ACCOUNTING INFORMATION MANAGEMENT
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Beyond the Productivity Paradox Computers are the Catalyst for Bigger Changes Forthcoming in the Communications of the ACM August 1998 June 1998 Erik Brynjolfsson MIT Sloan School of Management and Stanford Business School erikbmit edu httpccsmiteduerild Lorin M Hitt University of Pennsylvania The Wharton School lhittwhart0nupennedu http grace Whartonupenn edu lhitt Beyond the Productivity Paradox Page 1 1 Why Should We Care About Productivity An important question that has been debated for almost a decade is whether computers contribute to productivity growth Productivity isn39t everything However as noted by the economist Paul Krugman in the long run it is almost everything Productivity growth determines our living standards and the wealth of nations This is because the amount a nation can consume is ultimately closely tied to what it produces By the same token the success of a business generally depends on its ability to deliver more real value for consumers without using more labor capital or other inputs Productivity is a simple concept It is the amount of output produced per unit of input While it is easy to define it is notoriously dif cult to measure especially in the modern economy In particular there are two aspects of productivity that have increasingly de ed precise measurement output and input Properly measured output should include not just the number of widgets coming out of a factory or the lines of code produced by a programming team but rather the value created for consumers Fifty years ago tons of steel or bushels of corn were a reasonable proxy for the value of output In today39s economy value depends increasingly on product quality timeliness customization convenience variety and other quotintangiblesquot Similarly a proper measure of inputs includes not only labor hours but also the quantity and quality of capital equipment used materials and other resources consumed worker training and education even the amount of quotorganizational capitalquot required such as supplier relationships cultivated and investments in new business processes The irony is that while we have more raw data today on all sorts of inputs and outputs than ever before productivity in the information economy has proven harder to measure than it ever was in the industrial economy Where does productivity growth come from By definition it doesn39t come from working harder that may increase output but it also increases labor input Similarly using more capital or other production factors does not necessarily increase productivity Beyond the Productivity Paradox Page 2 Productivity growth comes from working smarter This means adopting new technologies and new techniques for production The greatest increase in productivity has historically been associated with a particular class of technologies quotgeneral purpose technologiesquot The steam engine was an important general purpose technology It could be used in a variety of new applications from driving spinning looms in a newly mechanized factory to powering locomotives in a new transportation system Electricity was another key technology which set off a chain of innovation in the 1890s What general purpose technology might hold a similar promise in the 1990s The obvious answer is information technology IT Driven by Moore39s law the doubling of the number of transistors per chip every 1824 months computer technology has advanced at an exponential rate for several decades see Figure l Ultimately however these trends in basic computer power only provide greater inputs into production The question remains are computers increasing output Are computers pulling their weight On the one hand amazing success stories abound the billions of dollars already being transacted by rms like Dell and Cisco via the Internet are only the latest example On the other hand there is no shortage of stories about cost overruns abandoned systems investments and other IT failures Some authors have even described the idea that computers have substantial business bene ts as the big lie of the information age 12 Anecdotes can be found to bolster either side of the debate A better way to determine if computers are living up to their promise is by studying broader data sets which contain hundreds or even thousands of observations The idea is that unusually quotluckyquot or quotunluckyquot experiences with computers will tend to average out and we will be le with a clearer picture of the underlying relationship We have reviewed several such studies many of which were originally presented at the Workshop on Information Systems and Economics WISE across a wide range of technologies Beyond the Productivity Paradox Page 3 industries and applications We nd that a consensus is beginning to emerge Computers pulling their weight l3810 In addition a second even more important nding is clearly evident in the data While the average returns to IT investment are solidly positive there is huge variation across organizations some have spent vast sums on IT with little bene t while others have spent similar amounts with tremendous success Today the critical question facing IT managers is not quotDoes IT pay offquot but quotHow can we best use computersquot Fortunately the same methodologies used in investigating the first question can be directed at the second question and a number of provocative results are emerging Most importantly the greatest bene ts of computers appear to be realized when computer investment is coupled with other complementary investments new strategies new business processes and new organizations all appear to be important in realizing the maximum bene t of IT This change is rarely easy since many organizations will require a painful and time consuming period of reengineering restructuring and organizational redesign in order to best utilize their IT investments However once these investments in change are made these companies will be positioned to reap the bene ts of