When IT really matters to business strategy

John L. Cecil and Eugene A. Hall

Information technology (IT) is a field that has changed radically in the past five to ten years. It has moved from being a tool of incremental operational improvement to being a means of achieving fundamental competitive advantage. It is changing the shape of industry. By the mid-1990s most industries will be information intensive. Viewed from the perspective of customer value, manufacturing companies will become service companies and service companies will increasingly become information companies - all assisted and in fact driven by the potential of information technology and systems (IT/S). IT has advanced from the back end ofthe business system to the front end - from the accounting department to the production floor to the selling function to customer service. In many cases, it has become the product itself, the aspect of a relationship with a company that customers value most. It has also become the link between one company and others. More than ever, IT/S is having a substantial and growing impact on operational effectiveness. With the applications now made possible through new technologies, unit processing costs can frequently be cut in half and transaction error rates reduced by 90 percent or more. In the future IT/S will also make its mark on organizational effectiveness. Information systems will lead to improved measurement, more cohesive incentives, and substantially better communications and coordination. As a consequence, organizations will be flatter, more differentiated, more accountable, and more responsive. However, IT/S is not a panacea. In some cases, technology leadership may be very costly and deliver no advantage because companies invest in technology too early or in the wrong technology. Or IT/S investments may cause major unanticipated implementation problems. Top managers are, therefore, often

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"damned if they do, damned if they don't," and so are often frustrated by the inability of their companies to move forward.

The following article describes a framework for deciding when, | why, and how to use IT/S. It argues that the use of IT/S must be integrated into the overall design of business strategy and suggests how to do that. i Carter F. Bales McKinsey & Company Now that there is wide recognition of the central importance of information technology* to the competitiveness of individual companies, the belief has sprung up that, if a company is not using the latest technology, it is somehow missing out. Examples of companies using information technology to reduce costs, speed response times and improve accuracy are well documented. Even more appealing are the almost magical success stories of companies using information technology to change the nature of competition and gain sustainable competitive advantage. The same "classic" cases are usually trotted out - correctly or incorrectly - as evidence of how information technology can increasingly create competitive advantage: among them, Merrill Lynch's Cash Management Account, American Airlines' SABRE reservation system and the computerzied links to customers and suppliers set up by American Hospital Supply. Oft-repeated stories of "big wins" such as these have caused many companies to make significant investments in information technology in the hope of creating "strategic systems" that provide a competitive edge. Actual management experience, however, has been mixed. In general, so-called "strategic" information technology expenditures have not created competitive advantage. Companies in the property and casualty insurance business, for example, have invested hundreds of millions of dollars in automat* By information technology we mean those technologies that allow companies to capture, store, manipulate and distribute information throughout their operations. These include large-scale information systems, telecommunications, voice processing, image processing and expert systems. Our fmdings primarily concern the use of information technology to provide other products and services, rather than the business of providing IT products themselves. Author's note. We would like to acknowledge the assistance of Kevin Bradicich and Michael Miron who were critical in developing the concepts discussed in this article.

AUTUMN 1988

ing their back offices. Often these projects were justified by a belief in future profit improvements that would result from cost savings if prices remained stable. Costs were indeed reduced, but all major competitors implemented similar systems. Thus, no competitive advantage was gained, and each competitor was forced to lower its prices in an effort to maintain market share. The rate of return on these projects fell substantially below expectations. In some cases, misguided technology investments can be disastrous. Most of the major money center banks have invested in electronic payment systems designed to provide a speedy, low-cost mechanism for funds transfer. These systems have high fixed costs, principally from development, and very low incremental transaction costs. Each of the banks investing in this application assumed that its competitors would not invest because of these high fixed costs. If true, the lone bank that did invest would have a unique product and a very profitable business. Virtually all of the major banks built these systems, however - a set of decisions that led to gross overcapacity, pricing at marginal costs and industry losses in the hundreds of millions of dollars. Given disappointments such as these, an alternative school of thought has arisen, which suggest that competitive advantage through information technology may, in fact, be too elusive to plan for. In this view, most applications of information technology do not lead to competitive advantage and may even be poor investment decisions. Beyond these confiicting viewpoints, an additional problem surrounding discussions of information technology has been an overly narrow focus on historical examples. Commentators have made only limited attempts to prescribe appropriate strategic moves with information technology. As a result, businesses are often left with interesting case studies of "what others did," but only limited insight into how to identify the technology strategy best suited to their own situations. Understanding the questions Given the divergent viewpoints and the generally descriptive nature ofthe debate, how should a business use information technology? More specifically:

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H How should managers determine the probable payoffs of major investments under consideration? Will they be able to capture the benefits? If so, for how long?
]

T I More broadly, how can they use information technology to improve their competitive positions? Will competitors be able to copy what they have done? What will prevent them from doing so? ; ^ And, lastly, what role should information technology play in their overall business strategies? Our experience in working with clients across a range of industries suggests that it is possible to be prescriptive in determining how and when to use information technology. First of all, we must recognize that "success" does not always mean creating competitive advantage directly with information technology where none existed before. Such instances are relatively rare. Rather, using information technology to leverage already existing strengths, to maintain existing competitiveness, or to avoid inappropriate technology investments can have a profound impact on company performance. Furthermore, managers must understand that the role that IT plays differs depending upon the industry, the specific types of IT investments available to competitors, and the nature and degree of business changes that accompany these investments.
- - . - -J..

