, Cisco really had not changed much—a decline in performance led people to see the company differently. The same happened at IBM and ABB—they were admired for when performance was strong, then criti- cized for the exact same things when performance fell, with little evidence of meaningful changes. Why is the tendency to make these attributions so strong? Because many everyday concepts in business—from leadership to corporate culture, and from core competencies to customer orientation—are ambiguous and difficult to define objectively. Our perceptions of them are therefore often based on other things that appear to be more concrete and tangible, namely financial performance. When financial performance is strong, people tend to have broadly favorable opinions of other things that are less tangible; and when performance falters, they make the opposite judgments. As a result, many of the things that we commonly believe drive company performance are better under- stood as the result of performance. The halo effect may seem at first like harmless hyperbole that that helps reporters tell a coherent and satisfying story. In fact, however, the halo effect is pervasive in the business world and affects much more than journalistic accounts. In a series of experiments about group performance, UC Berkeley professor Barry Staw (then at the University of Illinois) showed that members attribute one set of characteristics to groups they believe are high performers, and a very different set of characteristics to groups they believe are low perform- ers.4 When told their group had performed well, members described it as having been more cohesive, with better communication, and more open to change; when told it had performed poorly, they remembered the opposite. In fact, the groups had done just about as well—the only difference was what Staw had told them about their performance. Similarly, in a series of studies about leadership, James Meindl and his colleagues found that the words used to describe leaders were highly dependent on the performance of the company. In fact, they con- cluded that there was no adequate theory of leadership in the absence of knowl- edge about company performance.5 A successful company with a strong record of performance? The leader appears to be visionary, charismatic, with strong communication skills. A company that has suffered a downturn? The same leader appears to be hesitant, misguided, or even arrogant.6 The halo effect is also present in large-scale surveys. A prominent example is the Fortune Most 8 UNIVERSITY OF CALIFORNIA, BERKELEY VOL. 49, NO. 4 SUMMER 2007 Misunderstanding the Nature of Company Performance Admired Survey, where evaluations of things such as managerial talent, product quality, and innovation have all been shown to be affected by the halo cast by financial performance.7 In sum, the halo effect has a powerful influence on our evaluations of company performance, whether we look at evidence from experiments, from empirical studies of surveys, or from content analysis of journalism. The impli- cation is clear: data independence is vital. As long as people are asked to assess companies when they already have an opinion about its performance, their evaluations are likely to be biased—and their resulting findings of questionable value. Popular Studies of Company Performance: Dubious Data and Flawed Findings Fortunately, many researchers—whether at business schools, in research institutes, or in consulting firms—are careful to be sure that their data are valid. Yet some of the most influential studies of recent years have relied on data of doubtful quality, leading to questionable findings and to a general misunder- standing of company performance. Reliance on contaminated data is the principal flaw in several of the most popular studies from recent years.
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