Information technology is an increasingly important source of firm value; indeed, it is rapidly outpacing material goods as the main source of economic value in post-industrial economies. Accounting for the nonmaterial value of IT, however, is inherently complex. This value is often integrated into the production process, making it difficult to separate the discrete contribution of IT from the complementary processes and activities in which the IT is embedded [2]. Undetected reinvestment and collateral investments often absorb the financial benefits derived from IT implementations [4]. Also, the use of supportive IT for monitoring, controlling, and improving production can hide visible return on IT investments. So, while we know IT produces value for firms, knowing where, how, and how much is a significant problem.
The key roadblock to accounting for the value of IT is a lack of a systematic, objective methodology specifically designed to separate and identify the contribution of IT. The methodologies now used to assess IT value are inconsistent and outdated, oriented more toward production-based industries than toward service provisioning and knowledge work [6]. Existing valuation methods are subjective and often based on incomplete or unreliable data, creating wide differences in firm valuation and indicators of firm performance [7].
This hidden asset value of IT has significant implications. The inability to account for IT value means that its contributions to firm value are not reflected on the firm’s income statement or balance sheet. This is an increasingly serious problem. The value of IT and intangible assets in all companies rose from 5% to 72% of their market value between 1978 and 1998, which means tangible asset value from income and balance sheets now reflects less than 30% of a firm’s true market value [3]. In the 1990s, unreliable and subjective assessments of intangible asset value created increasingly unrealistic expectations, leading ultimately to the shakeout of the dot-com phenomenon. Today, this lack of a standardized, formal approach to valuing IT within firms continues to make technology risky for investors, stakeholders, and firm management across industries.
Many new measures such as economic value added (EVA), Tobin’s Q, calculated intangible value (CIV), and the Balanced Scorecard have been suggested to address this problem. EVA measures after-tax cash flow generated by a business minus the cost of the capital it has deployed to generate that cash flow. As such, EVA is an estimate of economic profit, or the amount by which earnings exceed or fall short of the required minimum rate of return shareholders and lenders could get by investing in other securities of comparable risk. Tobin’s Q relates the company’s market value to the replacement cost of its fixed assets and defines the difference as the value of intangible assets. CIV computes the value of the intangible assets by a comparison between the company’s performance and that of an average competitor that has similar tangible assets.
These measures perform well, provided the value of a specific asset is discretely identifiable (that is, the value-producing qualities are known) and value-autonomous (that is, the asset does not contribute value to, or derive value from, other assets of the firm). These are no small problems. Without a systematic methodology to guide the use of these metrics, the value contribution lacks rigorously defined boundaries. Instead, cost quantification and revenue contribution are based on subjectively inferred collections of organizational activities. This creates problems in distinguishing contributions from IT versus other activities that surround the value-adding process, such as reinvestments, collateral investments, and complementary applications. Without a systematic method to define rigid boundaries around value contribution, value assessments resulting from these measures continue to be susceptible to bias and varying interpretation.
To make the distinction between value created by an IT asset and the independent value creation activities of other organizational processes, the value analysis must establish the boundaries around all of the elements involved in the value contribution of IT within an organization (the asset scope), and identify the specific contribution of IT to each element within those boundaries (asset specificity).
Asset Specificity and Asset Scope
Fixing value is a difficult matter of separating the value contribution of IT assets from the context in which they operate. The costs and benefits of IT are inextricably woven into the operational processes, structure, and strategy of firms [8]. To make the distinction between value created by an IT asset and the independent value creation activities of other organizational processes, the value analysis must establish the boundaries around all of the elements involved in the value contribution of IT within an organization (the asset scope), and identify the specific contribution of IT to each element within those boundaries (asset specificity).
The contribution of IT to the firm is often diffuse, entangled across many processes, structural units, and functions, and sometimes across organizational boundaries. Measuring the total value contribution of IT requires demarcating a “locus of value” around the IT asset [5]. Such a locus of value must include the complementary organizational processes, decision making, and activities necessary for IT to create value. Most valuation approaches call upon knowledgeable subject matter experts and stakeholders to identify value-adding activities and processes based on their personal domain knowledge, experience, and familiarity with the system. Unfortunately, depending upon the various interpretations and interests of analysts and stakeholders leads to biased and conflicting estimates of value.
Identifying the distinct contribution of complementary assets to IT value production raises another problem. Complementary assets increase in value because of IT, including labor (decision making and information use), equipment (production control, such as CAD/CAM or CNC), and products (value-added services and product enhancements), but these assets also have value independent from the IT contribution. When assessing the value contribution of IT, these two types of value must be separated. The intrinsic value of complementary assets needs to be separated from the value contributed by the IT asset; otherwise the calculated value of IT is overinflated. In identifying IT-specific contributed value, firms must separate the IT contribution to discrete work practices, isolate IT-based impacts on operational and strategic processes, and unbundle the contribution of IT to management decisions.