To determine how information technology fits within a company's business strategy and to understand the likely payoff of any given IT investment, managers need to answer the following questions, which highlight three very different roles for IT: 1. Do the initiatives under consideration or available to a business represent essentially "standalone" information technology applications'? Investments that simply introduce information technology without significantly altering or leveraging other elements of the business do not create competitive advantage. At best, these applications (typically, the automation of existing processes) are needed simply to stay abreast of competition; at worst, they may actually reduce profitability. To get the most out of these investments, careful selection, timing, and execution are key. So, too, is the ability to avoid technically interesting projects with limited business benefits.

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2. Can a company use information technology to leverage other, non-technology-based competitive advantages such as economies of scale or product differentiation? If so and if executed effectively it can be assured of a payoff on the investment and should be able to improve both performance and competitive position. Exploiting these opportunities often requires integrating activities in new ways across products, business functions, or geographic areas - not simply automating existing processes. 3. Can information technology be used to change fundamentally the way business is conducted? If so, powerful changes in competitive position and industry structure can result. These investments must be accompanied by major business changes, except in a limited number of rare, but obvious, situations. The answers to each of these questions will provide managers with the necessary framework for thinking through the possible roles of information technology in their business strategies. "Standalone" applications Most information technology investments today are "standalone" applications: that is, applications which automate or improve some aspect(s) of an existing business system. These initiatives may dramatically change product/service features, reduce costs, or improve service, but they do not require broad changes in the business. Although they are often critical to maintaining a business's competitiveness, they do not lead to competitive advantage because they can be replicated by competitors. (The only exceptions here are applications that, though replicable, leverage other forms of competitive advantage such as scale. In such cases, they may extend existing competitive strengths.) Improve business performance "Standalone" applications can improve business performance by increasing the effectiveness of specific operational functions. Take, for example, the loan applications processing function of credit card companies. Usually, paper applications are mailed to a processing center where clerks edit the information and key it into a computer. Applications are then stored in paper form, while calls are made to verify employment and credit history. Evaluations, which may include some form of credit scoring, are made based upon the information obtained, and approval or turn-down letters are sent. The whole process takes several days.
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Exhibit I Impact of technology on costs of key functions

Credit card operations
New accounts processing cost index 100 '

EXAMPLE
other seiected financiai functions 100% = = 10

\ I l l l l l l l l l l l\

40% <25%'cost reduction

t \ \

50

III
Current process Applications processed and stored in paper form Coding and editing done by hand Calls to obtain or confirm information made manually Credit-scoring models updated infrequently; frequent manual overriding of system New process Image capture and retrieval of applications reduce paper handling Image capture/ expert systems reduce manual coding Automated calling system places calls Reliable and dynamic scoring systems aid credit decision

25-50% cost

30% >50%eost reduction

Recently, a major financial services company announced the implementation of new technologies that are expected to lower costs by as much as 50 percent within two years, improve turnaround time, and enhance the consistency of approval decisions (see Exhibit I). Image capture technologies will reduce the amount of manual coding and eliminate expensive paper filing and retrieval. Automated calling systems will improve the productivity of outbound calling by eliminating busy and no-answer calls. Expert systems will boost the quality and consistency of credit decisions by ensuring the best decision-making capability is available to all analysts. Indeed, when we looked at a number of other financial functions in the credit card industry, we found that the improving capability and ever declining prices of these technologies will allow similar dramatic cost reductions and service improvements. Businesses in many other industries have also used standalone applications to improve the performance of specific functions. A large insurance company's installation of image processing equipAUTUMN 1988

