Expert Voice: Erik Brynjolfsson on Organizational Capital

By Mark Kindley  |  Posted 10-01-2001

Expert Voice: Erik Brynjolfsson on Organizational Capital

 

Hidden Assets

The recent bursting of the internet bubble, together with its unsustainable and sometimes bizarre business models, has resurrected the debate on the degree to which IT investments contribute to productivity growth. While economist Erik Brynjolfsson is a firm believer in the long-term contribution of technology to productivity growth, he also believes the answer isn't as easy as buying a few computers, a server and some software.

Brynjolfsson, a professor of management at the Massachusetts Institute of Technology's Sloan School of Management and the codirector of the Center for eBusiness@MIT, is one of a new breed of economists who invoke the concept of "organizational capital" to describe a whole range of intangible assets and investments necessary to leverage IT investments into fully productive parts of a successful, even innovative, business. His in-depth studies of more than 800 of the Fortune 1,000 companies—extending back to the pre-Internet economy—have provided some of the most tangible evidence of the value of the intangible assets that make up "organizational capital."

At the end of a two-hour interview with journalist Mark Kindley in his office at MIT, Brynjolfsson mused on how he would characterize organizational capital. It's not so much an economic theory or an accepted fact. Rather, he said, "It's a perspective. It lets you see things you might not otherwise see."

CIO INSIGHT: What is organizational capital?

BRYNJOLFSSON: I think of organizational capital as analogous to physical capital. Just as you make an investment in the bricks and mortar of a factory, you could also make an investment in a new supply-chain system, inventory-management system or a new accounts-payable process. They may take hundreds or thousands of person-hours to redesign and implement; they may require consultants and special software and be very costly to put into place. But once they've been put into place, the expectation is that they will yield a stream of benefits over a period of years—not only in terms of lower costs and greater efficiencies, but also in terms of better customer responsiveness, more innovation and more transparency for management to understand how their organization is working.

An economic definition of capital is something you make an investment in and then get a stream of benefits back from over time. Clearly, a factory fits that profile. I have been arguing that many business processes are also investments in economic terms and, therefore, just as we talk about "physical capital," we should also be thinking in terms of "organizational capital." Firms that have made such investments have an asset others don't have. It's just like having a factory your competitor doesn't have.

Is organizational capital directly linked to technology?

No. There is organizational capital that is not associated with technology. What our studies found, however, is that there is a disproportionately large amount of organizational capital associated with technology investments. In fact, we found that among the companies we studied, there were on average $10 of organizational capital associated with every $1 of technology capital.

What's included in that?

All of the direct costs, such as hiring consultants, the time spent by internal and external software developers to rewrite the code and adapt the code to work for the organization, the training of the personnel at all levels, whether it be the secretaries or the line workers or the sales people or the middle managers, all the way up. Then there's the management time in thinking about which processes need to change and how. I call them costs, but you could also think of them as investments. You are spending this money with the expectation of getting some return.

Is this a new measure of corporate worth?

Yes. Organizational assets are a subset of intangible assets. Intangible assets include a lot of things, like patents and goodwill, and organizational capital is an important subset of that. Our official statistics have been ignoring them because they are hard to measure. If you look at the gross domestic product, they don't show up anywhere. Most companies—with the exception of a few like Merck & Co.—don't do a real accounting of their intangible assets. The economy, however, is becoming more and more dependent on those kinds of assets, so every year we ignore them we are getting a more and more misleading understanding of where the value is in the economy.

My research suggests that U.S. firms have made very large investments in organizational capital over the past decade or so; and these large investments mean that the "true" capital stock of these firms, including both conventional capital and organizational capital, is much larger than had been thought. As a result, the productive capacity of firms is higher, and productivity growth is likely to grow as well as more and more of this organizational capital is put into use. Bottom line: I think the productivity surge we've seen in the past five years or so is largely sustainable. A portion of it was due to cyclical effects, but most of the increase in productivity growth in the 1990s is likely to be long-lasting.

Organizational capital recognizes many more benefits than are typically taken into account when IT investments are evaluated. That sounds like a good thing for IT professionals.

Absolutely. There are two parts of output that have been mismeasured or unmeasured in a lot of traditional studies, and in the way a lot of managers think about things. One is the intangible unmeasured components of customer value, and the other is the intangible organizational assets. Let me take each of them in turn.

