The Real Story Behind the IT Revolution

By Nancy Moffitt

Wharton’s Lorin Hitt studies the impact and implications of the Computer Age

Is computer technology a giant black hole that drains corporate resources, demands ever-rising levels of expensive support staff and returns only negligible productivity increases?

Is the Internet driving down corporate profits as companies are forced to drop prices in order to compete in an arena where consumers can easily search for the lowest price?

Do e-commerce and the Internet mean an end to traditional competitive issues?

It’s questions like these that have intrigued Lorin Hitt since the days he put himself through college at Brown University writing computer test code and software. Hitt, assistant professor of operations and management, studies the evolution of e-commerce, its influence on corporate performance, and the effect of information technology on productivity, among other trends. And in the largely uncharted waters of the IT revolution, it is information many observers believe can’t be disseminated fast enough.

As corporate America’s investment in and dependence on computer technology has mushroomed in recent years, some industry experts have called its value into question. A simple but provocative study by Morgan Stanley’s chief economist Steven Roach first drew attention to this so-called “productivity paradox” in 1987, arguing that the tremendous increase in computerization has in fact had little effect on economic performance. Hitt, somewhat skeptical of such arguments, began searching for answers in the early 1990s.

After earning his bachelor’s and master’s degrees from Brown, Hitt worked briefly as an engineer, then spent three years as a strategy consultant for Oliver, Wyman & Co. where he focused on quantitative computer- based data analysis for the financial services industry. After growing weary of a near-constant travel schedule, he decided to pursue his PhD at MIT’s Sloan School of Management, where his earliest research on IT and productivity began. Hitt joined Wharton in 1996.

What has his research on computers and productivity revealed? Working with Erik Brynjolfsson of MIT, Hitt examined data from 599 firms across a broad spectrum of industries, calculating productivity levels and growth from 1987 to 1994. Hitt and Brynjolfsson estimated the relationship between changes in productivity and changes in computerization and concluded that companies that invested heavily in computers were in fact more productive than their industry competitors. Further, these returns were two to five times greater over a seven year, versus one year, period. “Our results suggested that computers increase productivity both directly and by making new types of work structures possible over time,” Hitt says.

But despite this overall positive trend, Hitt’s research found huge variations across organizations: some spend aggressively on IT with great success, while others realize little benefit. What explains these differences? Hitt found that companies that combine decentralized decision-making processes, training, investment in employees, and customer-focused strategies are more productive technology users. Such companies, he notes, have many of the characteristics of “new organizations,” a buzzword coined by management guru Peter Drucker to describe a less hierarchical corporate structure.

The bottom line: firms that couple IT investments with work practices that leverage the skills and education of their employees are about 5 percent more productive than those that don’t. “Over the next decade, these decentralized and empowered organizations may begin to pull away from their industrial age counterparts … as they are better able to exploit increasingly inexpensive information technology,” Hitt says. “These results suggest that it is becoming more important to organize in ways that leverage the value of IT.” He warns, however, that companies should never assume that productivity gains are but a new computer system away. In fact, simply plugging in new technologies without simultaneous organizational change can actually have the opposite effect.

Researchers at MIT, for instance, studied one major consumer products company that spent millions on computerized flexible manufacturing technology to boost productivity at an under-performing plant. The new system replaced a traditional production line with individual manufacturing cells designed to allow employee teams to work on many different products with very little set-up time. But after the new equipment was in place, productivity actually fell. Workers, it seemed, were uncomfortable with the change and quickly learned to set the new system to replicate their old production methods.

Facing this unexpected paradox, the company was forced to re-examine its processes. Officials ultimately overhauled production incentives, paying employees based on team output rather than individual piece rates. Workers were also sent to training for basic problem solving and other “softer” skills and were given more authority to set their own production schedules and expectations. Over time, the plant become one of the company’s most productive, Hitt says.

“Until very recently, the classic way of thinking about technology was that you put it in, and you get cost savings. Companies thought ‘I’ll put a new machine in, and I’ll be able to get by with fewer operators and tenders.’ Or, ‘I’ll automate my branch so I’m going to have fewer tellers.’ That’s the old story. It turns out that staff reduction is one possible strategy, but you don’t get all the benefits you would get if you stepped back and decided to redesign the way your organization works,” Hitt says. Why do so many companies remain wedded to a traditional, hierarchical structure? A plausible reason, Hitt says, is that major organizational changes are time consuming, risky, and costly. In many cases, they require throwing out practices that have been successful for decades in favor of relatively unknown, radically different ones.

But Hitt suggests companies reconsider their view of such change. Instead of warily regarding it as a cost, firms should adopt the view that major organizational change is a necessary long-term investment in a new asset.

e-commerce: What’s it all about?

What about e-commerce and its effect on corporate profits? Are companies’ profits threatened by customers’ ability to search online for the lowest possible price? Another study co-authored by Hitt provides some surprising answers to these questions. In the study “The Nature of Competition in the Electronic Markets: An Empirical Investigation of Online Travel Agent Offerings,” Hitt, Wharton’s Eric Clemons and Carnegie Mellon’s Il-Horn Hann examined the growing concern that customers’ unlimited ability to search for the lowest possible price will diminish profits as prices converge. The researchers studied one of the fastest growing and most competitive online markets: the online travel agency industry, in which consumers are able to search for airfare deals and bid on unsold tickets in online auctions.

