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IT and firm profitability

Oct 01, 2009

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Research by Sunil Mithas

By the late 1980s there was computer on every desk. But that wasn’t necessarily a good thing, according to some researchers, who observed that there was hardly any visible workplace productivity improvement in services despite this initial influx of information technology. But IT has come a long way since then. While the productivity effects of IT have been obvious for some time, new research indicates that investing in IT may have more of an effect on a firm’s profitability than advertising or even R&D.

Most previous research into the profitability of IT used data collected prior to the mid-1990s. Many of those studies failed to detect the effect of IT on profitability. But in a new study Sunil Mithas, assistant professor of decision, operations and information technology; Ali Tafti, University of Illinois-Urbana-Champaign; Indranil Bardhan, University of Texas-Dallas; and Jie Mein Goh, a doctoral student at the Smith School, found that “new” information technologies, those deployed since 1995, have a significant positive impact on firm profitability.

The study uses proprietary, archival data from more than 400 global firms collected over a six year time period. The worldwide benchmarking survey was administered annually over this period to CIOs and other senior IT executives from large global firms, and collected firm-level IT investment data and other IT investment-related information. IT investments include all hardware, software, personnel, training, disaster recovery, facilities, and costs associated with supporting the IT environment, from servers and desktop machines to help desk staff.

Research conducted before the advent and widespread use of the Internet found no effect of IT expenditures on firm profitability. But this study found a strong connection. Unlike their older counterparts, newer IT systems seem to help firms improve their bottom line—which should dispel any doubts of the strategic value of IT investments, says Mithas.

But some kinds of IT projects will prove more advantageous than others. IT can be used to reduce costs by creating more efficient operations, or it can be used to support sales growth through customer satisfaction and customer retention strategies. Cost reduction had a negligible effect on the profitability of IT investments, the authors found.

But IT investments did have a marked positive effect on revenue growth. Companies that are able to take advantage of the power of IT to serve customers in increasingly more personalized ways are benefiting from the new value propositions IT has made possible: by allowing firms to create more customized, personalized offerings to their customers; by creating new marketing channels to promote awareness of the company’s product or service; and by improving the company’s ability to manage its customer lifecycle, leading to greater customer loyalty.

Mithas also found something that managers may find surprising: investment in IT has more of an impact on firm profitability than either advertising or research and development efforts.

“Most firms already know how to manage R&D and advertising to their best advantage,” says Mithas. “There is much more variability in firms’ abilities to manage IT. It is possible that a manager has implemented an ineffective IT program and has gotten his fingers burned. So next year he says ‘we’re not going to give resources to IT because that doesn’t work for us,’” says Mithas. “So there is variation in how firms are handling IT, and the benefits they are able to reap from it.”

IT investment seems to have a greater effect on the profitability of firms in the service sector than on firms in the manufacturing sector, though Mithas says that more firm-level evidence is needed to document the sources of profitability provided by IT.

The pathways leading to profitability aren’t always compatible, so knowing the impact of an IT investment can help managers make savvy choices among discretionary expenditures. “This is a question of interest to many in the business world—what really affects firm profitability?” says Mithas. “We can now be sure that IT does impact firm profitability, and our findings suggest that its effect is greater than that of R&D or advertising.”

“Information Technology and Firm Profitability: Mechanisms and Empirical Evidence” is a working paper and has been presented at several research conferences. For more information about this research, contact smithas@rhsmith.umd.edu.

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