We found that computers and computer investments were correlated with increases in customer service, product variety, greater speed and timeliness in delivery and quality improvements as well as cost savings. But the official productivity statistics are only really good at measuring the cost savings and are so-so at measuring the quality improvements. The other benefits—product variety, customer service and timeliness—are entirely missing. The firms that invested most in IT had the greatest changes in these unmeasured aspects of output, but because the value of these benefits is often unmeasured, the productivity value of IT for those firms is often substantially underestimated.

The other kind of mismeasurement we found is the value of intangible organizational assets. We have just recently completed a paper on this, and we were surprised at how large the numbers turn out to be. The U.S. economy has created somewhere in excess of $1.3 trillion of new organizational assets over the past decade that are closely associated with IT. These assets are comparable in economic impact to $1.3 trillion worth of new factories or new equipment in those factories.

Unfortunately, there is often a focus on the technology—on hardware costs—when our research indicates that those costs are just the tip of a much larger iceberg of necessary investments. Business leaders and CIOs need to understand that so they can plan accordingly and make sure they don't give short shrift to these investments.

Otherwise they risk budgeting only 10 percent of the real cost?

Right. And in fairness, not all of that is in the CIO's budget. It means you have to get your marketing people and your human resources people and your operations people all on board and make sure they are all making the necessary investments and changes to get the leverage from the technology investments.

When IT people go to their CEOs and say, "The business side needs to make some changes, spend some money on training, spend some money on the business process we designed," our study provides evidence that that is critically important. Trying to skimp on those other parts of the budget will be counterproductive.

Too often, people roll out expensive technology investments, but if the organizational investments are not made, they end up falling well short of their goals—or what they see happening in other firms. Our data show that the firms that make changes on all these dimensions have higher productivity and higher market value than those that don't.

In your view, IT investments should be associated with organizational change, and once those changes are made, they constitute a measurable intangible asset, which you call organizational capital.

Yes.

But not all organizational change is good, and it also seems that organizational change could make existing organizational capital obsolete. How would that work?

Let me give you an example. I was working with a manufacturing organization that had its roots in Henry Ford's era of mass production and standardized products. They wanted to move toward what we call modern manufacturing, which involves much lower levels of inventory, flexible machinery, greater product variety, cross-training and more diverse skills. As they made that transition, they were smart enough to understand that it wasn't enough just to change the technology. They also made another list of changes they needed, such as incentive systems, training, product line and inventory systems. I figured they were going to have a very nice, successful transition.

I was very wrong. It was a horrendously difficult transition. We worked with them to try to understand what was going on. It had to do with the fact that when you mixed and matched the old system with the new system, you got a terribly dysfunctional mongrel. They had made some changes in their technology, but they hadn't updated their inventory system quite at the right time. Workers were still mentally thinking in the old system. I remember interviewing one of the workers. This guy was saying how much he wanted this change to be successful, and then he told me that the key to productivity is to keep the machinery running all the time. He had exactly the right attitude but the wrong approach. Keeping the machinery running all the time was the old way. The harder he worked at trying to use his old rules of thumb, the more dysfunctional he was for the new system.

There were literally dozens of examples like that—leftover bits of the old system, the old culture, the old business processes, the old rules of thumb—gumming up the new system. Initially there was a bunch of finger pointing, but ultimately there is a happy ending to the story. What they did was go to a greenfield site, a new location, to make a clean break from the old system. It worked very well and they were super-productive; so productive, in fact, that they painted the windows of the factories black so the competitors couldn't peek in and see what they were doing.

What had been organizational capital in the old system had become an organizational liability in the new system.

Yes. Their old organizational capital became obsolete, even counterproductive. It was worth a negative number.

So organizational capital is really a very dynamic commodity.

It is. It's more dynamic than physical capital. That's one of the reasons we haven't had very good measures of it. And it's a good excuse for ignoring it. But, unfortunately, the evidence suggests that if you are ignoring it, you are ignoring nine-tenths of the relevant capital.

Of course, the value of a factory can change, too. At some point the factories that made buggy whips were not so valuable anymore. So it's not an entirely different argument from what you have for physical capital. It's just more difficult to measure.

Have you also found cases where a company's existing organizational capital survived significant organizational and technological change?

