'Frugal' IT Doesn't Guarantee Profits

By Edward Cone Print this article Print

What M.B.A.s can learn from MLB.

Quantifying a return earned on an investment in information technology can be tough. Analyst firms from Nucleus Research to Alinean to Gartner have developed metrics, with acronyms ranging from ROI and ROIT to TCO and TVO.

But it's not an exact science. Just look at the differences between Merck and Colgate-Palmolive, two companies that Orlando, Fla.-based benchmarking firm Alinean rates as "frugal leaders" in the use of information technology in their respective industries, pharmaceuticals and consumer packaged goods.

But Merck, despite good marks for getting the most productivity from its technology investment ranks, ranks at or near the bottom of its industry in terms of earnings growth and other key financial metrics, while Colgate scores well against its competitors.

Indeed, Merck reported that its net income dropped 4.5% to $6.8 billion last year, while Colgate saw its net income increase 10% to $1.4 billion.

Alinean's analysis of the companies' success with technology is based on both companies' reported financial data and an "information productivity" metric developed by a former director, Paul Strassmann.

Information productivity is a ratio of profitability to expenses. Profitability is defined as the Economic Value Added (EVA) by a company's management, which Alinean calculates as its net profit minus its cost of capital, multiplied by the net worth that's left after subtracting all assets from all liabilities. The expenses are selling, general and administrative (SG&A), according to Alinean. The greater the "true profit," or EVA, and the lower the expenses, the better the ratio.

More recently, Alinean has started using a productivity metric called ROIT (return on information technology) that uses its own information technology estimates as the denominator, rather than SG&A. Either way, a "frugal leader" is a company with high productivity and relatively low spending on information technology as a percentage of revenue.

In 2002, Colgate had an information productivity rating of 41.7%, compared with 17.4% for other companies in the personal products industry, while Merck rated 87.6% compared with 49% for its pharmaceutical peers. Meanwhile, Colgate spent about 4.3% of its revenue on information technology, compared with 5.4% for its competitors. Based on Alinean's 2003 figures for Merck, its I.T. spending is up from 2.6% of revenues in 2002 to 4.8% in 2003, but is still below the peer average of 5.1%.

But what passes for frugality in one industry may not in another.

Drug companies make more money than personal products companies, and they spend like it. While Merck ranks near the bottom of its industry in financial performance, its operating profits were 40.7% of sales last year, nearly twice the 20.5% managed by Colgate.

So while Merck has been able to afford a culture of internal development and a habit of running multiple systems in different parts of the enterprise, Colgate has worked to achieve a uniform strategy across the company. Under long-time chief information officer Ed Toben, Colgate has committed to SAP, which runs 95% of the company's business around the world; has standardized on leased IBM hardware; and has gone from 75 data centers to one.

"We try to be very productive on low cost in I.T.," Toben told Baseline in an interview last year.

Merck, under CIO Chris Scalet, has embarked on an effort to standardize and consolidate systems, employ more off-the-shelf software and find places, such as clinical research, where Merck can get a better bang for its I.T. buck.

Still, as Strassmann, a former CIO at Xerox and the National Aeronautics and Space Administration, maintains, the direct correlation between I.T. leadership and financial performance can be shaky. "You cannot look for precision," he says. "When companies fail, they don't fail in detail, they fail in aggregate."

But if Merck can go from thrifty-for-pharma to just plain thrifty, it might well see a bigger payoff on its bottom line.

This article was originally published on 2004-06-08
Senior Writer and author of the Know It All blog

Ed Cone has worked as a contributing editor at Wired, a staff writer at Forbes, a senior writer for Ziff Davis with Baseline and Interactive Week, and as a freelancer based in Paris and then North Carolina for a wide variety of magazines and papers including the International Herald Tribune, Texas Monthly, and Playboy. He writes an opinion column in his hometown paper, the Greensboro News & Record, and publishes the semi-popular EdCone.com weblog. He lives in North Carolina with his wife, Lisa, two kids, and a dog.
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