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Back to the Basics: Accounting for IT in Business Performance
Not so long ago, many considered speed to be the primary tactic for blocking competition and increasing market share. Companies rushed to field a dot-com strategy or some innovative application of IT that was going to secure their role in the new economy. As a result, many firms under-analyzed or over-invested in IT in pursuit of market dominance. ROI was a fruit thought certain to be enjoyed down the road.
Today, it's back to the basics. Companies are serious about using technology as a competitive advantage. They are learning that IT purchases tied to a company's business strategy have the most clear-cut business value, as expressed in traditional financial terms like Net Present Value (NPV) and payback. Moreover, when IT solutions and business strategy are woven together, companies are finding that business benefits are often broader and deeper than expected.
Indeed, firms should think twice about what their strategic needs are before they make a particular IT investment, cautions Donald Koscheka, a senior consultant at Microsoft. Not knowing what benefits to expect is a sure-fire way of capping those benefits. A company should take a two-step approach in determining the business impact of any technology it is considering, he says. First, it must know which business processes it needs to stay in the money — for example, the flows of information and decisions that must be made to process an insurance claim, prepare a case for litigation, or make a new drug. Then the company must map technology to those processes and decide whether the investment will have positive or negative impact. Pretty basic.
Companies should find an appropriate measure of the benefits that technology can deliver. Koscheka gives the example of a pharmaceutical company in Pennsylvania. The drug company wanted to improve the productivity of its research scientists but couldn't settle on the right metric to use. Ultimately, it defined productivity as the number of chemical trials that test positive for a certain disease model. If a drug company is looking for a cure for, say, Parkinson's, he notes, it might have to screen a few hundred thousand chemicals to find one that has a positive effect on the disease model. "You can't predict success by the number of chemicals tested, but we were able to increase the number of chemicals the research department could screen for a disease model, and therefore increase the probability of finding the right chemical," he says. "We measured the productivity of scientists by the amount of data they could analyze rather than by what they produced."
Just as IT can speed up a process basic to the business objective of a company, the right technology investment has the potential to catalyze or alter a company's strategy—as long as senior management is willing to make the necessary changes to the organization.
Business Value of Customer Benefits
In the late 1990s, e-business was the new thing, held up as a way to squeeze every last inefficiency out of the supply chain. Many of those e-business initiatives were wilting on the vine until the idea of sharing information with clients caught on.
Scott Specialty Gases, a Philadelphia-headquartered firm, didn't jump blindly into e-business, simply assuming customers would change their ordering habits. Scott identified ways it could help customers and turned to IT to make its core business model more customer-oriented. The 500-person company makes specialty gases for utilities, petrochemical plants and others in the chemical industry. "The advent of the Internet caused us to think differently," says Leanne Merz, director of e-business at the firm. "For the last three decades, we tracked the containers holding gases we sent to clients—because we rent those containers. We said, 'We have all this information about our cylinders, what's been in them, how long our clients have had them. How can this help our clients better manage their chemical inventory, and how can it help differentiate Scott from the competitors that don't have this information?'"
The firm had begun contemplating an e-business initiative in the mid-1990s and launched eScott, its supply chain management product, in 1998. Scott quantified potential savings from an internal perspective. "We looked at the number of line items a customer service person enters, how much time it takes to do that, how much the person is paid," says Merz. In addition to the savings in data entry costs from customers entering orders themselves, there were fewer mistakes, and customer service people could be moved to other, revenue-generating areas. Broader benefits included attracting new customers to the firm through the Internet and greater customer satisfaction.
From a customer's perspective, the benefits were clear. Clients could go online and check the status of their orders anytime—and not just when Scott was open (many of the company's clients run around-the-clock operations). There were also cost savings for customers. Processing each individual order used to cost customers $100-$250. According to Scott, research suggests that the cost of an online order has dropped to $10-$25.