Yes. Merrill Lynch is a good example of that. We were trying to help them transition from a traditional brokerage to an online brokerage model. We went through and mapped all the principles of the traditional brokerage as well as the online brokerage. At the time, the online brokerage model was synonymous with the E*Trade, Charles Schwab model: You didn't have much research, and you didn't have a personal broker. It was kind of a thin thing. Merrill didn't see how that fit with their knowledge base and all the assets of the firm. They had about 17,000 financial consultants; what were they going to do with them? The conventional wisdom a couple of years ago was, "Too bad. You're a dinosaur, and you're going to have to throw all that away." Their stock market valuation plummeted.

Some analysis that we did with a tool we call the Matrix of Change, however, indicated that there was actually another way to do business that really played much more to Merrill's strengths. Merrill Lynch now calls it "Unlimited Advantage." It uses the Internet, but it also uses their analysts. Instead of having to choose between their old high fees versus the low fees—where they couldn't make money on trades—they got rid of fees on trades altogether. Now, for that service, they charge a single annual fee as a percentage of assets, a kind of wrap account. Once you pay that annual fee, you have no costs for trading.

This has had a lot of other benefits. Ultimately, by bundling together a whole set of services that their competitors don't offer, they are in a stronger position than they ever were. Now their market value is about double that of Schwab's.

So organizational capital doesn't necessarily have to mean "new economy" or "new technology."

That's one of the most important lessons we took from this and from some of our other studies. If anything, I have a heightened appreciation for the organizational capital that some of these traditional firms have built up over many, many years. It may have taken 50 years to build up a set of business processes that are incredibly valuable, and for you to simply throw them away and say, "Okay, we are starting fresh with the Internet," would be a gross miscalculation and a real waste.

Rather like throwing the baby out with the bath water.

Exactly. I think the number-one reason why so many change efforts fail is because people think too narrowly about just one element of the new system. They see Dell Computer doing something neat with their supply chain or Cisco Systems doing something neat with their self-service customers or Schwab doing something interesting with their compensation system, and they say, "That's great. Let's implement it in our organization." Almost inevitably the results are disappointing and people don't understand why. People feel it worked at this other organization; why doesn't it work at our organization? The answer, typically, is that the practice they analyzed and are trying to implement is only one piece of a larger system of practices. Whether it is a technology or a human resource practice or a factory principle, you have to think of it in the context of a larger system change. If you don't do that, you are really setting yourself up for failure.

Are you, or were you, an advocate of the "new economy"?

I don't think I've ever used those words in any of my writing or in my talks. I don't think there is a new economy in the sense that the old rules don't apply. In my MBA courses it was sometimes frustrating at the height of the Internet boom to be reminding people of the fundamentals of business. The students would say,"'No, no, it's a whole new world." Now there is a danger of them going too far in the opposite direction and saying, "Well, I guess the whole thing was just a mirage." That would be an equally inaccurate image.

What I do believe is that computers and communications and associated information technologies have had a vastly disproportionate effect on the economy compared with the actual size of the spending on computers. It is still a fairly small part of the economy, but it has a very big impact, in part because of the way it has reshaped organizations. I expect and am quite confident that the influence of those technologies on the economy is going to grow in the next five or 10 years.

Mark Kindley, a freelance journalist with almost 30 years of experience covering business and technology, is a former editor of VARBusiness magazine. Comments on this story can be sent to editors@ cioinsight.com.

Truth in Numbers

Truth in Numbers

Typical Start-up Cost Structure for an Enterprise Resource Planning (ERP) Suite

Hardware $0.8 Million
  • Application, Web and database servers, including storage
Software $3.2 Million
  • ERP application suite license (HR, financials, distribution)
  • 1,000 regular trained users, 2,000 casual users
Implementation
and Deployment
$16.5 Million
  • 9 months to complete pilot site, including process engineering, apps configuration and testing
  • 30 external consultants at $1,200 a day
  • 30 internal staffers at an average salary of $100,000
  • 3 additional external consultants at 9 sites for 3 months
  • 9 additional internal staffers at each site for 6 months
  • 5 days of user training at an average burdened user salary of $50,000
  • 3 full-time training staff at an average burdened salary of $100,000
Total Costs $20.5 Million
Ratio of Total
Start-up Costs
to IT Hardware Costs
26:1

Note: These figures do not include management time selecting, designing and managing implementation, including the modification of business processes, nor does it include staff time informally learning to use the system or modifying business processes to work with the system. Source: Forrester Research Inc. and Brynjolfsson's calculations.