MD 240 Information Technology Economics

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MD 240Information Technology Economics
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Key Ideas

• Micro-Economic (Production) Theories of Software
• Macro-Economic (Economy Level) Theories of IS/IT
  Investment
• Objective Managerial Decision Making
• Subjective Influences on Decision Making
• Common Managerial Decision Making Tasks
• Outsourcing as an Economic Strategy
• Questionable Theories About IT

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Micro-Economic (Production) Theories of Software
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Micro Economics of Software Production

• Software production in a for-profit company
• Software viewed as a manufactured product
• Typically, a high fixed cost of producing the
  first unit
• Once the first unit is produced, software can be
  copied for close to nothing, and thus has close
  to a zero marginal cost for subsequent units
  produced
• Motivation for Production
• Sale value
• value as a final good

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Micro Economics of Software Production

• Some Software Statistics
• 5 of software development is written for sale as
  a product
• 95 of software development is written in-house
  for internal corporate use
• most software is not driven by sale value
• most software expenditures are driven by the cost
  of maintenance of in-house software code
• Source Eric Raymond, The Magic Cauldron

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Micro Economics of Software Production

• Open Source Software Economics
• From a software product for sale viewpoint, it
  may seem irrational for developers to contribute
  to open source software projects
• Shouldnt self-interest lead them to make money
  off of it themselves?
• KEY DIFFERENCE Open Source Software is motivated
  by use value
• use value is economic value as a tool, as a
  productivity multiplier, as an intermediate good
  used to deliver other products and services

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Micro Economics of Software Production

• Open Source Software Economics
• Widespread use of open source software tends to
  increase its value, as users contribute their own
  bug fixes and feature enhancements
• If the payoff (in use value) is high enough for
  someone to fix a bug or enhance some feature,
  they will do the programming (SELF INTEREST)
• Sale value of this fix difficult to measure
• Sale value impossible to capture
• Fundamental Open Source economic decision
• Should I keep bug fix to myself?
• If I dont contribute the bug fix, Ill have to
  keep performing maintenance programming myself
  (BAD OUTCOME)
• Should I contribute bug fix?
• Open Source project can maintain the fix for
  me!!!!! (GOOD OUTCOME SELF INTEREST means
  programmer will donate the fix)

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Macro-Economic (Economy-Level) Theories of IS/IT
Investment
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Micro Economic Production Activities

• Software Production Activities
• ISD Planning Activities
• Strategic IT Planning
• Information Requirements Planning
• Resource Allocation
• Project Planning
• Systems Development Life Cycle (SDLC)
• Programming
• Implementation
• Maintenance

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What does all the IT Planning and IT Investment
get us at a Macro-Economic level?
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Macro Economics of IT Investment

• Uncertainty about the impact of IS
• Academics unsure about payoffs
• Business people unsure about usefulness
• Ex eWeek (8/13/2001) reader poll
• Is the world better off now with the PC than it
  was 20 years ago?
• YES 90
• NO 3
• DONT KNOW 7

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Macro Economics of IT Investment

• The Productivity Paradox
• Difficult to show that IT investments (on a
  national/macroeconomic level) lead to better
  outputs/productivity (on a national level)

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What do we know for sure about the impact of IT?
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Information Technology Economic and Financial
Trends

• Overall a General Improvement in Productivity
  Along Many (Micro-Economic) Dimensions
• Expanding power / declining costs
• Moores law - price to performance ratio
• Technically versus economically feasible
• Earlier IT uses were often direct substitution of
  IT to automate physical processes
• easier to measure
• Later IT uses involve satisfying intangible
  benefits
• difficult to access

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Can we explain The Productivity Paradox?
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Professors Attempts at Explaining the
Productivity Paradox

• Data and analysis problems hide productivity
  gains
• problems with our research methods
• Tangible IT dimensions (found in manufacturing)
  are not so common now easier to measure
• Intangible IT dimensions (found in service
  industries) are more common now difficult to
  measure
• IT productivity offset by losses in other areas
• problems with our research methods - were not
  controlling for these
• IT productivity offset by IT costs or losses
• Wasted time
• were not accounting for how people implement
  and use IT -- effectively or ineffectively

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Explaining the Productivity ParadoxPossible ISD
Planning Problems

• Software development problems
• Software maintenance
• Incompatible systems
• Upshot The Productivity Paradox may result from
  a combination of (1) actual problems in ISD, and
  (2) problems with professors research methods.