One of the smaller, privately held players in the specialty gas industry, Scott managed to hold its own in a field of much larger, billion-dollar companies by making its e-business offering more advanced than those of others and the information it was sharing more useful to clients. Its project management information system, for example, helps clients identify redundant inventory or products they're paying rent for. "We can let them know they're wasting resources because they have idle inventory," says Merz. "That's been a great way to show customers that we can help them take some of the costs out of their business and be more productive." The company also helps clients meet EPA compliance rules by ensuring that they have access to EPA-mandated documentation and by notifying clients when their products are about to expire.
Valuing "Potential" Benefits
While many companies require some kind of justification for IT investments, such as breakeven, NPV or ROI, many also recognize that it can be a bit of a stab in the dark. After all, technology purchases may be investments in capabilities in general and not just in IT. "What's nice is that [IT investments] can be leveraged in many markets and in new ways," says Paul J.H. Schoemaker, a Wharton marketing professor and research director of Wharton's Mack Center for Technological Innovation. "What's frustrating is that it is hard to price these potential benefits."
A technology, for example, may only have value in conjunction with other things—like a good strategy, an installed customer base, or a product or service that the market desires. "To tease out the value that one component contributes to the basket is not easy," he notes. "The fact that capabilities have plasticity that can be leveraged in a number of ways further complicates it." Even if managers attach a particular business value to a specific IT capability, adding up the hypothetical pricing benefits may still underestimate the true value of the technology, he says.
What, for instance, is the dollar value of making a bank's monthly portfolio statement available electronically to customers? It certainly cuts down on the bank's printing and distribution costs, but the impact for customers is trickier to measure. The answer is that it may come down to customer retention and attracting new customers. The same goes for wireless technology. But the question then is, how many new customers can the company capture? The answer can only be derived empirically, says Microsoft's Koscheka. He notes that more companies should run small tests to try out new technologies, or should try to model the impact of those technologies using Monte Carlo simulation. Sometimes, applying the basics can get complicated.
Schoemaker and Koscheka also make the case that real options offer a good way for companies to look at some IT investments. Real options, which apply the idea of financial options to capital budgeting, can be used to quantify the changing value of an investment or asset in an environment of uncertainty. The real options framework allows more flexible decision-making so a company doesn't have to stick its neck out as far.
This is one of the arguments made in Wharton on Managing Emerging Technologies, co-edited by Schoemaker and George S. Day. The book, published last year, asserts that managing new, unproven technologies represents such a different game that old approaches probably won't work. On the financial side, the editors recommend using real options rather than NPV, because of uncertainty about the technology as well as future business conditions. In terms of intellectual property, the focus should be less on patents and copyrights and more on viewing the new technology as a complementary capability that derives value in combination with other things the firm does. Emerging technologies may also require a different approach to marketing, HR and legal issues.
New Ways to Measure Business Value
Various models have been constructed to evaluate the business value of IT investments. Microsoft's Rapid Economic Justification program, for instance, offers an in-depth analysis of a technology's potential benefits, along with hurdles that may need to be overcome to realize the benefits of the investment. The REJ model also tries to establish accountability in a company's business units for the success of IT investments.
While there is no cookie-cutter way to evaluate the business value of all IT investments, one new methodology that makes sense for certain companies is revenue distance, says Ravi Aron, a professor of operations and information management at Wharton. Particularly in knowledge-intensive firms—those such as brokerages and financial services firms for whom information about customers is chief competitive asset—the revenue distance methodology is a way to prioritize IT initiatives. "If I'm a financial services company, most of my revenue comes from customers," says Aron. "If I implement a system that makes the interface with customers—the point at which revenue is realized—richer and deeper, I can immediately see the value of this. As the revenue distance increases, the benefits of an IT investment become less clear and the justification for the investment more nebulous." Firms using this common-sense technique, he notes, could decide to outsource business processes as their distance from the source of revenue increases.
Jeanne Ross, a principal research scientist at MIT's Center for Information Systems Research, points out that some IT investments—particularly those related to infrastructure—have such a significant, long-term impact on an organization that making a business case for them cannot capture all of their benefits. For infrastructure decisions, she notes, "a company may have to start by saying, 'Who are we as a company and what are we trying to accomplish? And then, what core infrastructure must we have in place in order to accomplish this?'" Basic questions, indeed.
