61-04-64 Economics of Advanced Information Technology A. Perry Schwartz IN COMPANY AFTER COMPANY, advanced information technology is a hot topic; in many of these same companies, however, there is a tremendous gap between talk and action. The gap exists as a direct result of the failure of too many information systems projects to have immediate, tangible payoffs. In fact, many projects to reduce the costs that were approved by management have actually increased costs. By now, every company has experienced its share of these projects. On the other hand, projects that have reduced tangible increases in revenue or profitability are few and far between. Indeed, expectations of increased revenue or profitability are often so low that many firms fail to keep even the most basic data for determining whether such increases have occurred. Many Internet and Intranet uses are not even conceived with payoff in mind and often leave the impression of a technology in search of a business purpose. Consequently, the typical executive has been preoccupied with the cost of side of the equation, ignoring the benefit side. This means that the executive is essentially ignoring the fact that the fundamental economic purpose of introducing new technology is not really to reduce costs but to increase a firm s growth and profitability potential. Costs savings are the least important part of the equation. ENHANCING GROWTH AND PROFITS For this model, it is useful to distinguish between two types of activities by introducing two new terms; paced and pacing: Paced Activities. Provide support to the firm s operation, but do not drive revenue. Pacing Activities. Improves performance and increases revenue.
Exhibit 1. Relationship between revenue and activity level for a paced and a pacing activity. Some examples help to distinguish between paced and pacing activities. In a bank, prospecting for new corporate account is a pacing activity; credit file maintenance is a paced activity. More prospecting generally increases revenues. More credit file maintenance, above the level required for the current amount of business, does not contribute to an increase in revenues. For firms that depend on product innovation to attract customers, research and development is pacing and production is paced. In most firms, the sales activity is pacing while accounting is personnel, maintenance, legal, and staff functions are generally paced. By definition, an asymmetry exists between paced and pacing activities as illustrated in Exhibit 1. For a pacing activity, an increase in activity enhances revenues, whereas a decrease in activity reduces revenues. Restrictions or limits on pacing activities constrain growth. A decrease in a paced activity may also reduce revenue, but this is a result of the paced activity acting as a constraint on a pacing activity. For example, if a bank s computer cannot handle additional accounts, there is no point in making any extra effort to attract new accounts. On the other hand, an increase in the level of a paced activity does not increase revenue or constrain growth. If the sample bank s computer system capacity is increased but no new accounts are opened, the change in computer capacity has only increased costs and reduced profits.
Although the difference between pacing and paced activities seems obvious, a distinct tendency is observed among all but the most senior managers to overlook pacing activities and to focus on paced activities when they are asked to consider the prospects of advanced information technology projects. This is understandable, because most of these managers are more concerned with cost control, as measured by their departmental budgets, than growth, and they have a corresponding narrow view of the firm. On the other hand, higher-level executives have a more comprehensive view of the firm and can distinguish between paced and pacing activities. SELECTING TARGET PACING ACTIVITIES Investments in advanced information systems are usually made for the purpose of enhancing economic outcomes. If pacing activities are targeted, increased revenues are likely. Alternately, if paced activities are targeted, decreased coats are usually the only reasonable goal. Ordinarily, the incremental increase in revenues from leveraging pacing activities far exceed the potential cost savings from improvements in paced activities. Therefore, pacing activities represent the greater opportunity for advanced information systems, and as the first step in developing a technology strategy, these activities should be identified. Once the pacing activities have been identified, four criteria can help select the ones that are likely to be successful advanced information technology projects: Will increased emphasis on the activity actually result in more business? This confirms whether the activity is really one that is pacing. If the sales staff believe that the market is saturated, for example, new product development rather than sales may really be the critical pacing activity. Will the additional capacity for quality or quantity of work be directed toward the pacing activity? For example, if freed up time will be soaked up by the administrative work rather than by increased sales efforts, the investment in advanced information technology is not likely to pay off. Will the additional business resulting from enhancing the pacing activity actually yield more profit? This may not be true in cases in which a costly production and manufacturing infrastructure must be created to support a large increase in sales or in which prices must be lowered to induce additional purchases. Does the pacing activity contribute to a line of business that is a high priority? This firm should have a fundamental interest in enlarging the aspect of its business that will be targeted by the advanced technology.
The result of this analysis will be a list of one or more pacing activities that represent the firm s best advanced technology investment opportunities. In general, the more positive the answer to these questions, the greater the likelihood for significant payoff. After the key pacing activities have been identified, it is time to determine whether opportunities, problems, or bottlenecks exist that can be resolved by advanced information technology. Those activities that cannot be improved through the use of advanced information technology still may be identified as targets for improvement but are not relevant to the technology strategy of the firm. Those pacing activities amenable to enhancement by technological means should be subjected to thorough systems analysis because technology, in isolation, cannot be expected to overcome organizational, human relations, workflow, or structural problems. In addition to the usual systems analysis concerns, there are three major considerations on the analysis of a target activity. ADDING PEOPLE OR COMPUTERS Insightful executives were asked whether they can get the same increase in output just by adding more staff, rather than more technology. The question reflects a course of action every prudent executive should consider. After all, if increased activity is the goal, it can certainly be generated by additional staff. A three-part answer is offered to the question of people vs. computers: One of the major benefits of advanced information technology is the capability to perform tasks more quickly and thoroughly. An increase in staff size often degrades responsiveness because of the increased need for communication and management control within the organization. The hidden cost of organizational control can seriously drain profits. 1. Nevertheless, if an increase in activity through the addition of staff will increase revenues at a much greater rate than it increases costs, yielding increasing incremental profits, a staff increase is likely to be desirable. 2. On the other hand, if the resource committed to the pacing activity have been set to maximize profit, expanding the resource commitment along conventional lines by adding staff will only decrease profits. Because advanced information technology can change the underlying cost structure of the business, use of technology to increase effective activity without a corresponding increase in staff may provide the basis for increasing profits.
