By Diana Farrell, Terra Terwilliger, and Allen P. Webb

Who can blame business technology executives if half a decade of overspending on IT now makes them somewhat obsessed by costs? Indeed, companies in much of the world are capping their IT expenditures. 1 Some companies even peg the performance bonuses of chief information officers to how much money they cut from technology budgets. 2

Yet companies underinvest in technology at their peril -- even in lean times. New technology, deployed intelligently, can help organizations make dramatic leaps in productivity and redefine competition within whole sectors, as Wal-Mart and Dell Computer, among others, have shown. The essence of smart deployment is knowing where and when to invest. Which technology expenditures will yield a sustainable, differentiable advantage? Will the bleeding edge of technology bolster a company's bid to be a leader, or should executives wait until the risks and costs fall? These perennially difficult questions -- which hinge on a complex array of industry-specific factors -- become even thornier when earnings pressures are high.

Compounding the challenge is the tendency to view technology, first, as a panacea and, then, after the hype proves unrealistic, as anathema. The experience of the leaders shows that new technology alone won't boost productivity. Productivity gains come from managerial innovation: fundamental changes in the way companies deliver products or services. Companies generate innovations, in fat years or lean, by deploying new technology along with improved processes and capabilities. 3

Priorities for investment

How can companies invest in technology to achieve meaningful gains? The McKinsey Global Institute (MGI) spent two years investigating the relationship between IT and productivity and found that the former most effectively stimulates the growth of the latter by helping companies to innovate. Innovation sometimes means creating new products (such as faster microprocessors), services (mobile telephony), or processes (on-line securities trading). But it also involves using technology to turbocharge existing processes by helping companies to extend their current advantages in key areas. When Wal-Mart linked IT with its efficient distribution network, it advanced both the state of the art in supply chain management and the productivity frontier of its sector. 4

MGI's research suggests that to foster innovation rather than merely spawn systems that are quickly imitated or promote the wrong goals, companies should focus on two priorities. The first is to identify the productivity levers offering the greatest opportunity for competitive differentiation: targeting the few specific levers that could well create a competitive advantage produces results more reliably than striving for improvement everywhere. The most promising IT initiatives usually evolve along with related business processes and build on an organization's operational strengths. When taking this route, companies should beware the siren song of IT success stories from other industries, since the levers that matter in one sector may be irrelevant in another.

The second priority is to master the sequence and timing of investments. Many technology-based advantages, particularly those that don't involve fundamental business changes, have a limited life because they diffuse rapidly through the sector. Timing is therefore critical if IT investments are to generate returns. Companies that get it right develop a clear understanding of how IT-enabled competition is evolving in their sectors. Investing ahead of the pack makes sense if the technology is hard to mimic, continues to yield benefits even if imitated, or offers great near-term value. Otherwise, companies can often hold down their spending and boost their returns by diving in only after others have made investments -- and mistakes.

Responsibility for addressing these two priorities lies with technologists and business executives alike. An IT organization needs help to have a thorough understanding of the sources of a company's productivity advantage and the competitive dynamics that influence the diffusion of technology. A smart approach to IT that emphasizes innovation, differentiation, and productivity thus requires senior executives to help set the technology agenda and be accountable for its results.

Innovation and diffusion

Our insights into the chemistry between effective IT investment and productivity build on earlier MGI research into the impressive US productivity gains achieved since 1995. Productivity, this study 5 concluded, flourishes when competition becomes so intense that managers must innovate and competitors must adopt innovations quickly. Productivity boomed in the wholesale pharmaceutical sector, for example, when downstream retail consolidation squeezed wholesalers, forcing them to achieve major efficiencies by automating their warehouses.

The rapid diffusion of technology may be good for economies, but companies derive the greatest advantage from innovations when competitors can't adopt them quickly. Once many companies in a sector have implemented a set of IT applications, they become just another cost of doing business, not sources of competitive advantage. Naturally, competitors can most readily adopt the simplest IT-enabled improvements -- those that primarily involve dropping a technology into place.

In retailing, for instance, central support systems, warehouse-management and -automation systems, and point-of-sale (POS) upgrades are now core IT investments that every large company makes. Although they do improve productivity for the whole sector, they confer no differentiating competitive advantage on individual companies; the benefits accrue to consumers, who enjoy lower prices and more convenient shopping. In the most extreme cases of rapid diffusion, competitors adopt similar technologies in a "me-too" investment frenzy; think of customer-relationship-management (CRM) and enterprise-resource-planning (ERP) software in the late 1990s.

But some technology initiatives either do generate new products, processes, and services or substantially extend a company's existing advantages. Some of these innovations don't diffuse rapidly, because embedded in them are barriers that reduce the competition's ability to follow suit. Such barriers arise, for instance, when IT innovations are fused with broader changes in business processes or coupled with other, more sustainable advantages, such as economies of scale and scope or deep intellectual capital. Of course, the use of IT to generate innovations that enhance productivity and defy imitation poses important strategic questions. How, for example, should a company seek out investments that genuinely differentiate it from competitors? How can it plan the timing and level of investment to derive long-term value amid fierce competition?

Related thinking from The McKinsey Quarterly:
A Hard and Soft Look at IT Investments