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Professors Find It Difficult to Correctly
Measure IT to Study The Productivity Paradox
What Does This Mean ForMIS Managers Decision
Making?
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Objective Managerial Decision Making for IT
Investments
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Objective Decision MakingFour Types of IT
Decision Making Methods

• Financial Approaches
• Consider only those impacts that can be
  monetary-valued
• Multi-Criteria Approaches
• Consider both financial (monetary) impacts and
  non-financial impacts (those that cant easily be
  expressed in monetary terms)
• Ratio Approaches
• Use ratios to provide metrics that facilitated IT
  investment evaluation
• Portfolio Approaches
• Apply portfolio/grid analysis methods to plot
  several investment proposals against decision
  making criteraia

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Objective Decision MakingProblems of IT
Measurement That Affect Managerial Decision Making

• Problems of IT Measurement
• How to measure intangible outputs of the ISD
• How to evaluate the portfolio of financial and
  non-financial outputs and impacts
• reducing this portfolio into a number you can use
  for reasonable decision making
• How to ensure a reliable supply of the outputs
  promised by the ISD

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Objective Decision MakingEvaluating IT
Benefits and Costs

• Value of information in decision making
• (Net benefits with information) (Net benefits
  without information)
• Evaluating automation by cost-benefit analysis
• NPV capital investment methodology
• Evaluating IT infrastructure
• Benchmarks
• Metrics
• Evaluating IT performance
• Total Cost of Ownership (TCO)
• Service Level Agreements (SLA)
• Insight each is conceptually useful, but often
  each has problems with operationalization

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Objective Decision MakingDifficult to Evaluate
Intangible Benefits

• Assume monetary values for Intangibles,
• OR
• Use concrete indicators
• Estimate through proxy variables assumed to
  result from IT
• Solve for an unknown
• Ask Can shortfall in NPV analysis be made up for
  by IT?
• Prevent competitive disadvantage
• Opportunity costs assumed to result from not
  implementing IT
• Insight Were replacing old assumptions about
  Intangibles with these new assumptions

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Objective Decision MakingEvaluating IT
Infrastructure

• Metric benchmarks
• Direct comparison with others along real
  dimensions
• Maybe partner with a (noncompetitor) company to
  do the benchmarking
• Problem are we using appropriate measures? are
  managers interpreting them correctly?
• Best practices benchmarks
• Common request of managers Tell me who has the
  best practices in my industry!
• Problem difficult to define who is best?

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Objective Decision MakingEvaluating ISD
Performance

• Total Cost of Ownership
• TCO is a formula for calculating the cost of
  owning and operating a PC. The objective of
  calculating TCO is to get a more accurate
  cost-benefit analysis, and to reduce the TCO. TCO
  includes costs of
• Hardware
• Technical support
• Maintenance
• Software upgrades
• Help-desk support
• Peer support

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Evaluation of Software Packages
Identify/Evaluate/Summarize Intangible Benefits

• Value Analysis
• Try (to identify value) before you buy
• Information Economics
• Scoring methods/Weighted Scoring Methods
  (Additive, Multiplicative)
• Flexible for decision-making
• Different decision weights can be incorporated
  easily
• Different variables can be incorporated easily
• Management by Maxim for IT infrastructure
• 5-step method for determining appropriate IT
  infrastructure investments
• Real Options valuation of IT investments
• Hot topic among professors
• Almost impossible to operationalize for real
  problems

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Subjective Influences on IT Decision Making
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Subjective Influences in IT Decision Making

• Managers often make substantial investments in IT
  projects by relying on intuition when evaluating
  investment proposals rather than concrete
  decision making methods (Gray and Watson 1998)

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Subjective Influences on IT Decision Making

• FUD (Fear, Uncertainty, Doubt)
• A marketing technique used to instill fear in the
  minds of managers considering whether to switch
  from your software to a competitors software
• Basic message It is very risky to choose our
  competitors software. Stick with us. Our next
  soon-to-be-released version of our product is
  going to be so much better anyway!!!
• Debunking FUD
• Dont believe the marketing messages of software
  companies
• Learn the capabilities of software and hardware
  technologies yourself

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Subjective Influences on IT Decision Making

• Shifting Standards (SS)
• Get many software standards out of the door as
  quickly as possible
• Quickly create upgraded versions of open
  standards for software so that nothing is open
  at all,
• No 2 companies have the same sets of supported
  features from the standard
• Implicit product differentiation
• Problems
• Difficult for managers to understand which
  feature are truly crucial
• Lock-in to an open-but-proprietary platform
  inter-operability problems
• Overly complex systems
• Debunking Shifting Standards
• Only adopt new software standards supported by
  multiple vendors
• Be very conservative about upgrading software
  dont upgrade often
• Monitor Open Source Software tried and tested

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Subjective Influences on IT Decision Making

• Runaway Projects
• Runaway Project Project requires much more money
  and time than planned, regardless of whether it
  is ever completed or used.
• Losses from runaway projects can often be many
  millions of dollars
• Managers are often very hesitant to terminate
  failing IT development projects
• Want to avoid failure, embarrassment of failure
• SUNK COST EFFECT Weve spent so much money on
  this already, wed better just keep spending and
  hope that it eventually succeeds.

