By Erik Brynjolfsson and Lorin Hitt
Issue date: Sept. 9, 1996
nformation technology is the defining tool of the emerging information economy. IT promises to create new sources of value and redefine industry boundaries. But it also threatens to absorb millions of scarce investment dollars for ill-conceived projects.
Evaluating investments in corporate information systems isn't easy. The basic output of these systems is information, but information is not valuable for its ow n sake. Information creates business value only if it leads decision-makers to take actions they would not otherwise have taken. It's possible to count gigabytes of disk storage, pages of reports printed, numbers of online queries processed, and columns of numbers crunched, but these are, at best, only indirect measures of the real output of a well-designed system.
What matters to customers is the quality, cost, timeliness, and appropriateness of a company's products and services. IT can have a big impact in all of these areas, and the most successful users of IT among the InformationWeek 500 are those companies that use technology to better serve their customers.
During our research on the relationship between IT and business productivity over the past several years, we've designed a methodology based on the concept of productivity. In particular, we look at "total factor productivity" to focus on IT value. TFP is a generalization of its well-known cousin, l abor productivity. However, instead of simply dividing output by the number of labor hours, TFP includes all costs of business--capital equipment, materials, energy, services, and technology--in the denominator.
Thus, while a company might be able to boost its labor productivity by using more equipment or energy, its TFP will increase only if it works "smarter" by producing more output without proportionate increases in its total input. In other words, companies with greater TFP growth create additional value for their customers or cut waste in their old systems.
In the short run, depending on the competitive environment, a company might be able to boost profitability or market share without improving its TFP. But in the long run, TFP and competitive advantage are inextricably linked.
IT And Productivity
In the past, a key barrier to putting TFP into practice has been a lack of the data needed to calculate TFP values for individual companies. However, working with InformationWeek, we h ave surveyed several hundred companies. By combining the survey data with additional information from public and private sources, we have been able to analyze how IT can influence TFP.
Our analysis reveals three basic findings. First, computer investments are associated with increased productivity. On average, companies with more computer capital and higher IS budgets were more productive than others in the same industries with less computer capital.
Investments in computers were associated with greater productivity growth than investments in other equipment, despite the shorter service life and higher life-cycle costs of computers. Similarly, IS workers, despite their higher average compensation, were linked to higher output than other employees.
However, these findings don't imply that companies should simply increase spending on computers or IS staff. The companies with high returns and high levels of computer investment differ from the low performers in many ways that cannot be rectified simpl y by increasing IS budgets.
Also, while the average company in our sample had success with its overall investment in computers, the variance in outcomes was quite large, with some companies easily surpassing the average and others actually losing money on their IT investments. The same dollar spent on the same system may give a competitive advantage to one company but only expensive paperweights to another.
Focus On The Customer
Our second major finding is that customer focus is the best predictor of IT value. Companies expressed a variety of rationales for their investments in IT. However, our analysis exposed an underlying pattern in the responses. The same companies that rated customer service as important were also likely to put a lot of weight on flexibility, timeliness, and quality. We call these companies customer-focused.
We found that the more aggressively a company pursued a customer-focused strategy, the higher its productivity. Those with a customer focus were almost 7% more productive than their competitors, which is economically and statistically significant. This finding is consistent with an analysis we did two years ago, but this year's data is even more convincing.
In contrast, a simple cost-cutting emphasis appears to do little, on average, for productivity, although the drop in productivity wasn't as large as when cost-cutting was combined with a customer-focused strategy. Companies with no clear strategy at all tend to sink to the bottom of the list, averaging 8% lower productivity than the typical company in their industry.
When we compare the reasons for investing with those given in 1994, we find that customer-focused strategy has become more common, while cost reduction now gets much less weight. Perhaps companies are beginning to better understand the true source of IT value.
It's also clear that the term reengineering increasingly has become synonymou s with downsizing. In the 1994 survey, reengineering and cost-cutting were not closely associated. In this survey, they were.
A Strategy For Productivity
Our third basic finding is that a good technology strategy can make a difference. Although the most important sources of IT value were links to the customer and to the rest of the business, the IS strategies of the most productive companies also had some distinctive characteristics.
For one, the use of client-server was strongly correlated with greater productivity. This strategy was especially evident in fast-moving industries such as electronics and computers. Not surprisingly, it was less common in businesses such as banking, where a focus on transaction processing continues to favor the traditional mainframe architecture.
Although recent studies have shown that the annual cost per user for client-server is greater than the costs of a mainframe approach, our analysis indicates that the productivity benefits more than outweigh the a dditional costs.
Second, a moderate amount of outsourcing is associated with higher productivity. In particular, companies that outsourced to take advantage of vendors' economies of scale or expertise with advanced technologies reported the greatest benefits. However, the benefits taper off quickly for companies that devote a larger share of their budgets to outsourcing.