ment in its applications processing operation will result both in the elimination of 160 paper filing and retrieval jobs and in net cost savings of $15 million per year. A large bank's automated calling system, which eliminates busy and no-answer calls, has more than tripled the productivity of the credit card collections department. Mrs Fields Cookies has installed a PC-based expert system in each store to advise managers on store operations. Based on historical data from the specific store, the system recommends a detailed staffing schedule and the exact number and mix of cookies to make in 15 minute intervals. Information technology can also improve business performance by linking functions to improve their coordination, or by Unking a company to its suppliers or customers in ways that increase responsiveness or reduce costs. For example, one packaged goods company has developed a portable system that automates salesforce activities and connects the salesforce to manufacturing and distribution. The system has not only improved responsiveness, but has also - based on clerical savings and improvements in sales productivity and product distribution - raised the return on sales by about 1 percent. Stafford, a clothing manufacturer, has used electronic data interchange with customers to cut inventories by 20 percent, while increasing sales by 60 percent. But... technology is replicable As noted, these types of "standalone" IT applications do not lead to sustainable competitive advantage. Most of the specific technologies and applications are provided by external vendors since development costs would be prohibitive for any one user. Even largely internal applications, such as large systems development efforts, can be acquired externally from vendors, which spread costs across competitors. The net effect is that, even if these applications could directly create major cost or service advantages, the benefits can be copied and do not lead to sustainable competitive advantage. Because the underlying technology is often widely available, competitors with comparable scale can replicate each new application, and smaller competitors can often gain access to them through independent vendors. A case in point is a western US bank which developed its own system for automating the origination, secondary marketing and
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servicing of mortgage loans. It quickly found that abandoning this system in favor of one that was vendor-provided would cut its operating cost by two-thirds. The extra "bells and whistles" that it had developed for its own system were not worth the additional cost. In fact, since the cost of single-user, internally-developed systems based on widely available technology is much higher than that for most externally-acquired systems, companies that develop applications that could be purchased externally put themselves at a cost disadvantage. Even so, it might at first appear that large-scale competitors might have an advantage over smaller competitors. However, most standalone applications have relatively low minimum efficient scale (i.e., the point where costs stop declining significantly with increases in volume) so that minimum costs can be attained even by competitors with small market shares. Moreover, the overall trajectory of IT costs points toward rapidly declining minimum efficient scale. Where minimum efficient scale remains high, smaller competitors may band together to create a shared utility, which neutralizes the scale advantages of a larger company.
" " (

For example, there are significant scale economies in image processing today, with unit costs at 25,000 images per month costing about four times as much as at 200,000 images per month. However, by 1995 the cost of processing 25,000 images per month is expected to be nearly the same as that of processing 200,000 per month.
- ' ] .

"Homogenization" of competitive positions

'

'

The non-exclusive nature of these standalone applications will often allow competitors to meet or exceed the service levels of existing market leaders at substantially lower costs. As a result, IT will tend to reduce long-standing differences between competitors (i.e., to "homogenize" competitive positions) by driving the cost and service quality of competitors toward similar levels. This has already occurred in the brokerage industry, where discount brokers are using IT to offer, at much lower cost, many of the services that a full-service broker has traditionally provided. The net impact of IT-driven homogenization is typically a reduction in total industry cost and profitability. In a competitive industry, cost savings will not be captured by the company applying the technology (except in the short term before others copy the application). Instead, they will be passed on to customers. In addition,
AUTUMN 1988

IT-driven homogenization tends to intensify the severity of price competition by minimizing other forms of differentiation. The benefits of standalone IT investments will be captured only by companies that already have a competitively defensible position on another dimension, such as strong customer loyalty, which allows them to retain the benefits - usually cost reductions - of these applications. This is especially important when all competitors seek to replace labor-intensive, high incremental-cost, differentiable operations with automated, high fixed-cost, more commodity-like operations. The result, which most ofthe major money center banks experienced in their adoption of electronic payment systems, is an erosion in prices to the point where they approach the level of incremental costs. This, of course, eliminates profitability for all competitors. Superior execution as strategy None of this suggests, of course, that IT investments can be ignored. At minimum, companies will need to make them to avoid losing ground competitively. More often, management must understand the likely extent and pace of homogenization and take compensating actions. With respect to the use of IT, the best "strategy" in these situations is superior execution. Investments in new applications should be made selectively, consistent with overall competitive positioning and careful attention to timing, and executed effectively. Consider, for instance, the private banking support system implemented by one high-service regional bank. This system both provides customer information for more personalized service and triggers actions that support the customer relationship. This service improvement application will become less expensive to implement over time, and competitors will be able to replicate it. Still, the bank's high-service position requires it to be among the first to adopt the technology if it is to avoid erosion in its market position. By contrast, IT applications that are primarily intended to reduce costs should be timed to minimize total life-cycle costs, not to duplicate competitors' adoption of similar uses of IT. The same initiatives may not be equally cost-effective for all competitors. The collections department of one credit card company realized significant cost savings by implementing an automated calling
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Exhibit 1! Timing of cost reduction applications based on overall cost minimization