continued technological progress in the computer industry while others may be le lrther and lrther behind 11 The Productivity Paradox Attention was rst drawn to the quotproductivity paradox by a simple but provocative study quotAmerica s Technology Dilemma A Pro le of the Information Economyquot by Morgan Stanley s chief economist Steven Roach published in their April 22 1987 economics newsletter series He attempted to explain why the measured productivity growth rate in the US economy has slowed substantially since 1973 Roach observed that the amount of computing power per whitecollar worker in the service industry was growing dramatically over the 1970s and 1980s yet the measured productivity of this sector was at His conclusion was that the tremendous increase in computerization has Beyond the Productivity Paradox Page 4 had little effect on economic performance particularly for those sectors of the economy with large numbers of quotinformation workersquot Other studies also showed little evidence of a link between computer investment and productivity using data on computer investment in manufacturing industries or in a sample of business units of large rms A few studies found positive effects on intermediate factors such as cost efficiency or market share but it was still difficult to tie these bene ts to the bottom line Furthermore despite the tremendous advances in computer power the aggregate statistics suggest that productivity has grown more slowly since 1973 than it did between 1950 and 1973 By the late 1980s the conventional wisdom was that computers were not contributing significantly to productivity As succinctly stated by Robert Solow in the New York Times BookRevz39ew July 12 1987 quotwe see the computer age everywhere except in the productivity statisticsquot However while these results generally found little evidence of a relationship between IT and productivity there was also little evidence that computers were unproductive In particular many people pointed to the inadequacies of productivity measurement One problem is that until recently overall computer investment was relatively small compared to overall capital investment and labor expenditure Economist Zvi Griliches in his presidential address to the 1996 annual meeting of the American Economic Association likened the search for IT value to looking for a needle in a haystack However even as the magnitude of IT investment grows larger he notes that there are still systematic biases in conventional productivity measurement that prevent an accurate assessment Most productivity metrics are oriented around counting things number of employees pounds of nails or number of checks processed As long as computers allow firms to produce more of the same product at lower costs these metrics work reasonably well But there is strong evidence that managers are not simply making IT investments to cut costs When managers are asked quotWhy do they invest in ITquot surveys suggest that customer service and quality consistently rank above cost savings as the prime motivation for making investments 3 Beyond the Productivity Paradox Page 5 The quirks of productivity measurement are easily seen in banking ATMs reduced the number of checks banks process so by some measures banking output and productivity decreased The increases in convenience ATMs have created go uncounted in conventional productivity metrics while their costs are counted At an aggregate level banking labor productivity is measured like all sectors as the ratio of an output metric to number of employees But since the aggregate level of the true quotoutputquot of banks is difficult to measure most conventional analyses have shown that labor productivity has essentially been at Not surprisingly when you can easily count the costs of computer investment but have a difficulty assessing the bene ts particularly those that take time to be realized IT can look like a bad investment I A An Information Payo In the early 1990s new data became available which allowed a reexamination of some of the previous results on IT productivity These data for the first time enabled researchers to look at the IT investment behavior and productivity of large numbers of firms rather than focusing on higher level aggregates such as manufacturing industries or the whole economy This microlevel approach had a number of advantages While there is only one US economy and only a few dozen manufacturing industries these data allowed analyses to be conducted on hundreds of rms over several years The increase in sample size enabled much more precise estimates of computers39 contributions improving the chance of identifying the needle in the haystack Firm level data also enables the measurement of at least some of the intangible value that was being created by computers even if this value could not be directly observed If consumers are willing to pay more for increases in quality or convenience then a firm s revenue will re ect some of this increase in intangible value However these di erences will not appear at the industry level high quality rms will force low quality firms to lower their prices to remain competitive Therefore overall industry revenues will not necessarily increase as firms computerize While some of the value from IT investments Beyond the Productivity Paradox Page 6 made by rms and passed on to consumers through competition and will not be observed at least some of this intangible value can be captured in rmlevel productivity measurements Initial rmlevel studies of IT and productivity found that a dollar of IT capital is associated with a substantial increase in revenue each year 1211 Other analyses have replicated these basic ndings using diiTerent sets of econometric assumptions different characterizations of IT mainframes PCs IS staff or some combination and diiTerent subsets of the economy manufacturing vs services 38 Across all these studies there is a consistent nding that IT has a positive and signi cant impact on rm output contradicting claims of a quotproductivity