A Dependency Approach to Business Valuation
To understand how to identify and isolate value, we must first examine how value is created within the firm. Firms use assets to create value for the organization through the creation or exploitation of valuable resources. Resources themselves have no intrinsic value, but become valuable when needed to accomplish some goal. Value itself, then, materializes through the relationship between someone with a need and someone with resources to satisfy that need. The relationship between the two is a dependency of one upon the other, expressed through an exchange relation, and economic value is the outcome of the dependency [1]. Using this notion of value as resources-at-work, we can focus on the value-creating exchanges an asset passes through to paint a complete picture of the asset’s true value.
To identify and trace the various value-producing exchanges, we will employ the Dependency Network Diagram (DND) methodology [9] to focus on the exchange of resources. DNDs are representations of roles, goals, activities, and governance controls involved in exchange relations. Unlike other methods that focus on the flow of information, materials, or the relationships between data, DNDs represent organizational relationships that are quite revealing about the relative importance of activities, entities, and their relationships. Assets used in exchanges are depicted graphically as rounded rectangles separated into three areas: their names, their activities, and their goals. Dependencies are represented by an arrow from the resource-deficient asset to the supplying asset (Figure 1).
While IT systems perform a variety of activities, not all generate value. When a need to use an IT system occurs, a cascading sequence of activities is precipitated that ultimately results in the resolution of the initial need. For example, a customer relationship management (CRM) system (an IT asset) is involved when a customer contacts an organization. The CRM system provides customer information to the account manager in response to the customer’s contact (see Figure 2). Providing customer information is an activity invoked as a result of the customer contact, and this defines the CRM system’s asset-specific value. Activities the system can perform that were not activated (such as data backup or utility programs) are left out of the value calculation. The activities not crossed out in Figure 2 define the CRM system’s value asset specificity. In this way we can differentiate between value-producing and non-value-producing activities commingled within specific IT assets.
Of course value-generating assets may be invoked by more than one event. Aside from facilitating the customer interface, the CRM system may generate value by, for example, providing summaries and analyses of customer demand for marketing purposes. The marketing request for such information invokes another set of activities that produce value from the CRM system, giving it more activities of specific value to the firm.
By identifying the dependencies placed on the IT system and tracing the cascading sequence of activities that are invoked as a result of these dependencies, the value-generating activities within the system and the complementary activities required from others may be identified.
So far we have considered how to differentiate between value-producing and non-value-producing activities within a given asset. Most IT applications, however, are not independent and depend upon complementary activities from other resources or people to create value. The CRM system, for example, requires management decisions allocating relationship-building activities to high-margin customers over low-margin customers to operate effectively. This decision is needed to manage the customer contact and is therefore necessarily part of the value creation process. All of the firm’s activities (internal and external to the CRM system) invoked as a combined result of initial events define the CRM asset scope. That is, the locus of value of the CRM system includes both the computerized provisioning of customer information and the improvements to the manager’s ability to identify key clients.
Because the initial events are defined a priori as the value-creating processes, only those dependencies and activities that support the value-adding process are invoked by the initial event. By explicitly tracing the activities directly precipitating from an initial event, DND excludes the many other dependencies and activities that are not pertinent to value creation from the representation. In this way the DND process abstracts away firm activities unrelated to value creation.
The union of the set of activities invoked by all the initial events constitutes a complete representation of the value of the IT asset. Combining the activities cascading from these events provides a picture of the value created by an organization’s IT assets. Once the full picture of the value-adding activities is assembled, each activity can be discretely assessed in terms of the cost and benefit derived from it.
By identifying the dependencies placed on the IT system and tracing the cascading sequence of (internal and external) activities that are invoked as a result of these dependencies, the value-generating activities within the system and the complementary activities required from others may be identified. Operationally, all activities invoked as a result of a dependency upon a given IT asset define the asset scope. A systematic definition of asset specificity appears as the subset of activities activated within the IT to resolve the dependencies placed upon it.
The Loan Department
Let’s turn now to a more specific example, a fictitious loan department at a financial institution, to demonstrate how DND analyses are applied. We begin with the prospective client’s request for a loan. This simple event cascades into activities designed to find an appropriate solution to the borrower’s need for funds, with proper assessment of risk and the inclusion of sufficient control systems to ensure repayment. IT is a critical component in creating value here. IT provides decision makers with an efficient means to store, calculate, and report information about risk, profitability, collateral analysis, and precedent conditions for the loan. This results in a quicker response for the client and efficient identification of the appropriate risk controls to enable the financial institution to realize a profit.
