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.