Economics and Justification of Electronic Commerce Chapter 15 Economics and Justification of Electronic Commerce

Learning Objectives Describe the need for justifying EC investments, how it is done, and how metrics are used to determine justification. Understand the difficulties in measuring and justifying EC investments. Recognize the difficulties in establishing intangible metrics and describe how to overcome them. List and briefly describe traditional and advanced methods of justifying IT investments. Electronic Commerce Prentice Hall © 2006

Learning Objectives Understand how e-CRM, e-learning, and other EC projects are justified. Describe some economic principles of EC. Understand how product, industry, seller, and buyer characteristics impact the economics of EC. Recognize key factors to the success of EC projects and the major reasons for failures. Electronic Commerce Prentice Hall © 2006

Why Justify EC Investments? How Can They Be Justified? Increased Demand for Financial Justification Addressing accountability is difficult: 65% of company executives lack the knowledge or tools to do ROI calculations 75% of company executives have no formal processes or budgets in place for measuring ROI 68% of company executives do not measure how projects coincide with promised benefits 6 months after completion Electronic Commerce Prentice Hall © 2006

Why Justify EC Investments? How Can They Be Justified? Other Reasons Why EC Justification Is Needed Companies now realize that EC is not necessarily the solution to all problems. Therefore, EC projects compete for funding and resources with other internal and external projects. Analysis is needed to determine when funding of an EC project is appropriate In some large companies, and in many public organizations, a formal evaluation of requests for funding is mandated Electronic Commerce Prentice Hall © 2006

Why Justify EC Investments? How Can They Be Justified? Other Reasons Why EC Justification Is Needed Companies need to assess the success of EC projects after they have been completed and then on a periodic basis (see Chapter 14) The success of EC projects may be assessed in order to pay bonuses to those involved with the project Electronic Commerce Prentice Hall © 2006

Why Justify EC Investments? How Can They Be Justified? EC Investment Categories and Benefits The IT infrastructure provides the foundation for EC applications in the enterprise EC applications are specific systems and programs for achieving certain objectives Electronic Commerce Prentice Hall © 2006

Why Justify EC Investments? How Can They Be Justified? Specific Benefits cost reduction (85%) productivity improvement (7%) improved customer satisfaction (6%) improved staffing levels (5%) higher revenues (4%) higher earnings (4%) better customer retention (4%) more return of equity (3%) faster time-to-market (3%) Electronic Commerce Prentice Hall © 2006

Why Justify EC Investments? How Can They Be Justified? How Is an EC Investment Justified? cost-benefit analysis A comparison of the costs of a project against the benefits Electronic Commerce Prentice Hall © 2006

Why Justify EC Investments? How Can They Be Justified? Justification may not be necessary when: The value of the investment is relatively small for the organization The relevant data are not available, inaccurate, or too volatile The EC project is mandated—it must be done regardless of the costs and benefits involved Electronic Commerce Prentice Hall © 2006

Why Justify EC Investments? How Can They Be Justified? Using Metrics in EC Justification metric A specific, measurable standard against which actual performance is compared key performance indicators (KPI) The quantitative expression of critically important metrics Electronic Commerce Prentice Hall © 2006

Difficulties in Measuring and Justifying EC Investments The EC Justification Process The EC justification process varies depending on the situation and the methods used In its extreme, it can be very complex Electronic Commerce Prentice Hall © 2006

Exhibit 15.1 A Model for EC Project Justification Electronic Commerce Prentice Hall © 2006

Difficulties in Measuring and Justifying EC Investments Difficulties in Measuring Productivity and Performance Gains Data and Analysis Issues EC Productivity Gains May Be Offset By Losses in Other Areas Incorrectly Defining What Is Measured Other Difficulties Electronic Commerce Prentice Hall © 2006

Difficulties in Measuring and Justifying EC Investments Relating IT Expenditures to Organizational Performance The relationship between investment and performance is indirect Factors such as shared IT assets and how they are used can impact organizational performance and make it difficult to assess the value of an IT (or EC) investment Electronic Commerce Prentice Hall © 2006

Difficulties in Measuring and Justifying EC Investments Difficulties in Measuring Costs and Benefits Tangible Costs and Benefits—are those that are easy to measure and quantify and that relate directly to a specific investment Intangible Costs and Benefits Costs may involve having to change or adapt other business processes or information systems Intangible benefits include faster time-to-market, increased employee and customer satisfaction, easier distribution, greater organizational agility, and improved control Electronic Commerce Prentice Hall © 2006