Automated calling system
Present value of costs 50$ thousands

EXAMPLE
Business A

40

Opportui^cost of fcvonfl beneflts

Source: Inten/jews; leam analysis

system because its typical calls to residences experienced only a 35 percent live contact rate. By eliminating no answers and busy calls, it was able to get an immediate 150 percent productivity benefit. Another credit card operation checks credit references and verifies employment. Since it calls mostly places of business during business hours, its live contact rate was over 85 percent. Thus, the benefits of adopting the same automated calling system will not be justified until the price/performance ofthe system improves. (Exhibit II illustrates how this improvement should be calculated: by weighing the present value of the cost of adopting the technology against the opportunity cost of not adopting it.) In either case, superior ability to execute can maximize the benefits from the application. For cost reduction applications, superior execution skills can lower adoption costs. For service enhancement applications, they can increase the value received from the new
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11

Exhibit III

Impact of superior execution

ILLUSTRATIVE
Cost-reduction applications Service enhancement applications

Average capabilities

Cost at which enhancement is justified

Time

Time

application by shifting the cost curve downward and, thus, permitting the application to be adopted earlier (see Exhibit III). Leverage existing business strengths If using IT in standalone applications to reduce costs or improve service does not often create competitive advantage, how then can a company use IT to improve its competitive position? One answer lies in using information technology to leverage its existing, nontechnology-based sources of competitive advantage. The most common forms of advantage that can be leveraged by IT are scale economies, product differentiation and unique institutional skills. Enhance scale IT can be used to exploit scale economies in four basic ways. The most obvious approach is to use IT to reduce total costs or improve service through fixed-cost investments. Competitors will be com-

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pelled to follow; but because these types of investments increase the share of total costs that are fixed, they will provide a cost advantage for industry share leaders. For example, a major industrial goods manufacturer has strengthened its competitive position in its core business by adopting its own CAD/CAM system. Its competitors also need such systems because this new technology shortens product life-cycles and reduces development costs. But, unlike many other IT applications, CAD/CAM systems require large fixed-cost investments. Thus, as the market share leader, this company has created an IT-driven advantage by virtue of lowering its total development costs per unit produced.
' '" I

IT applications that improve performance through fixed-cost investments will affect overall competitive position in situations where both the impact on customer value or cost reduction is substantial and only a few competitors have sufficient market share to achieve minimum efficient scale on the IT application. As the above example indicates, these situations do arise. However, management should be aware of two cautions. First, for many IT applications, minimum efficient scale can be achieved with relatively small market share, and technology generally pushes toward lower minimum scale. Second, the implementation of high fixed-cost, large capacity applications can be risky. If too many competitors make such investments, their combined actions may produce excess capacity. Competitors may then price off marginal costs (and below full costs) to increase utilization. If so, the net result will be that competitors cannot recover their investment costs. This is what occurred in the electronic funds transfer example described previously. A second way to exploit scale is to use IT to schedule and coordinate complex but predictable demand more effectively. This improved scheduling can permit a company to reduce buffer inventories and capacity. Increasing the utilization of these fixed costs enhances the company's scale advantage. A major packaged goods company faced the problem of distributing enough of its perishable food product to meet highly volatile consumption pattems. The worst thing it could do was to run a promotion and be unable to supply enough product. Consequently, it had established multiple facilities around the country and had regularly overstocked them with inventory to avoid being caught short.

A U T U M N 1988

' - -: :

'

I3

Although such overstocking obviously caused waste (underutilized facilities, inventory breakage, higher unit costs), the company was afraid to consolidate its distribution network for fear of losing sales. Recently, however, it constructed an IT-based system to improve sales forecasting by using historical information to analyze complex demand swings under different kinds of marketing plans. The system showed that demand was actually quite predictable. This realization, in turn, allowed the company to reduce its inventories and consolidate its facilities - actions that both lowered branch operation costs by 20 percent and improved capacity utilization without the risk of stockouts. Applications of this sort have the greatest potential in businesses with large demand swings and with distribution networks that cover wide geographic areas, such as consumer product businesses. A third means of exploiting scale is to use proprietary information to reduce costs or improve service through IT applications that benefit from superior scale of information. Most companies that provide credit to consumers (e.g., credit card companies, consumer lenders, stores that sell on credit) predict creditworthiness using statistical models. Because geography often affects creditworthiness (recall the recent depression in oil-producing areas), companies would like to develop models for very specific markets. Unfortunately, their ability to refine such models becomes limited as the number of "data points" in each area diminishes. This is where scale plays a role: the larger the customer base, for example, the more customers in any given area and the more finely tuned the credit scoring models. A major retail chain has taken this advantage to the limit by developing distinct credit models for each major store location. A final means of exploiting scale is to share costs across businesses. For example, a major multinational credit card company is developing a common set of systems for transaction capture and billing that can be used in several countries around the world. By developing these systems only once and sharing them worldwide, this company enjoys lower costs than companies that do not have similar worldwide scale. Strengthen product differentiation Beyond scale economies, information technology can be used to provide new, tailored features to strengthen product differentia14 THE McKINSEY QUARTERLY