Third, in this year's survey, we're beginning to see the impact of the Internet and electronic ties to customers and suppliers. Although it's still a small share of overall budgets, more productive firms report higher spending in this area, especially to improve links with customers.
Overall, the clearest distinction of the highly effective IT users was their focus on customer benefits like quality, flexibility, timeliness, and service. Unfortunately, these are the very components of output that are hardest to measure. They're also likely to differ slightly for every company and project.
But while a customer-focused strategy m ay make measurement and evaluation more difficult, discussion with senior managers affirms that the basic principles of project selection still apply. For IT projects no less than for any other project, the value of an investment is equal to the risk-adjusted present value of the resulting productivity gains for the entire business.
A surprising number of managers have given up making realistic attempts to formally assess their IT project selection, or have succumbed to common mistakes. One pitfall that bedevils attempts to value IT investments is measuring the wrong outputs. Lines of code, MIPS of processor power, transactions per hour, hits on Web pages--these are all easy to measure, but largely irrelevant to the productivity of a business.
Counting the number of widgets coming off the assembly line or the direct labor used for assembly is little better. While they're well-suited for the mass-production, mass-marketing paradigm that dominated industry in the past, these measures are increasingly re moved from the real sources of customer satisfaction.
Instead, successful project selection depends on developing clear, concrete metrics that are directly linked to business value. For a factory automation project we examined, these include estimates of the reduction in inventory required, savings in floor space, improved turnaround time for new orders, reduced setup time, and greater flexibility to handle new products or unusual orders. At a software services company, improved communication and information sharing enable quicker response at its customer-support call center.
Wherever possible, a dollar value should be attached to each metric. In many cases, the "intangible" benefits may be more important than the traditional measures. For instance, a study by McKinsey & Co. found that for a product with a five-year life cycle, a six-month edge in product introduction would boost overall profits by 33%, while a 9% reduction in product costs would improve profits by only 22%.
Similarly, the life-cy cle costs of maintenance, training, and support, when properly measured, typically dwarf the up-front costs of new computer systems and must not be ignored. Nonetheless, many companies continue to fall back on the simple expedient of measuring IT's contribution by how much head count has been reduced and other more tangible measures of cost savings.
A second common pitfall in determining the value of IT is to not measure output at all. Of course, many important aspects of output will continue to defy measurement, but that doesn't mean one should give up on them altogether.
On the contrary, the most effective users of IT apply extra caution to avoid the blunder of assuming that if something can't be measured well, it should be ignored. This strategy amounts to valuing intangibles at zero, which is no less arbitrary than making an educated guess.
A third mistake is to stumble into the trap of the vanishing status quo. Even when a discounted cash-flow analysis is done carefully and correctly, manager s often fail to consider alternative scenarios. The "base case" often implicitly or explicitly assumes that business would continue as usual. But if a cost-reducing or service-enhancing IT investment is available to you, it's likely to be available to your competitors as well.
Many retailers that delayed considering data-mining techniques in the 1990s fared little better than consumer banks that waited too long to create or join ATM networks in the 1980s. As Henry Ford put it, if you don't make an investment that you need to make, you risk paying for it without getting it.
Finally, managers shouldn't ignore the flexibility investment can provide. The inherent flexibility of computers represents one of the biggest differences between IT and other investments--a difference that can translate into a reservoir of value.
IT can be used in a variety of functions and applications, some of which haven't even been invented yet. Who could have predicted that the Internet infrastructure designed for academic computing would be used by millions for access to the World Wide Web? Unfortunately, traditional discounted cash-flow analysis will systematically understate the value of projects with options because it ignores the potential of managerial flexibility. While greater risk detracts from the value of inflexible projects, it can boost the value of projects when managers can modify their actions on the fly.
The fact that successful IT users are more customer-oriented than their peers is good news not only for their customers but also for their employees. It suggests the road to higher productivity is not paved with reduced head counts. Ironically, it also presents an opportunity for IS managers, because the metrics and techniques for assessing IT's contributions to customer value are not yet well developed. If a cookbook approach to evaluating IT investments were readily available, there would be far less need for talent and sophistication among senior managers.
Today, it is common to classify customer se rvice, quality, timeliness, and flexibility as intangibles or "soft" benefits. This mind-set may signal the early stages of the transition to an information-based economy. The confusion about how to measure value in the information economy is as much a symptom of our relative ignorance as of any inherent mystery in the new sources of value.
As businesses enter an information era that emphasizes competing on customer service, quality, flexibility, and speed, new measures must be developed to enable companies to use the tools of the information age as effectively as they used their industrial-age precursors.
Erik Brynjolfsson is a professor of IT at MIT's Sloan School of Management and a visiting professor at the Stanford Graduate School of Business. Lorin Hitt is an assistant professor of operations and information management at the University of Pennsylvania's Wharton School. More information about their research on the effects of IT on organizational performance is available on the Web at http://ccs.mit.edu/erik.html .
See related story: " Choosing The Best " to find out how the InformationWeek 500 survey was conducted.
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