paradoxquot If fact in the studies the returns to IT appear to be quite high This raises the possibility that computers are not only pulling their weight but contributing substantially more However at least part of this high rate of return is required to compensate for rapidly falling prices of computer equipment In addition these returns may represent more than just the returns to the technology Technology is only one component of an IT investment there are usually large expenditures on training process redesign and other organizational changes accompanying a systems investment This doesn39t change the conclusion that computers contribute to increased output however it does make exact rate of return calculations more dif cult I B Beyond the Averages While computers on average appear to be productive this fact alone is not enough for an IS manager to make good investments In fact the dif culty of establishing the overall value of IT may be a symptom that the value that IT brings to a rm varies enormously from company to company When we plot the relationship between IT and productivity in Figure 2 two features stand out First when a line is tted through these points it slopes upward which suggests that rms with more computers are compensated by increased output However there is also an enormous amount of variation around this Beyond the Productivity Paradox Page 7 line some rms have high IT investments and are highly productive others have similar investments but have poor performance What explains the difference One way to start thinking about the sources of variation is to divide the bene ts of IT into two parts those that are unique to a particular rm and those that appear due to variation in spending across rms These two dimensions can be distinguished by a statistical technique known as a rm effects model Applying this technique we found that the measured bene ts of IT were reduced by almost half when rm effects were included 1 One interpretation of this result is that about half of IT value is due to unique characteristics of rms while the remaining part is shared generally by all rms What goes on inside the quotblack boxquot of the rm has a substantial in uence on the productivity of IT investments To obtain a better characterization of the organizational factors that affect IT value we can examine the relationship of IT investment to productivity over diiTerent time periods If organizational changes can be made instantaneously with IT investments then it should not matter whether we look at one year changes in the rm or ve year changes However if there is some lag or adjustment time required to match organizational factors and IT investments we would expect to see more bene ts over longer time periods The statistical results were striking Figure 3 While short term bene ts were about what would be expected if they had quotnormalquot returns long term bene ts were substantially larger from 2 to 8 times as much as short term bene ts 3 Our interpretation is that the organizational factors that unlock the value of IT are costly and time consuming This could simultaneously explain why the effects rise these changes take substantial time and are put in place incrementally and why IT appears unusually productive in the longer term the long term bene ts are not just the returns from IT but returns from a system of technology and organizational changes In other words for every dollar of IT there are several dollars of organizational investments that when combined generate the large rise in measured rm productivity and value Beyond the Productivity Paradox Page 8 I C The Arrival of the quotNew Organization quot Thomas Malone 10 Peter Drucker and others recognized that general changes in the economy as well as the increased di usion of IT into the workplace was going to facilitate and necessitate a dramatic restructuring of organizations For example Drucker39s article quotThe Coming of the New Organizationquot 9 predicted that technology rich firms will increasingly shift toward atter less hierarchical organizations where highly skilled workers take on increasing levels of decisionmaking responsibility Similar ideas underlie other management trends such as business process redesign the emergence of quothigh performance work systemsquot and the shift from quotmass productionquot style manufacturing to exible quotmodern manufacturingquot In essence these all represent organizational changes that exploit low cost communications and information processing capabilities created by IT Do these types of practices actually make a di erence The initial answer appears to be yes Recently completed studies suggest that organizations that utilized decentralized decisionmaking and have employees with greater levels of skill and education appear to invest more in information technology 10 Irrespective of how IT is measured there is a consistent positive relationship between the use of these technologies and a set of work practices that include the use of selfdirected work teams greater levels of individual decision authority particularly over method and pace of work increased investments in training and screening for education and incentive systems that reward and encourage high team performance Part of this relationship is due to the fact that organizations that employ large numbers of educated workers particularly professionals or employ technology and skillintensive production processes are likely to use more IT and adopt decentralized structures However the relationship between IT and the new organization of work goes beyond that which would be predicted by the composition of the work force and is present both within and between industries Beyond the Productivity Paradox Page 9 A cynical explanation of these results is that firms adopting the new work practices are waste ll users of IT they spend too much or are too quick to adopt various management fads including IT investment and the new work practices In fact the opposite appears to be true In addition to spending more on IT these