tion. American Airlines provides IT-based services geared to the needs of specific segments. It provides mileage awards to all of its frequent flyer program members and maintains a customer preference data base for use in making reservations. i For the top 2 to 3 percent of customers who account for a large share of the business travel volume, the system identifies the person as a valued customer on all customer service screens and reports, gives those customers the ability to overbook, offers them larger mileage awards, automatically blocks off seats next to them if the plane is not full, and gives them free first class upgrades at the gate whenever seats are available. . , , Competitors cannot match these services cost-effectively since they cannot access the information needed to identify the few American customers who would qualify for such preferential treatment. Thus, as a result, American has a competitive advantage with respect to its own core customers. Even if other airlines take similar steps to lock in their key customers, market share leaders can secure their positions and benefit further if the industry proves able to raise prices more aggressively as customer switching diminishes. . , , Companies can also enhance product differentiation by executing IT-based approaches that coordinate the introduction of new products so as to maximize customer loyalty. Market intelligence is crucial in launching a new consumer packaged good, especially during the national roll-out phase when a company needs to monitor closely retailer behavior, consumer purchase patterns, and competitive responses. Missing information forces a company to rely on "gut feel" to determine the best course of action. Several years ago, when data from supermarket scanners on product sales was not as widely available as they are today, a European consumer goods company began the launch of what was to become a successful new product by positioning it to offer the same quality as the existing market leader but at a lower price. During the launch, the market leader responded with a large trade promotion allowance to retailers. Because scanner data on actual prices paid were not available, the company was not sure if retailers were passing the full amount of the market leader's allowance along to customers - an uncertainty that sparked internal debate about whether the proposed consumer promotion coupon had to match the allowance in full. In
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retrospect, the company has estimated that the lack of such information cost it $25 million in lost revenues. The product was successful, but with the right information it could have been more so. Leverage unique skills It is also possible to exploit existing strengths by using information technology to leverage unique institutional skills. One approach is to automate routine activities to allow a company's most skilled employees to concentrate on higher value-added tasks. Another is to use expert systems to share proprietary expert knowledge across a broader segment of the labor force. A leading investment bank, for example, has developed unique knowledge on how to spot and execute arbitrage opportunities, captured that knowledge base, and replicated it on an expert system for use by all traders at the firm. Such IT-applications are, indeed, quite powerful when unique and valuable skills really do exist and are sustainable. But these conditions occur only in select situations. Most ofthe time, skills rapidly spread to competitors. Ten years ago, top-fiight brand management skills in the consumer goods industry were limited to a few ofthe best consumer goods manufacturers. Since then, the massive growth in business education and in the movement of skilled personnel between companies has resulted in a much greater consistency of skill levels across the industry. Therefore, IT-based decision support systems for consumer goods brand managers are less likely to bolster any company's competitive advantage. Seek integration The most powerful uses of IT to enhance existing non-technologybased strengths arise not from straightforward automation of activities, but from integrating various aspects of a business. As Exhibit IV suggests, IT can be used to integrate across products or customers to create a customer focus, across business functions to coordinate business system elements, or across geographies to leverage a company's global presence. Integrative applications are so powerful because they unlock the fullest potential of IT. This is so because most large companies find it hard to recognize or exploit such opportunities for integration. They are structured around strong organizations defined by pro16 THE McKINSEY QUARTERLY

Exhibit IV Information technology used to enhance competitive advantages

Automation Make IT-based, fixed-cost automation investments Automate routine activities Existing advantages Scale Experience/skills Product differentiation Implement expert systems to share knowledge Integration Products/ customers "Custonner orientation" Tailor products/services to enhance differentiation Provide additional products/ services to increase volume

"Integrated business" Business functions Coordinate business system elements, e.g., coordinate complex demand, coordinate new product introduction

"Global presence" Provide global products/ services to share fixed costs

duct lines, functions, or geographic customer segments. These companies find it hard to exploit such opportunities because of their divergent priorities and lack of internal coordination. Not surprisingly, the IT applications that get developed in such contexts often take the form of a series of add-ons that can never really be linked. As a result, integrative applications tend to have great power and lead to genuinely sustainable advantage. Fundamentally change the business . . i