Exhibit 2. Profit maximization based on activity level. Exhibit 2 helps explain these last two points. In this figure, the x-axis is the level of activity and the y-axis is dollars. The revenue curve is typical for a pacing activity. The cost curve, showing fixed and variable costs, reflects the general concave upward pattern that the standard economic theory of the firm projects for costs. The profit curve is simply the difference between the revenue curve and the cost curve. The maximum profit occurs at a point A on the x-axis in Exhibit 2. If the level of activity is less than A, it may be appropriate to add staff, thereby increasing profits. This is the circumstance described in term 2 in the preceding list. If the level of activity is greater than A, however, adding staff is a poor strategy. This is the circumstance described in item 3. ACCELERATION OF THE FIRM Effective executives ask the tough questions and demand sound answers. For advocates of the new information technology projects, one of the tougher questions is: How is the new technology going to increase profits? The answer is rooted in the basic economics of the firm. In fact, the economics are much the same as those used as a basis for the introduction of the most industrial automation factories.
Exhibit 3. Effect of change in cost structure on profit. The basic economics are illustrated in Exhibit 3. This figure superimposes two new curves in Exhibit 2 (i.e., new cost and new profit) to illustrate one possible effect of the introduction of advanced information technology. In this case, the new technology increases fixed cost while it decreases the variable costs of performing an activity. Thus, the new curve starts above the old cost curve but has a lower slope. The break-even point occurs where the two costs curves intersect. From this point on, the advanced information technology will produce profits that are uniformly higher than those that would have been achieved without it, and the new, higher maximum profit occurs at activity level B rather than level A. In addition to long-run cost saving, advanced information technology holds the promise of increased revenues. For example, technology might be used to create new features or services. The firm may anticipate additional revenue per unit of activity to the extent that the basis of competition is altered. Exhibit 4 illustrates the combined impact of both decreased cost and increased revenues. In this case, the effect of introducing advanced information technology is reflected by two structural curves. The first is the new cost curve. This reflects the increase in fixed costs and decrease in variable costs associated with the new technology and is the same curve shown in Exhibit 3. The second curve reflects new revenue that would result from new or improved products and services. The new profit is then
Exhibit 4. Acceleration of the firm. the difference between the new revenue and the new cost; there is an associated new profit-maximizing activity level B, reflecting profit levels substantially higher than those achieved at the previous maximizing level A. the overall result is a change in the cost structure of performing the activity. The alteration of the cost/revenue structure illustrated in Exhibit 4 is referred to as acceleration. The acceleration effect is the most desirable outcome, occurring only when the firm takes advantage of both the costreducing and the profit-enhancing potential of a new technology. Is acceleration real? The evidence is that it exists in company after company that has converted from manual to automated procedures since the introduction of the modern business computer. It is clear that information technology has transformed the cost structure of these companies so profoundly, few if any could survive without this technology. In the modern company, however, the impacts of IT projects that accelerate the firm are difficult to use. Experience suggests that the reason for this is not the absence of acceleration but the inadequacy of systems for measuring the economic contribution of information technology projects. The typical executive is therefore likely to view advanced IT proposals or project outcomes in terms of costs rather than acceleration. Such a view can lead to rejection of IT projects that are fundamental to a company s long-term profitability.
CONCLUSION In the face of an explosion in advanced information technologies, many firms are approaching new information system opportunities without a guiding set of principles for leveraging the results. This is evidenced by an epidemic of Intranet implementations that are little more than very fancy email or calendar systems. In many of these cases, the information system executives are either choosing to treat these initiatives as outside the normal budgetary concerns, that is as research and development projects, or are willing to accept the costs without concern for enhanced benefits. However, downplaying the costs or ignoring the potential for positive outcomes often results in misguided initiatives, and misguided initiatives usually result only in changes to paced activities. The payoff is far greater if the firm directs the application of advanced information technology toward improvement of pacing activities. This is an essential first step for any firm wishing to prosper from the use of advanced technology. Nevertheless, the choice of pacing activities as targets for advanced information technologies is only the start. Over the long term, a successful strategy for the introduction of technology must be driven by fundamental economic considerations. Obviously, no firm can long continue sacrificing profits to buy advanced information technology. Likewise, the inclination to apply advanced information technology will be strengthened as information technology initiatives clearly and demonstrably result in greater sales or profitability. Advanced information technology has the power not just to reduce cost or increase profits, but to transform the firm. The economics for advanced information technology as discussed here provides a model for understanding just what that transformation means and how that transformation occurs. An understanding of acceleration is fundamental to correctly assessing and using advanced information technology.