firms also appear to receive slightly higher returns on their IT investments When we look at diiTerent combinations of IT and work practices in a the 2x2 matrix shown in Figure 4 we see that firms that couple IT investments with the decentralized work practices are about 5 more productive than firms that do neither However rms can actually be worse o if they invest in computers without the new work systems In addition to getting more total bene ts from IT these organizations also appear to be adopting IT at a faster rate In 1994 this amounted to only about a 50 difference in overall IT investment intensity however this gap is growing by 10 per year Over the next decade these decentralized and empowered organizations may begin to pull away from their industrial age counterparts in performance as they are better able to exploit increasingly inexpensive information technology These results suggest that it is becoming increasingly important to organize in ways that leverage the value of IT While these types of results may not hold across all possible settings the general trend is clear So why do so many organizations still retain the old structure A plausible reason is that these types of organizational changes are time consuming risky and costly Redesigning management infrastructure replacing staff changing lndamental firm practices such as incentive pay and promotion systems and undertaking a redesign of core business processes are not easy In many cases this may involve abandoning business practices that may have been successful for decades in favor of work systems with which the organization has little experience or adopting an abrupt radical and discontinuous change in organizational structure Given the large number of documented difficulties and failures of change of this magnitude it is reasonable to conclude that these types of changes are indeed costly Beyond the Productivity Paradox Page 10 The experience of one rm we visited is instructive It spent millions of dollars to implement a new computerized manufacturing process Top management was wise enough to understand that fundamental changes in work practices would also be required For instance to exploit the new more exible equipment they proposed a sharp reduction in workinprocess inventories and more frequent product changeovers in production lines Despite the best of intentions there were initially no signi cant gains in either productivity or exibility 5 The reason was that workers maintained the old ways of doing things not in a conscious effort to sabotage the new manufacturing system but simply because they had too many ingrained habits For example one worker explained quotThe key to productivity is to avoid changeovers and keep the machines running at all timesquot This was a very use ll rule of thumb with the old in exible equipment but it nulli ed the bene ts of the new machines Effectively the huge investment in exibility machinery was being used mainly to make the new machines work just like the old machines Interestingly management39s attempts to quotempowerquot line workers with more decisionmaking responsibility were not much more successful Several workers confessed that they had no interest in having more decisionmaking responsibilities when chatting with their colleagues at work they preferred to discuss sports rather than statistical process control Eventually the rm was successful in managing this change and they ultimately surpassed their production goals However the unmistakable lesson was that purchasing computerized equipment was the smallest part of the overall cost of creating a new manufacturing system The biggest costs were in changing the organization One way to think about these changes is to treat the organizational costs as an investment in a new asset Firms make investments over time in developing a new process rebuilding their stalT or designing a new organizational structure and the bene ts from these investments are realized over a long time period Our earlier results suggest that these types of organizational assets need to be matched to information technology assets in order to be maximally valuable Beyond the Productivity Paradox Page 11 To get an idea of the potential magnitude of these assets one can look at how the stock market values different types of assets owned by the rm see Figure 5 For large corporations a dollar of most types of capital is valued by the stock market at about a dollar However for these same corporations a dollar of computer hardware appears to be associated with about 10 of market value 6 While it could be that IT is just extraordinarily productive it seems more reasonable to argue that this extra 9 represents the value of hidden complementary organizational assets For instance with each dollar a rm spends in enterprise resource planning software ERP like SAP s W3 system it typically spends 34 on consultants who implement the new system Even bigger costs are incurred in employee retraining and management time spent redesigning business processes However in the end the rm has a new system with lasting value 7 they own a new asset These assets don39t show up on a rm s balance sheet but accompany and complement IT investments 111 What We Now Know About Computers and Productivity Research on computers and productivity is entering a new phase While the rst wave of studies sought to document the relationship between investments in computers and increases in productivity new research is focusing on how to make more computerization effective Computerization does not automatically increase productivity but it is an essential component of a broader system of organizational changes which does As the impacts of computers become greater and more pervasive it is increasingly important to consider these organizational changes as an integral part of the computerization process This is not the rst time that a major general purpose technology like computers required an expensive and time consuming period of restructuring Signi cant productivity improvement from