So far, we have looked at IT initiatives that deal with existing business approaches. However, opportunities may exist in some businesses to use IT to create entirely new sources of competitive advantage by changing the way the business is conducted. These "strategic breakthroughs" generally occur in industries where there is a rapid rate of change in technology, government regulation, customer needs, and the like. Such an environment allows
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companies that are among the first to understand and use information technology - the "early movers" - to create new sources of competitive advantage and even to change industry structure. Create new structural advantages Where these types of changes are occurring, early movers may be able to build competitive advantage with information technology itself - by establishing switching costs or cross-business scale advantages or by gaining power over suppliers or customers. 1. Switching costs. In some cases, information technology can be used to create large customer switching costs. This occurs when suppliers develop linkages with customers in such a way that the incremental value of moving to a competing supplier is less than the one-time cost of switching. American Hospital Supply's computerized customer links and American Airlines' SABRE system are well known examples of using IT to create these linkages. In both situations, the supplier introduced an automated interface for making frequent purchases more conveniently and accurately. Over time these linkages became an established part of the customer's business system. Switching to a new supplier would probably not be attractive. Customers would need to learn a complex new system, extensive information would need to be transferred and, in American Hospital Supply's case, savings on many items wouid likely be perceived as small since they are of low value. IT-based switching costs are especially important in businesses whose customers make frequent repeat purchases of low-value items because the potential savings from competitive products are likely to be very small relative to the customers' costs of switching to new suppliers. Switching costs are also likely to be competitively important where there is a complex supplier/customer interface that requires substantial customer effort to replace. 2. Scale advantages. When a market is developing, early movers can develop powerful scale advantages by making fixed-cost investments in IT that give them a low-cost business approach and a position as market share leader. For example, several companies are investigating opportunities to capture IT-based scale economies in mortgage servicing. Such opportunities are most likely to occur when the business is dominated by a single IT-intensive application, when the share of

18

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Exhibit V Cross-business scale advantage through infornnation sharing

Mortgage cross-sell

EXAMPLE
Potential profits per customer

Mortgage loan process Mortgage Income Credit history Relocation , . Banking Vv refationshlpS';* Investments V'. Potential cross-sell opportunities Checking Preapproved account credit card Payment Preapproved advance line deductions Credit Credit card application insurance Credit line application
NPV of origination and servicing rights on $100,000 fixed rate loan NPV of annual value per product limes cross-sell probability (or 5 years.

Application

\ Approval

\Postdosing \ Postclosing

$1,000* Origination and servicing

Preapproved home equity Preapproved car loan Savings accouni/CD Money market fund

Cross-sell opportunities

market required to achieve minimum efficient scale in that application is high, and when the application is difficult for followers to copy quickly. The best examples of these situations occur in transaction-based businesses like credit card processing. Companies entering new product markets can also use IT to achieve superior cost positions by sharing information costs with an existing business. These opportunities can most often be found in businesses with large-scale, proprietary customer information that is able to predict a consumer's buying patterns. This kind of information allows precise targeting, which in turn lowers customer acquisition costs. In personal financial services, for example, banks use the information captured in the mortgage application process to cross-sell other financial products. They can do this because mortgage-related information is a good predictor of individual purchasing patterns. If a person applying
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19

for a mortgage has just relocated from another area ofthe country, he may also be in the market for a new banking relationship. That information allows the bank to offer a checking account, savings account, or payment deduction service to the same customer. Experience shows that the potential profitability of such "cross-sell" opportunities may be almost as high as that of the original mortgage loan (see Exhibit V). In the most extreme situations, the dominance of a scale-driven IT application in one part of the business system can cause that function to break out of an integrated company setting and evolve into a service provided externally by independent businesses. This is most likely to occur in fragmented industries where external providers can gain a scale advantage over the internal operations of any one company by capturing the volume of multiple companies. If companies then decide to purchase the service or function externally, the "functional disaggregation" of integrated providers occurs. In the credit card business, for example, all but the largest banks now purchase transaction processing externally. They have moved from being integrated providers to being marketers, funders and risk bearers. In the mortgage industry, changes in information technology permit banks to package individual loans into securities for sale to investors instead of holding on to them until they are paid off. As Exhibit VI shows, this process, known as securitization, breaks up the traditional business system of mortgage lending into discrete roles that are played by a variety of firms, not just the firm that originally created the mortgage. Securitization has changed the bases of competition along the entire mortgage industry's business system and has facilitated the entrance of non-traditional competitors. A leading insurance company has entered the origination end ofthe business with a highly automated and centralized direct mail/telemarketing approach that has cut application processing from 23 days to 10 days. It has also saved the expense of branch offices and loan offices (an estimated 50 basis points) and, thus, been able to offer lower rates to customers. 3. Gain power over suppliers or customers. Information technology can sometimes be used by customers to shift power away from suppliers. In the consumer packaged goods industry, for instance, most major retailers are beginning to integrate the data obtained from checkout scanners on item-specific performance. Doing so
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Exhibit VI

IT contribution to changes in mortgage industry structure

Traditional business system Mortgage bank, commercial bank, or thrift Oricjinate Fund/sell