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Common Decision Making Tasks of IT Managers
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Common IT Manager Tasks

• Management control
• need an estimate of total IT costs
• Allocating shared costs
• need to spread costs to departments and customers

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Common IT Manager Tasks Accounting for Costs

• Accurate measure of IT costs
• Charge users for IT investments in a way that
  doesnt work against organizational goals
• Chargeback/Chargeout
• Outsourcing as an economic strategy

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Common IT Manager TasksOverhead Cost Allocation

• Unallocated cost center
• Very common method
• Expenses become overhead
• Ex consulting firms often bundle all computer
  expenses, calculate their percentage of total
  expenses (often 40-70), and then bill to
  customers through overhead added on to labor cost
  of contract
• Downside get little idea of what is being used
  by whom
• Downside IS becomes a free good leading to
  free rider problem -- users may use more than
  they rightfully need
• Upside IS becomes a free good, meaning there is
  no cost if people want to experiment with
  creativity and innovation

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Common IT Manager TasksUse-Based Cost
Allocation Chargeback Systems

• Standard Chargeback
• Based on estimates of actual costs and usage
  levels
• Difficult to do, difficult to get users to
  understand
• Behavior-Oriented Chargeback System
• Determine objectives
• Determine appropriate measures
• Implement and maintain the system

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Common IT Manager TasksUsage-Based Cost
Allocation Chargeback Systems

• Possible objectives of behavior oriented
  chargeback
• Efficiency doing things right
• Reduce amount of wasted resources
• Reduce use of scarce resources
• Encourage use of off-peak hours (load leveling)
• Discourage false economies and suboptimizing
  behaviors of individual units that harm the
  organization as a whole
• Effectiveness doing the right things
• Encourage IT usage consistent with organizational
  goals
• Encourage experimentation, technology
  assimilation, learning
• Encourage more productive use of surplus
  resources
• Encourage data sharing across organizational units

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ISD Outsourcing as an Economic Strategy ...
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Outsourcing as an Economic Strategy

• Core competencies
• Maybe you can say IS is not ours, and is not
  (and never will be) key to our distinctive
  competence
• Then consider
• Which sources are less expensive
• How much control is needed

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Outsourcing as an Economic StrategyOutsourcing
Trends

• Off-Shore Outsourcing
• Outsource IT development and/or IT-based services
  to companies in foreign countries (e.g., India)
• Storage Outsourcing
• Physical hard drive storage and transfer capacity
  for storing computer files
• Application Outsourcing
• Application Service Providers (ASPs)
• Internet-based exchanges, portals, etc.
• Business Process Outsourcing

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OutsourcingTheoretical Advantages

• Possible to know exactly what your IT needs are
  costing you and your end users
• You receive a bill that tells you the costs
• Hardware economies of scale
• Staffing economies of scale
• Specialization
• Tax benefits

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Outsourcing Possible Drawbacks

• Limited economies of scale
• Staffing problems
• Lack of business expertise
• Contract problems
• Internal cost reduction opportunities
• Clemons (2000)
• Shirking vendor deliberately under-performs
• Poaching vendor develops a strategic application
  for you (using your money) and then re-sells it
  to others at a low cost
• Opportunistic Re-Pricing or Holdup vendor
  changes financial terms or overcharges after
  youve signed a contract and are stuck with them

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Some Questionable and Unproven Theories
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The New Economics of IT

• World Wide Web (WWW)
• Network effects The more people in the network,
  the higher value people assign to their own
  participation in the network, the more people
  join
• Previous network examples railroad networks,
  telephone networks, Microsoft Office/Windows/DOS
• Increasing returns
• Higher customer value implies higher monetary
  value to reap from system
• Profitability rises more rapidly than production
  increases

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The New Economics of ITIncreasing Returns

• Advantages of Increasing Returns
• Higher profitability
• Network effects
• Lock-in effect

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The New Economics of ITIncreasing Returns

• Management Strategies Under Increasing Returns
• Build a large customer base through low prices
• Encourage development of complementary products
• Use linking and leveraging

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Problems with the Idea of Increasing Returns

• Much more expensive to build these networks than
  some people expected
• Marginal cost of giving away IT product
  (acquiring customers) is pretty high
• Capacity is expensive to add
• Value of human interactions in these networks has
  been pretty low
• Typical chat room Hi, is anyone there?