electric motors did not emerge until almost 40 years after their introduction into factories 7 The first use involved swapping gargantuan motors for large steam engines with no redesign of work processes The big productivity gains came when engineers realized that the factory layout no longer had to be dictated by the Beyond the Productivity Paradox Page 12 placement of power transmitting sha s and rods They quotreengineeredquot the factory so that machines were distributed throughout the factory each driven by a separate small electric motor This made it possible to arrange the machines in accord with the logic of work ow instead of proximity to the central power unit It has also taken some time for businesses to realize the transformative potential of information technology to revolutionize work However the statistical evidence suggests that revolution is occurring much more quickly this time around Beyond the Productivity Paradox Page 13 Figure 1 Moore s Law The number of transistors that can be placed on a semiconductor die doubles about every 18 months Beyond the Productivity Paradox Page 14 Figure 2 Variation in productivity and IT investment across firms Caption The vertical axis labeled quotProductivityquot is multifactor productivity de ned as output divided by a weighted sum of inputs in constant 1990 dollars The horizontal axis labeled quotIT Stockquot represents the total IT inputs in a rm Both productivity and IT input are centered at the industry average Note that some of the variation in IT Stock is due to diiTerences in rm size The points represent an individual rm in a particular year There are approximately 1300 data points in this graph 40 Productivity relative to industry average 012 025 10 40 80 ITStock relative to industry avera e Beyond the Productivity Paradox Page 15 Figure 3 Productivity of IT Investments over Time The vertical axis represents estimates of the productivity growth contribution of IT capital The numbers are estimated output elasticities of IT capital which represent the percentage change in output for a small percentage change in the quantity of IT The value would be approximately 01 if IT has a quotnormalquot rate of return These estimates were computed by linear regression and the diiTerent lines represent dilTerent statistical techniques quotOLSquot refers to ordinary least squares quotSRFquot semireduced form is similar to OLS except that labor expense was not included in the list of inputs to reduce biases on the IT estimates from reverse causality between output and labor expense quotIVquot represents instrumental variables regression which is an alternative way of addressing reverse causality Further discussion of this analysis appears in 3 IT Productivity over Different Time Periods 005 0045 004 0035 003 0025 002 0015 001 0005 OLS SRF T Contribution 0 2 4 6 8 Number of Years Beyond the Productivity Paradox Page 16 Figure 4 Productivity Effects of IT and Decentralization Each quadrant contains the average productivity the standard error of the productivity estimate in parenthesis and the number of rms from our sample in each group Productivity is de ned as multifactor productivity output divided by input costs in constant 1990 dollars The productivity numbers are relative to the quotlowlowquot quadrant which is set to zero as a reference point More rms line up on the diagonal highhigh lowlow than on the offdiagonals indicating IT and decentralization are correlated Reproduced from 4 IT Low High Decentralization 016 1 045 5 High 0191 0177 N47 N69 0 0366 Low na 0197 N69 N47 Beyond the Productivity Paradox Page 17 Figure 5 Relative Size of the Market Value of Computer Capital Estimates of the market value of computers relative to the market value of other assets from 5 This analysis suggests that a one dollar change in IT capital is associated with a change of about 10 in market value for the average rm in our sample For this to be an equilibrium there must be about 9 of unmeasured intangible assets associated with each dollar of measured IT capital Market VaV 107 8 lt I Intangible Assets Iii Tangible Assets 67 L p 4 27 07 Computers Physical Capital Beyond the Productivity Paradox Page 18 References N E 5 V39 05 gt1 9 0 O N Brynjolfsson E and Hitt L 1995 quotComputers as a Factor of Production The Role of Diiferences Among Firmsquot Economics of Innovation anal New Technology 3 34 May 183199 Brynjolfsson E and Hitt L 1996 quotParadox Lost FirmLevel Evidence on the Returns to Information Systemsquot Management Science 42 4April 541558 Brynjolfsson E and Hitt L 1997 Computing productivity Are Computers Pulling Their Weight MIT and Wharton Working Paper November 1997 Available from httpccsmitedueri1d Brynjolfsson E and Hitt L Information Technology and Organizational Design Firm Level Evidence MIT Stanford and Wharton Working Paper January 1998 Available from httpccsmiteduerild Brynjolfsson E Van Alstyre M and Renshaw A The Matrix of Change Sloan Management Review 38 2 Winter 1997 3754 httpccsmitedumoc Brynjolfsson E and S Yang 1997 quotIntangible Bene ts and Costs of Computer Investments Evidence from the Financial Marketquot The Proceedings of the International Conference on Information Systems December Atlanta Georgia David P A 1990 The Dynamo and the Computer A Historical Perspective on the Modern Productivity Paradox American Economic Review Papers anal Proceedings 12 355361 Dewan S and C Min 1997 quotThe Substitution of IT for Other Factors of Production A FirmLevel Analysisquot Management Science 43 12 December 1660 1675 Drucker P F 1988 quotThe Coming of the New Organization Harvard Business Review 66 1 JanuaryFebruary 4553 Lichtenberg F R 1995 The Output Contributions of Computer Equipment and Personnel A FirmLevel Analysis Economics of Innovation anal New Technology 3 34 May 201217 Malone T Is Empowerment Just a Fad Sloan Management Review 38 2 Winter 1997 Schrage M 1997 quotThe Real Problem with Computersquot Harvard Business Review 75 5 NovemberDecember 178 183
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