New business system Originate \ \ Service ^ \ Structure \ / Credit enhance \ f > Place/trade \ \ Invest

Thrift Commercial
oank

Retail securities firm

Investment bank Commercial bank Specialized payments processor

Investment bank Retail securities firm

Insurance company

Investment bank Commercial bank

V_^
Investment bank Commercial bank Thrift Pension funds Individuals

Role of information technology changing Securitization Permitting assignment of very complex cash flows from borrower to investor Permitting analysis required to accurately assess role and price securities Servicing consolidation # Providing scale economies Supporting development of applications expertise ~ - . .. ,.j . Origination consolidation Coordinating origination flow to maximize volume discounts

increases their power over manufacturers through better purchasing, greater control over shelf management and direct storedelivery sales forces, and improved understanding of promotions. Similarly, information technology can also help independent consumer goods wholesalers compete in an increasingly difficult environment. One major wholesaler has just installed a computerbased purchasing system, which helps sort through the myriad of promotions and special deals that manufacturers offer. With more than 2,000 distinct products to buy from some 100 manufacturers every week, the company has to make a purchase decision, in effect, every 30 seconds. This new system, which allows the purchasing department to optimize among all of its forward buying opportunities, is projected to add 0.5 percent margin to the company's profitability. This represents a significant gain in an industry with less than 5 percent average profit margins. The wholesaler can either capture these
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increased profits directly or use the cost savings to cut prices to gain market share. Even if other wholesalers eventually adopt the same kind of system, this early moving firm may have already gained valuable share. All wholesalers that use IT in this fashion are gaining power at the expense of manufacturers. Gaining such power, however, is possible only when suppliers previously enjoyed an information advantage and customers can now capture the information that is produced as by-products of their own businesses. Information technology can also be a powerful tool in improving a supplier's competitive position relative to its customers. For example, airlines are using their computerized reservation systems to capture value added formerly provided by their distributors, the travel agents. In the past travel agents provided three services to business travellers: they made the reservation with the airline, identified the lowest fare, and ensured that travel policies were followed. Now, airlines like American and United are building these capabilities into their own computerized reservation systems and placing terminals on-site with travel customers, potentially bypassing travel agents altogether. Create new business approaches Though quite attractive, all these opportunities to create new sources of structural advantage are relatively rare - not only because they involve creating a new approach to a business, but also because most IT applications are readily available to competitors of all sizes. A more common source of IT-based competitive advantage is the use of IT to restructure the business system and to achieve competitive advantage through superior institutional experience with the new approach. This strategy demands early use of IT and a significant commitment, as well as the ability, to make needed organizational and other business changes ahead of competitors. These advantages can be sustainable. Competitors must not only copy the technology; they also must adopt similar business system changes. In addition, they must overcome the early movers' accumulated experience. An example of experience-based advantage has occurred in the mortgage industry. Increased securitization of mortgages, growing product complexity, and extreme levels of interest rate volatility
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Exhibit Vil

Information technology used to develop new approaches

Mortgage prepayment analysis system

Publicly available data Monthly economic data by State and MSA
t

EXAMPLE
IT applications Related business changes

\ \ Ouarterly default/ delinquency survey

Bond buyer pool characteristics /

Computerbased analytics/ decision support

L
if'

A \

Trading Improved pool-specific pricing

Conduct intensive training in computer analytic capability Provide direct software programmer support on trading floor Eliminate interest rate bets Facilitate customer education via videotapes on uses and benefits Conduct intensive sales training Enhance research reputation through publication

Sales Superior customer portfolio valuations

FNMA, GNMA FHLMC prepayment rates

Underwriting More accurate structuring of CMO payment tranches

' Emphasize profitable deals over more deals

and industry overcapacity have led to intensifying competition and declining margins. These, in turn, have placed a greater premium on risk management. Since the mortgages acting as collateral in mortgage securities can be prepaid at any time, assessing and managing prepayment risk is crucial to the profitable structuring, placing and trading ofthe securities.
.. i -