Delta Airlines is a case in point. A few years ago, the company looked at its infrastructure and found it wanting, she says. If a change was made to a flight in progress, many people at Delta who needed to know about the change would not be aware of it. A gate agent, for example, might not know why a flight hadn't arrived or at which gate it would arrive. The systems were disjointed. The company's senior management decided they needed a core infrastructure that centralized all information about flights—and that getting that database in place and developing standardized methods of accessing that information was critical to the company's future success and agility.
"That's not done by talking about how much it will cost to put the infrastructure together and how much money the company will save," says Ross. "Instead, you say, 'Here are the systems we use and here's what it would take us right now to get this information. For one application it may make no sense to develop this infrastructure, but for ongoing applications and to be as good as our competitors, if not better, we need to do this." It is incumbent on CIOs and senior technologists, she insists, to tell senior management what it will take to build a more robust infrastructure and what the benefits are.
FedEx Corporation is another firm whose success and performance hinges on the agility of its ongoing engagement with technology. It approaches the problem of teasing out components of IT's business value by sorting them into three basic levels, depending on the purpose of the technology. First, says Robert B. Carter, executive vice president and CIO, there are required IT investments made for safety and regulatory reasons. Second, there are strategic customer initiatives. "While we do some level of ROI and cost justification on these initiatives, at the end of the day we may invest at a strategic level—in other words, the ROI may not meet the hurdle rate," he says. Third are productivity and internal IT initiatives, which are always evaluated on an ROI basis.
When the Company Must Change
Management must also be realistic about how much their organization may have to change to take advantage of new technology-generated capabilities. William Barna, a senior consultant at Microsoft Consulting Services, says, "in companies where IT is seen as a way to gain competitive advantage, a CIO can make a competitive difference, while in more old-school companies, IT is seen as an administrative resource that is supposed to result mainly in cost-cutting."
One company Microsoft did an REJ study for, he says, knew that its current technology equipment was getting in the way of services it wanted to provide customers, but wasn't prepared to let a technology solution change the way the company sold itself to customers. It feared—reasonably—that its IT staff wasn't as skilled or as innovative as those at its competitors and that its investment would be imitated away. IT must have enough stature within a firm to ensure that any advanced technology plan can be executed and maintained at that level, notes Barna.
Making investments at a strategic level often requires some soul-searching. Sometimes there are institutional obstacles to embracing a new technology. If a new technology supplants an existing one, divisions may be realigned, skills once considered valuable may no longer be as relevant, and people may lose their jobs.
For example, Eastman Kodak Company faced a host of obstacles when it wanted to move from chemical emulsion technology to digital imaging photography. Digital initiatives were buried in different parts of the organization and "the organizational structure was run by and favored chemical emulsion," points out Wharton's Schoemaker. It wasn't until a new CEO—George Fisher, who came from Motorola—was aboard that the company could reorganize itself to take advantage of the new technology. Fisher put the digital technology projects in a separate division that was as powerful as the chemical emulsion division, hired people with electronic engineering backgrounds rather than chemical engineers, and paid them the market rate, which was higher than what chemical engineers earned.
Basic, yes. But the technology had to be one of the front and center priorities of the CEO for this to work. "The same is true for a company like, say, GlaxoSmithKline looking at genomics," says Schoemaker. "That [core technology] must be approached differently than if it were an enabling technology like a Palm Pilot that helps salespeople organize their schedules."
Gone are the days of companies racing to beat competitors to the next "must have" information technology solution. Companies are now approaching IT investments with a greater sense of seriousness than in the past. That is as it should be - and it spells good news for technology investors and vendors alike. For companies eager to make the most of their IT investments, it is crucial to align business strategy with technology's tools. In today's cost-conscious, productivity- driven business environment, that means going back to basics and focusing relentlessly on building and delivering long-term business value.
Written by Knowledge@Wharton (http://knowledge.wharton.upenn.edu) in collaboration with Microsoft
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