A little while back I was presenting the concepts and structure of my MBA course to a diverse group of my HBS colleagues. Pretty early on one of the professors in the Finance area asked me the question I was most dreading and least prepared for: "Andy, what do you teach students about conducting a financial analysis of proposed IT investment? How do you build a business case for IT?"
I was about to launch into a long-winded and poorly argued answer, but Bob Kaplan spoke up first. "You can’t," he said.
Kaplan is responsible for both activity-based costing and the Balanced Scorecard, so he speaks with no small authority on matters of costs and benefits. After the seminar he gave me a copy of Strategy Maps, which he wrote with David Norton. The subtitle of the book is "Converting Intangible Assets into Tangible Outcomes." Intangible assets consist of human, organizational, and information capital, which they define as "Databases, information systems, networks, and technology infrastructure."
The authors make their point forcefully and early in the book.
"None of these intangible assets has value that can be measured separately or independently. The value of these intangible assets derives from their ability to help the organization implement its strategy… Intangible assets such as knowledge and technology seldom have a direct impact on financial outcomes such as increased revenues, lowered costs, and higher profits. Improvements in intangible assets affect financial outcomes through chains of cause-and-effect relationships."
This is a very crisp articulation of what I was going to try to say in the seminar. I’ve probably seen hundreds of business cases that identify the benefits of adopting one piece of IT or another, assign a dollar value to those benefits, then ascribe that entire amount to the technology alone when calculating its ROI. The first two steps of this process are at best estimates, and at worst pure speculation.
The final step gives no credit and assigns no value to contemporaneous individual- and organization-level changes. It’s a little like giving all the credit for the Boston’s 2004 World Series victory (yes, I am still basking in it) to Terry Francona, or David Ortiz, or Theo Epstein. All three were critical and probably even necessary elements of the win, but it would be ludicrous to say that any one of them was responsible for it.
IT is vexing because its costs are so clear, and so high. Its concrete expenses make it look on paper like a new machine tool, assembly line, or factory, and very few responsible companies go around buying any of them without first conducting financial analyses. The difference between IT and these other fixed assets is that machine tools and factories add value directly, not through "chains of cause-and-effect relationships."
A company invests in a new assembly line because it needs more widget capacity. If it had that capacity, it could make and sell more widgets. The relationship between costs and financial benefits in this case is complicated in some ways (it depends on many factors, some of which must be estimated) but the cause-and-effect chain is a short one, and one that doesn’t depend on lots of contemporaneous changes.
With IT, cause-and-effect chains are often quite long, e.g. successful CRM adoption integrates the information about customer purchases across multiple channels – phone, web, store, etc. This information allows stores to accept returns of good purchased online and lets customer service reps see each customer’s entire order history. Both of these can increase customer loyalty, which in turn increases sales. Sales can also be increased if recommendations presented to the customer on the website take into account purchases made at the store.
(There are some shorter cause-and-effect chains with IT. eProcurement systems, for example, are popular with both CIOs and CFOs because centralizing and standardizing the purchasing process often yields savings that can be quantified, or at least benchmarked, in advance. The cause-and-effect chain in short in this case, and benefits are in the same terms (dollars) as costs. Such systems are the exception rather than the rule, however.)
So does this mean that companies should just stop building business cases for IT and proceed by intuition, or by the persuasiveness of a sales pitch?
Of course not. One half of the ‘classic’ business case — the costs — can be assessed in advance with pretty high precision. We know by now what the main elements of an ERP, BI, Web enablement, systems integration, etc. effort are, and what their cost drivers are. And we also know the capabilities that different types of IT deliver if they’re adopted successfully — if the human and organizational capital are well-aligned with the information capital.
The comparison of dollars spent to capabilities acquired isn’t one that yields an ROI or NPV number, but it’s one that business leaders are adept at making. Most of the executive teams I’ve worked with would have little trouble answering questions like "Is it worth spending $1 million and tying up the following resources for the next sixth months so that we can capture all customer contacts in a consistent digital format?" or "Is it worth spending $3 million so that over the next two years we can give all of our field sales people automated heads-up alerts whenever the business intelligence system predicts one of their customers is likely to defect?"
I don’t mean to imply that the answers to such questions are always "yes." I simply mean that most business leaders can quickly answer them because they’re posed in familiar terms — as cost vs. capability tradeoffs.
Across the hundreds of quantitative IT business cases I’ve seen, I’d estimate that the average ROI figure was about 100%. This brings up an obvious question, which I asked to every business case author that I could find: "If this ROI figure is at all accurate, why are companies spending money on anything else except IT? If there really are all these 100% ROI projects out there, doesn’t Finance 101 say that companies should immediately start lots of them, and not stop until the marginal return is less than the return from traditional investments like advertising, R&D, capacity expansion, etc.?"
I never got a satisfactory answer to this question until I read Strategy Maps and saw Kaplan and Norton’s points about how nebulous the numerator — the financial returns — of this ROI figure is, and how the denominator is actually composed not only of IT capital, but also human and organizational capital (what I call the ‘organizational complements‘ of IT).
The reason companies don’t go on an IT investment binge when they see 100+% ROI business cases is that their leaders explicitly or intuitively understand these points. In fact, I think these huge ROI figures are actually counterproductive; they lead to a response of ‘Give me a break.’ Framing IT business cases in terms of costs required to acquire capabilities might lead more often to a much better response: ‘Give me some technology.’