Originally published July 18, 2001, Knowledge@Wharton
Laptop computers could make a sales force more productive, but they also cost more than desktop PCs. Should a company buy laptops for its salespeople? Software programs such as Lotus Notes, which allow distributed teams to collaborate on projects, can be pricey – but they also have the potential to make a far-flung workforce more efficient. Should a firm invest in such software? When is information technology a good buy? How can managers know when an investment in IT has paid off and when it has been an expensive dud?
Answering these questions – and, by implication, measuring the value of IT investments – can be a major headache for U.S. corporations, executives and managers, who spent a collective $762 billion in 1999 on IT, according to the U.S. Commerce Department. So large is IT spending that between 1995 and 1999, the category accounted for fully one-third of all real economic growth and half of all productivity growth.
What these numbers do not quantify, however, are the returns from IT investments. Experts at Wharton and Intel, the world’s largest chipmaker, say that such returns are difficult to measure because they – and some of the costs – cover a host of intangibles. The intangibles include the time it takes for returns to emerge from an investment in IT; strategic fit in the company; opportunity costs; levels of innovation required; the value of connecting with customers; and finally, the possibility of retaliation from competitors.
Accounting for these intangible factors is crucial in valuing IT investments. “The greatest danger is the ‘concrete’ and ‘measurable’ driving the significant out of the analysis,” says Eric K. Clemons, a professor of operations and information management at Wharton. “When considering an (e-commerce) strategy it is clear what the costs are; the benefits are less clear.” The combination of tangibles and intangibles suggests a pair of gaps managers must face as they evaluate IT investments.
Filling the Gaps
The first gap could be called a “subjectivity gap,” according to Wharton dean Pat Harker, professor of operations and information management. Calculating estimated costs when a company wants to invest in technology is a relatively straight-forward process. Figuring out the benefits, however, can be difficult. Wise managers will “know what they know and know what they don’t know.” Too often, Harker says, executives get investment proposals that barely scale the hurdle rate required for them to be approved. Savvy managers know they can work the numbers so that an expected increase in market share or sales just makes it over the wire, but this suggests a corporate culture unwilling to acknowledge a need for subjective evaluation. And yet, such a subjective evaluation of intangible benefits received from an IT investment may dramatically affect the overall calculation.
The second gap can be called “revenue distance,” notes Ravi Aron, a professor of operations and information management. This refers to the gap between the investment itself and the revenue mechanism it supports. Aron suggests, for example, that building a corporate extranet where buyers can examine whether a company has a product available in its inventory before placing an order has a short revenue distance because it directly affects sales revenues. “Revenues come from the customer,” Aron says. “For something that makes my existing linkage more efficient and couples me tighter with the customer, the revenue distance is close to zero.”
But consider this: Managers of a geographically dispersed team may believe software such as Microsoft Whiteboard or Lotus Notes will lead to more productivity and efficiency among team members by making it easier for them to share data. “Does it bring the team members closer to the customer?” Aron asks. “The revenue distance between this investment and the revenue mechanism is substantial.” Still, great revenue distance does not disqualify an investment. It may demand subjective analysis.
Some Techniques for Measuring the Gaps
How can managers and executives account for intangible value? Experts suggest employing one or more of these techniques:
Business Value Index: Intel is piloting a method of quantifying the business value of IT investments. Martin Curley, director of IT people, intellectual capital and solutions for Intel’s IT group, says managers assign values between one and four to intangible benefits on a scorecard. “The assumption is that we have already performed a financial benefit analysis for the tangible benefits,” Curley points out. The exercise addresses the “subjectivity gap” that Harker describes. The result is a tool executives can use to gauge one investment against another over time.
Scenario Planning: This method can help avoid what Aron calls “managerial myopia” when addressing investments that may not show immediate financial returns. Scenario planning lays out a variety of paths that can occur if the investment is made – or if it is not made – and pushes decision-makers to define the likelihood for each scenario and make decisions accordingly.
Real Option Theory: Imagine a game of seven-card stud poker. On each deal, the player antes up to see his next card – and his opponents’. If he doesn’t like what he sees, he folds. The theory defines technology investments as “options” to be pursued. As opportunities present themselves, managers can place small bets -or investments – on a variety of IT projects and see how they play out. As one becomes more likely to yield gains, the “betting strategy” becomes more clear. “It’s not a common practice yet,” Curley says. “But it is emerging and there will be early adopters.”
Both real option theory and scenario planning are fertile ground for business researchers and can be highly esoteric. Experts say plenty of consultants stand ready to advise how to apply these concepts.
“R&D Council”: Curley says Intel has pushed some of this evaluation to a separate unit, devoting a small percentage of its budget to that unit for research. Managers bring the more “out-there” or innovative proposals to the council for evaluation.
Determining the value depends on corporate culture
Ultimately, business culture is critical. A CFO who demands hard numbers to justify every investment will get what he asks for, Harker says. But he may not be able to depend on what he gets. “People are often looking for a panacea, some magic computer program,” Harker says. “The answer is usually inside their organization. They have to have a clear process for decision making and a clear articulation of how we account for certain costs and benefits.”
Copyright © 2001, Knowledge@Wharton