Hitt and his colleagues found that despite these new competitive realities, prices varied by as much as 25 percent for the same airline ticket. “Thus, we found no evidence that prices have converged in this market,” Hitt says. Why the marked difference in prices? While it’s often argued that consumer search costs disappear on the Internet, Hitt’s study suggests that they are simply replaced with other transaction costs: the time it takes to sign up for an online agent, learn a new interface and enter flight preferences into multiple online sites. Faced with these tasks, most consumers choose not to spend the time necessary to find the entire range of market data. And online travel agents are still able to offer vastly different ticket prices without being put out of business by their rivals.

Another interesting finding: online travel agents sometimes use complicated web site designs to stall customers in their quest for the lowest possible price. A very complex interface design may be coupled with lower ticket prices under the assumption that a more computer-savvy customer will search harder for the best bargain. A very user-friendly interface, meanwhile, may be paired with high-priced tickets. The study also found that online travel agents tend to target specific types of travelers, thus differentiating their product.

What does this research tell us about e-commerce in general? A key finding is that many tried-and- true competitive strategies, such as product differentiation, still apply. Hitt’s research also suggests that the Internet is far from a perfect competitive market. Customers may be willing to seek out different web sites in search of the best price, but they also seem to expect much faster results online. Hitt acknowledges that the Internet has brought many changes such as lightning-fast cycle times, an abundance of customer data and the ability for customers to interact with one another. But many business fundamentals have not changed.

“Consumers are willing to drive to another store to check a price, even if it takes another 30 minutes,” Hitt says. “But no one is willing to sit and wait 30 minutes online to check a price. Preferences have changed in ways that some of the advantages of online channels have been dissipated because consumer expectations are that they will get faster, better service. So companies that will have long-term success are those that can play the old-style competitive games that have worked in the past: differentiating your product, locking in customers. All the things that mattered in the old economy matter in the new economy, they just look a little different.”

The Real Benefits of PC Banking

The financial services industry, particularly retail banking, has expanded its embrace of computer technologies for the perceived cost-savings that electronic distribution can offer. Today, most banks offer a variety of online products that allow customers to check account balances online, perform transfers, withdrawals, and pay bills. Banks hope such options will save them money, cutting down on face-to-face transactions between customer and teller. And some studies have borne this out: research by management consulting firm Booz-Allen & Hamilton, for instance, reported that the marginal cost of an online banking transaction is four cents, versus $1.44 for a teller-based transaction.

But Hitt’s research indicates otherwise. “Online banking in the 1980s was a miserable failure because there wasn’t an Internet and modems were expensive. Now the technology is cheap, and many banks have pursued the idea of offering online banking in order to cut costs,” he says. “But it’s not as simple as it sounds. We’ve found that, in its present incarnation, it’s very difficult for banks to realize these cost savings, especially when such a small number of customers are using these technologies.” Why? A study authored by Hitt and Harvard’s Frances X. Frei found that online banking offerings are largely the same, making it difficult for banks to stand out from the crowd. Savings are further eroded by the high cost of creating and supporting the infrastructure.

But in spite of this somewhat grim outlook on cost savings, Hitt’s research reveals other clear advantages to online banking which, to date, banks have largely not exploited. In their study, Hitt and Frei worked with seven banks with assets from $30 billion to $200 billion. The research looked at PC banking as an example of recent IT investment decisions, examining initial and ongoing costs, project timelines, reasons for the investment, and outcomes. Hitt and Frei also collected a large sample of customer records that shed light on demographic and product usage differences between customers who use PC banking and those who do not.

Their findings? While at present it has drawn only about a three-percent customer base, online banking was found to be disproportionately attractive to high-profit customers. Hitt and Frei found that customers who use PC banking are consistently wealthier, more likely to be married and own a home, and are two to six years younger than those who do not. They also tend to use more banking products and have larger asset balances. Thus, PC banking’s primary value may be as a tool to retain a small but growing segment of high-profit customers.

Knowing this, banks have some new opportunities. Rather than focusing on the perceived cost savings of PC banking, “a bank could design products for this segment, create promotions and other things that are intended to target this particular group. All the while, they have a delivery channel for launching it,” Hitt says. A small number of banks have already begun moving in this direction, he says.

Hitt believes the banking industry’s experience with online banking portends a larger trend: like many e-commerce ventures, PC banking’s profitability will likely decline long-term as more and more people own computers, gravitate online and the Internet population begins to reflect the overall U.S. population. “Today, Internet users are seen as a desirable group of high-income people with technical skills. But this is changing, and that’s going to have implications for what these businesses are going to look like five years down the road when they are not serving a nice, profitable demographic slice, but instead are serving everyone,” Hitt explains. Who will prevail? Companies that can move quickly to exploit current market forces, as well as those that, long-term, can make the transition to products or delivery systems with broader appeal.

Another general lesson to be learned from the banking industry’s forays into online banking: pursuing cost savings via technology is not always the right strategy. “There’s little competitive advantage to be gained by spending more on technology and more aggressively cutting staff – these moves are easily copied by competitors. A more promising strategy is to use technology to create value for your customers in new ways and to create new efficiencies by redesigning your organization.”

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