Many investment banks involved in the structuring of mortgage securities have invested in information technology to track and analyze prepayment rates. One firm, however, correctly anticipated the need to analyze the prepayment rates ofthe specific pools of loans backing coUateralized mortgage obligations (CMOs). When the CMO market was small, this flrm began to construct a system that integrates publicly available data on the economic performance of each geographic area in the United States, on default delinquencies, on mortgage pool characteristics, and on the prepayment rates from the Federal National Mortgage Associai tion, the Government National Mortgage Association, and the Federal Home Loan Mortgage Corporation.
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This computer-based analytic/decision-support system gives traders an improved pool-specific pricing capability that has led to a preeminent position for the firm in pool-specific trading. The system helps salesmen assist customers in valuing their portfolios, which strengthens customer relationships, as well as providing additional information about the location of specific securities. The system also allows the firm's underwriters to structure CMO payments more accurately. This has allowed them to obtain superior pricing by being among the first to construct innovative new securities that more closely meet investor needs (see Exhibit VII). The importance of learning The key to this firm's success has been the substantial experiencebased advantage it has achieved both as an effective and early adopter of the relevant technologies and as a maker of ongoing, wholesale changes to the way it conducts business. These changes did not occur all at once. Rather, they represent the cumulative learning and refinement of business approaches from years of experience. The experience of building and refining the system taught the firm which capabilities were required and made it realize that whatever was done would be useless unless customers recognized its value. That led the firm to conduct customer education seminars, which provided valuable feedback. In the meantime, customers began to use the firm's capability to execute trades, which generated market share, greater understanding ofthe marketplace, and ideas for refining the system. The firm then began to link other functions to the system and expand the training efforts with video tapes. These efforts led to additional share. They also created opportunities to underwrite innovative new securities, which further boosted both placement volume and the commissions that could be invested in ever greater IT capabilities. Competitors can duplicate the technology and information employed, since they are publicly available, but they cannot easily duplicate the real source of its advantage: its tremendous experience in adapting virtually all of its operations to the new business environment. Nor can they duplicate the learning embodied in the hundreds of refinements and enhancements made to the system since its inception. As a result, the firm has recently overtaken many of its traditional competitors and is now uniquely positioned to exploit additional information on specific loans within the pools as it becomes available.
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Exhibit VIII The spectrum of roles for information technology/systems in business strategy
Introduce "standalone" Leverage existing applications strengths Fundamentally change the way business is conducted Great

Itittle
Innpact

bi^ree of non-tedinology business change Powerful tool for strengthening competitive advantage Very powerful in creating new competitive advantage, but often very difficult

Will not generally create competitive advantage, but critical to remain competitive Execution is key; monitor and selectively adopt technologies consistent with cost and service position

Approach

Focus on integrating business activities in new ways across products, functions, and geographic areas- in addition to simply automating existing processes. ' Enhance existing nontechnology-based competitive advantages - Enhance scale - Strengthen product differentiation - Leverage skills

Move early to restructure business system, exploiting technology as part of integrated new approach

Objectives

Reduce costs Improve service

Create new structural advantages - Create switching costs - Exploit cross-business scale - G a i n power over suppliers or customers ' ' Build experience-based advantage

To succeed competitively in these situations, companies must continually adapt to the evolving business and technological environment. Change creates opportunities for competitors that "move early." This means that managers should: ^ Continually reexamine all elements of the business system in light of new technology and new applications of existing technology. H Commit substantial technical and non-technical resources to the development of IT-based applications early in the game, where real competitive gains appear feasible. . ^ . -.] ^ Recognize that neither the "ultimate" application nor the organizational support it requires can be fully identified beforehand. These principles contrast greatly with the approach best suited to standalone applications, where rigorous economic analysis is needed to select technologies and determine the optimal point of adoption. Creating new experience-based advantage means that managers have to commit resources early - long before they know the size of the total IT investment, the full end product, or the scope of the impact. They must have the vision and unwavering commitment to invest early enough so the company can make the

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26

thousands of inevitable adjustments and refinements to both the technology and its own organizational capabilities. Implications for management As Exhibit VIII indicates, "winning" with information technology means different things for different kinds of initiatives. The payoff can range from remaining competitive in an industry with declining profitability, to leveraging existing strengths, to creating entirely new ways to conduct business that lead to significant sources of competitive advantage. In all cases, however, organizational capability will be critical to success. The companies that have chosen appropriate IT-based initiatives and successfully implemented them have possessed such characteristics as: ^ Top management with a broad vision of how its company can be reshaped with information technology and a willingness to rebuild major parts of their current business system. K Highly-skilled business and technology managers with a deep and shared understanding of how IT-based capabilities can affect a business and who will drive specific changes. f An orientation toward active experimentation, testing for business impact, and aggressive implementation when initiatives appear attractive. Do not forget that all of the roles of information technology described here should be considered strategic. Omitting them or getting them wrong can cost a company its competitive position, even if IT does not enhance or create powerful competitive advantage by itself. Ultimately, the strategic use of information technology is a business decision, not a technology choice. The winners in any industry will be those players that first understand and then take the necessary steps to assess honestly and carefully the information technology potential for their own business situations. John Cecil, a Principal, and Gene Hall, an Associate, in the New York office are active members of the Firm's Information Technology/Systems practice. Carter Bales, a Director in the New York office, is the leader of that practice. This article is based on a McKinsey Staff Paper.

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THE McKINSEY QUARTERLY