Measuring the Value of Corporate IT Investments

The following is an abbreviated version of an article that appeared in the Spring/Summer 2002 edition of CSC World.

Returns to IT Investment - What the Numbers Say

By Vijay Gurbaxani, Jason Dedrick & Kenneth Kraemer

There is a strong consensus among economists that IT investment pays off in higher productivity, and that it was a significant source of economic growth in the second half of the 1990s. The argument now is whether the high rates of productivity growth associated with the move to the IT-intensive networked economy are due to a fundamental transformation derived from structural changes in business processes and accompanied by a permanent improvement in the prospects for economic growth, or whether it is a temporary phenomenon, enabled by the business cycle.

Investments by US companies in information technology increased steadily from 1950 until about 1995. Then they grew significantly, resulting in accelerated labor productivity growth, which in turn led to significant increases in per capita income. Labor productivity, which grew at 1.5 percent per year in the 1973-1995 period, grew at 3.1 percent per year in the period from 1995 to 2000.

Yet, in the face of the recent economic slowdown, IT investment has fallen sharply. A significant factor in the reduction in IT spending is uncertainty about the returns to these investments, magnified by the reduced competitive pressure from the dot-com companies. The trend is not universal. Companies such as Fidelity Investments and General Electric continue to spend aggressively on IT, perceiving increased opportunities as their competitors scale back their investments.

Their confidence is supported by evidence provided in the rich academic literature that has emerged in the last decade. Also, Alan Greenspan believes we are experiencing only a pause in what he calls "investment in a broad set of innovations that has elevated the underlying growth rate in productivity."

Two paths to productivity

The fundamental economic mechanisms by which IT investments boost productivity can be grouped into two categories. First, providing workers with more IT capital can increase labor productivity, in the same way as traditional capital investments such as factory equipment do. Economists call this mechanism capital deepening.

Second, some researchers have suggested that IT is different from traditional forms of capital in that it not just automates, but also provides better information for decision making, and enables substantial organizational transformation. Correspondingly, investments in IT have the potential to result in large performance improvement through an impact on production techniques and methods.

These improvements in production methods imply that higher levels of output can be achieved without increasing the levels of capital and labor inputs. Economists measure technical progress as multifactor productivity (MFP), or the increase in output for a constant level and quality of input.

A cashier at a retail chain store, for example, can process a transaction in less time using a point-of-sale system, increasing his productivity. Further, information provided by the system allows the firm to make better inventory decisions, which may further enhance productivity.

To achieve even higher levels of productivity, the company may redesign its supply chain using a supply chain management system, of which the point-of-sale system is a key element. These improvements in process may increase MFP at the firm level and lead to permanent improvements in productivity.

In recent years, numerous researchers have conducted rigorous empirical studies of the returns to IT investment to firms. The preponderance of evidence provided in these studies suggests that, in all sectors of the economy, IT investment raises productivity via capital deepening.

The results for multifactor productivity are witnessed clearly in some industry sectors, such as durable goods and high technology. In these sectors of the economy, it is the case that IT has also enabled structural changes in production techniques and process that permanently improve the prospects for economic growth.

Interestingly, while average returns to IT investment are significant and positive, the benefits vary widely among companies. The greatest returns accrue to companies that invested in systems that enhance and complement critical business processes. Of critical importance, investments in IT capital must be coupled with investments in organizational assets through practices such as process redesign, employee empowerment, training, and decentralized decision making.

Productivity increases will continue

There are sound reasons for expecting IT to continue to enhance productivity. As Alan Greenspan reported earlier this year, the exploitation of available networking and other information technologies was only partially completed when the cyclical retrenchment of the past year began.

It is both the direct impact of IT on labor productivity and its role as an enabler of more efficient business organizations that matter. Payoffs from IT investment accrue to companies that never lost sight of the basics - those that invested in IT and complementary organizational assets.

Importantly, these findings are derived mainly from examining the returns to IT investment in old-economy firms, suggesting that these firms can be central to productivity gains in the future.

Companies must seek not only to derive benefits from new applications of IT, but also focus on exploiting fully their prior investments in the technology. Executives must be driven by a relentless commitment to discovering additional sources of efficiency and effectiveness through the deployment of new information technologies in concert with organizational changes.

The authors serve in various capacities at the Center for Research on Information Technology and Organizations, Graduate School of Management, University of California, Irvine. Their perspective is based on their own original research at the firm and country level, as well as a critical assessment of the evidence presented in the rich academic literature that has emerged in the last decade.

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