When a loan customer is unable to independently raise capital for a new venture, the customer depends on the loan officer to assemble financing. This dependency begins the construction of the network of dependent activities shown in the DND of Figure 3.
As a consequence of the loan application, the loan officer performs several activities—assessing the stability of the product or service, the quality of ownership, sponsorship, and ethics of the borrower, the market and market position of the borrower, and management’s knowledge—before considering lending capital to the loan customer. In making these assessments, the loan officer depends upon a loan management system to provide profitability rating data about the loan customer and the investment. This is depicted as dependency 2 in Figure 3. The loan officer also relies upon the note department to construct a legally binding contract to ensure the loan generates the anticipated revenue (dependency 3 “note generation”). In constructing the note, the note department depends upon the loan management system to provide articles of incorporation, certification of incumbency, and customer information and history (dependency 4).
As we will see, these dependencies define which assets will be included in evaluating the Loan Management System (the core and complementary assets needed for value production), and also define which activities are relevant to the value calculation for each asset.
Dependency Valuation
To identify activities complementary to the Loan Management System, we use the DND representation linkage between activities and goals. There are two roles directly interfacing with the Loan Management System—the Loan Officer role and the Note Department. To make loans that have a sound economic purpose depends upon investigation and analysis of the credit relationship:
That is, “the Loan Officer’s goal (to make loans that have a sound economic purpose) depends upon activity 1 of the Loan Officer (investigating and analyzing credit relationships).”
Being able to perform investigation and credit analysis depends upon the ability to assess the profitability rating of the engagement (activity 1 of the Loan Management System, or LMS-1) and the ability to access customer profiles and history (activity 2 of the Loan Management System, LMS-2). The Loan Officer’s goal is therefore dependent upon an activity the Loan Officer can perform (LO-1) and two activities the Loan Officer cannot perform (LMS-1 and LMS-2):
Therefore the two activities LMS-1 (assess profitability rating) and LMS-2 (report customer profile and history) are complementary to LO-1 (investigate and analyze credit relationship) in achieving the loan officer’s goal.
A similar analysis of the DND reveals complementary activities in the Note Department. A summary of these core and complementary activities is shown in the table. We also see that to legally bind the loan customer to a repayment obligation (the goal of the Note Department) depends upon activities performed by the Note Department (make observations regarding collateral, define conditions precedent to the loan, and draft the agreement):
(ND goal)
{ ND-1, ND-2, ND-3 }
The Note Department’s ability to make observations regarding collateral and to define conditions precedent to the loan depends upon the Loan Management System, which serves to assess the profitability rating and to report customer profiles and history. The Note Department drafts agreements independently from the Loan Management System.
(ND goal)
{ ND-3 }
{ ND-1, ND-2 }
{ LMS-1, LMS-2 }
Therefore the two activities LMS-1 (assess profitability rating) and LMS-2 (report customer profile and history) are complementary to the two Note Department activities, “make observations regarding collateral” and “define conditions precedent to the loan” (see table). Note, however, that LMS-1 and LMS-2 are not complementary to NO-3 (draft the agreement), and NO-3 is not included in the value calculation for the Loan Management System.
The “Value” of IT Asset Valuation
Identifying the specific activities within and surrounding the Loan Management System provides the Loan Department with a stable, repeatable means to evaluate IT value. Because the DND method can be applied to other systems, the Loan Department can now directly compare IT assets and projects against each other for their relative contribution and can make investment and development decisions based on objectively defined criteria. The sets of value-producing activities resulting from the analyses can be compared against the organization’s goals for appropriateness, or the organization’s strategies can be realigned to capitalize on new competencies offered by the IT assets. With the activities and their relation with other organizational assets and personnel explicitly drawn, the Loan Department can also use its DND analyses in conjunction with initiatives to reengineer business processes for efficiency and effectiveness.
From this simple analysis we can generalize that DND value analyses help organizations in three ways. First, DNDs make value-producing activities explicit, so business unit managers and employees can see the relative value of activities and align around a common understanding of top priorities. When a firm agrees on how frontline actions affect overall value creation, management can harmonize the goals and measures instead of working at cross-purposes.
Second, DND valuation helps managers, investors, and creditors to understand how value is created and maximized in the business. Having a consistent method for IT valuation helps prioritize projects within the firm. “Small technology” projects that dramatically improve operations can be directly compared with “big” projects, and their relative return on investment calculated for the best allocation of scarce IS capacity. The DND method also creates comparability across diverse firms. With visibility into the value-production process, investors and creditors can compare across firms for IT value, even across different competitive spaces.
Third, DND valuation helps in prioritizing each activity based on its value, and thus determines where resources should be placed or removed. The DND methodology allows management to objectively balance and prioritize different value drivers as well as short-term and long-term actions. When difficult decisions must be made, management can use the DND methodology as the basis for the decision.
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