IT Investments That Pay Off

A mythic aura surrounds the soar and swoon of the "new economy." The scale was breathtaking, illusions abounded, and the forces at work seemed at once powerful and elusive. As the bubble inflated, many felt that information technology, and the Internet in particular, would "change everything." Today, with the technology sector in shreds, more than a few believe that IT changed scarcely anything at all. The truth, of course, lies somewhere in between. But where? What became of all the innovation we thought we were seeing? What actually happened to productivity growth? What effect did IT really have on companies and their ability to compete? Most important, what can managers learn from it all?

For more than two years, the McKinsey Global Institute has been studying labor productivity in the United States, France, and Germany and its connection to corporate IT spending and use. My colleagues and I have examined a large body of statistical and experiential evidence and conducted in-depth case studies of twenty industries, eight in the United States and six apiece in Germany and France. The studies involved not only the collection and analysis of data on industry and company performance but also extensive interviews with executives in each sector.

Even in the six sectors that gained the most from IT—retailing, securities brokerage, wholesaling, semiconductors, computer assembly, and telecommunications—many companies failed to earn strong returns from their technology investments. Some simply abandoned new systems when implementation difficulties arose or costs exceeded expectations. Others took a piecemeal approach, automating only parts of their business processes. Still others didn't invest in the areas with the biggest potential impact on productivity or invested too early in systems that competitors could easily copy.

Some of these errors seem surprisingly obvious. But in retrospect it's easy to see how some managers in the late 1990s got carried away with IT and spent money unwisely. As IT investment soared, so did productivity growth, economic growth, earnings, and stock market valuations. IT took on the appearance of a panacea, leading many managers to assume that "me-too" investments would pay off.

There's much to be learned from the companies that gained the most from their investments. Our research revealed, in particular, that three practices distinguish the companies that were most successful in their IT investments. First, such companies targeted their investments at the productivity levers that mattered most for their industries and themselves. Second, they carefully thought through the sequence and timing of their investments. Third, they didn't pursue IT in isolation but rather developed managerial innovations in tandem with technological ones. Let's look more closely at how these imperatives drive productivity.

Target the productivity levers that matter. There are many ways to improve productivity, as the exhibit "Working with the Productivity Equation" illustrates. You can reduce labor or other factor costs. You can increase labor efficiency or asset utilization. Or you can sell new or higher value-added goods to your customers. IT can play a role in each of these areas. The trick is to concentrate your IT spending on those levers that will have the greatest effect on productivity. Many companies we looked at spent heavily on seemingly attractive new technologies, only to find that they had little effect on results.

The levers that matter vary from industry to industry. That explains why the IT applications with the greatest impact are often tailored to particular sectors. We found, in fact, that no general-purpose application had much effect on productivity. In retail banking, customized applications for automating lending, credit card operations, and back-office transactions provided the greatest boosts to productivity. In consumer retailing, the key applications focused on streamlining distribution and logistics, merchandise planning and management, and store operations. In the semiconductor industry, the greatest gains came from highly specialized tools for electronic design automation, process control, and yield optimization. CRM applications, on the other hand, generally purposed to increase revenue through better customer management, tended to yield mostly poor results.

Even within an industry, different productivity levers can have very different impacts. Consider retailing. General merchandise retailers like Wal-Mart are low-margin, high-turnover businesses selling a vast number of items, many of which are consumer staples. They get the most benefit from tools such as warehouse and transportation management systems that allow for a tighter link with suppliers and an increase in inventory turns for a given product. On the other hand, specialty-apparel retailers like the Gap handle many items with short shelf lives and therefore rely on assortment and allocation planning tools to cut obsolescence and inventory-holding costs. Among electronics retailers like Circuit City or Best Buy, store allocation and price optimization tools play a key role in reducing markdowns. Home improvement retailers, whose profits hinge on after-sales services such as warranties, home deliveries, and repairs rely on extended order management systems to ensure greater customer satisfaction.

As these examples show, simply following broad IT trends can backfire. The smartest companies analyze their economics carefully and spend aggressively on only those IT applications that will deliver outsized productivity gains. As for other necessary applications, they seek out the cheapest possible solutions. And they always remember that the system that pays off for one competitor may do little for another. Take supply chain management systems, for instance. Spending on these popular technologies has proven to be a boon to general merchandisers, but comparable investments by apparel companies have yielded very little.

Get the sequencing and timing right. IT investments build on one another, often in complex ways. Companies that install sophisticated (and expensive) new applications before they've done the necessary groundwork are almost always disappointed. They either fail to achieve the expected benefits, or they find themselves doing constant retrofitting. But companies that take a disciplined approach, sequencing their investments carefully, often reap great rewards.

Wal-Mart's "step change" approach to IT investment during the 1990s is a great example. First, the company installed software to manage the flow and storage of products through its far-flung network of suppliers, warehouses, and distribution centers. Once it had automated product flow, it focused on using IT to coordinate its operations more tightly with those of its suppliers, leveraging its greater efficiency. With that smoother coordination, Wal-Mart could invest effectively in technology to plan the mix and replenishment of its goods. Finally, after integrating all these capabilities, the company built a data warehouse that uses information pulled from a range of sources to handle complex queries.

Kmart, by contrast, made a misstep in its IT investments that undermined their effectiveness. It invested in systems to improve promotions management before it had installed the supply chain systems necessary to handle fluctuations in sales volume. As a result, it was unable to capitalize on the more precisely targeted promotions. Many retail banks also made errors in sequencing. They invested in popular customer relationship management systems before they had built repositories of consistent and reliable customer data. Not surprisingly, the CRM investments fell well short of expectations.

Even with a sound plan for sequencing, firms have to consider the timing of their investments. They must ask themselves, in particular, one crucial question: Should we lead or follow IT trends? In making this decision, firms must understand that IT alone is almost never a true differentiator. As we saw with J.P. Morgan Chase's DealerTrack system, IT provides distinction only when coupled with other, less replicable advantages, such as scale or a strong brand.

A company should rush an investment, therefore, only when it's clear that the technology will advance the firm's business goals, enable true innovation that strengthens existing advantages, and be resistant to the leveling effect of imitation. In semiconductors, where superior chip design confers a major edge, Intel's investment in the development of the Pentium processor to replace the 486 proved essential to staying ahead of the competition. In semiconductor equipment, Applied Materials' aggressive investments in new manufacturing technologies also paid off, simply because its smaller rivals lacked the resources to rapidly imitate the advances.

Of course, it's hard to foresee whether an investment will yield innovative results. At the critical moment of decision, managers must be alert for red flags indicating that the investment will not differentiate the firm, such as widespread hype about the IT opportunity or a rolling wave of competitors considering it. Such signals of broad awareness suggest that any added profitability from the innovation will quickly dissipate. Companies must also know themselves: their taste for risk, their confidence that they can merge IT with other advantages to stay ahead of the pack, and their corporate track record in mobilizing people and processes to effect change. Where the indicators are weak, the best course is usually to follow, not lead.

Pursue managerial and technological innovations in tandem. History shows that technological innovations are typically of little use until managerial practices adapt to them. That was certainly true in the 1990s, and it remains true today. Wal-Mart, for instance, would have gained little from its investments in innovative information systems if it hadn't also redefined its relationships with suppliers and dramatically simplified the logistics practices at its distribution centers. Best Buy and Target would not have become leaders in retailing if they hadn't combined advanced IT with collaborative purchasing systems and advances in warehouse automation, cross-docking, and inventory tracking. Intel's IT investments turbocharged its productivity because they accompanied breakthroughs in materials technology and manufacturing processes. In all these cases, business managers led the way, reshaping their companies' processes and practices so that the full benefits of new information systems could be realized.

CRM in retail banking provides the cautionary tale. Banks hoped that the new systems for gathering and sharing customer information would boost cross-selling rates, reduce customer attrition, attract new customers, and increase profitability per customer. Yet despite massive spending on CRM, the number of products held by an average household at its primary bank has remained flat over the past three years. One reason for this, as already noted, was poor sequencing—the required customer data was not yet in place when the CRM systems came on-line. But many bank managers also failed to make necessary changes to their sales and marketing processes. The banks' business units continued to be organized around specific products and customer segments, hindering the integrated management of overall customer relationships. In addition, incentive structures for sales personnel undermined the kind of cross-selling that CRM theoretically makes possible.

The success of IT investments hinges on the particular characteristics of different industries and the particular practices of different companies. That fact goes a long way toward explaining the lack of correlation between IT spending and productivity that we've seen in recent years. For IT to fulfill its promise, users and vendors must deploy it thoughtfully, tailoring it to individual sectors and businesses and merging it with other product and process innovations. The challenge will be to use existing systems effectively while at the same time making targeted new investments that maintain competitive parity and, when possible, strengthen differentiation and buttress advantage. IT is not a silver bullet. But if it is aimed correctly, it can be an important competitive weapon.

Excerpted with permission from "The Real New Economy," Harvard Business Review, October 2003, Vol. 81, No. 10.

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Diana Farrell is the director of the McKinsey Global Institute in San Francisco.