Difficulties in Measuring and Justifying EC Investments Handling Intangible Benefits The most straightforward solution to the problem of evaluating intangible benefits in cost-benefit analysis is to make rough estimates of the monetary values of all of the intangible benefits and then conduct a ROI or similar financial analysis Electronic Commerce Prentice Hall © 2006

Exhibit 15. 2 Process Approach to IT Exhibit 15.2 Process Approach to IT Organizational Investment and Impact Electronic Commerce Prentice Hall © 2006

Methods and Tools for Evaluating and Justifying EC Investments Methodological Aspects of Justifying EC Investments Types of Costs Distinguish between initial (up-front) costs and operating costs Direct and indirect costs In-kind costs Break-Even Analyses Electronic Commerce Prentice Hall © 2006

Methods and Tools for Evaluating and Justifying EC Investments Methodological Aspects of Justifying EC Investments total cost of ownership (TCO) A formula for calculating the cost of owning, operating, and controlling an IT system total benefits of ownership (TBO) Benefits of ownership that include both tangible and the intangible benefits Electronic Commerce Prentice Hall © 2006

Methods and Tools for Evaluating and Justifying EC Investments Methodological Aspects of Justifying EC Investments Business ROI Technology ROI ROI calculator Calculator that uses metrics and formulas to compute ROI Economic Value Added Electronic Commerce Prentice Hall © 2006

Methods and Tools for Evaluating and Justifying EC Investments Traditional (Generic) Methods for Evaluating IT Investments Rate of ROI Method Payback Period Net Present Value Electronic Commerce Prentice Hall © 2006

Methods and Tools for Evaluating and Justifying EC Investments Advanced Methods for Evaluating IT and EC Investments value analysis Method where a company evaluates intangible benefits using a low-cost, trial EC system before deciding whether to commit a larger investment to a complete system dashboard A single view that provides the status of multiple metrics Electronic Commerce Prentice Hall © 2006

Examples of EC Project Justification E-Procurement E-procurement is not limited to just buying and selling It also encompasses the various processes involved in buying and selling: Selecting suppliers Submitting formal requests for goods and services to suppliers Getting approval from buyers Processing purchase orders Fulfilling orders Delivering and receiving items Processing payments Electronic Commerce Prentice Hall © 2006

Examples of EC Project Justification Justifying a Portal Internal payoff must result in productivity improvements External value is determined by revenue generation Justifying E-Training Projects When comparing e-training and traditional training methods, several factors, most of which are intangible, must be evaluated Electronic Commerce Prentice Hall © 2006

Examples of EC Project Justification Justifying and Investment in RFID Although such systems offer many tangible benefits that can be defined, many measures cannot be developed due to the fact that the technology is new and that legal requirements (for privacy protection) are still evolving Electronic Commerce Prentice Hall © 2006

Examples of EC Project Justification Justifying Security Projects More than 85% of viruses enter business networks via e-mail. Cleaning up infections is labor intensive, but anti-virus scanning is not Employee security training is usually poorly done. Employees told what to do, with little or no time devoted to why specific security rules are in place Electronic Commerce Prentice Hall © 2006

The Economics of EC Production Costs Increasing Returns to Scale network effects Effects created when leading products in an industry attract a base of users, which leads to the development of complementary products, further strengthening the position of the dominant product Electronic Commerce Prentice Hall © 2006

The Economics of EC Production Costs Increasing Returns to Scale lock-in effect Effect created when users do not switch to another site because of barriers posed by having to learn new site navigation systems and transaction processes Electronic Commerce Prentice Hall © 2006

Exhibit 15.8 Increasing Versus Decreasing Returns Electronic Commerce Prentice Hall © 2006

The Economics of EC Production Costs Product Cost Curves average-cost curve (AVC) Behavior of average costs as quantity changes; generally, as quantity increases, average costs decline Electronic Commerce Prentice Hall © 2006

Exhibit 15.9 Cost Curve of (a) Regular and (b) Digital Products Electronic Commerce Prentice Hall © 2006

The Economics of EC Production Function production function An equation indicating that for the same quantity of production, Q, companies either can use a certain amount of labor or invest in more automation agency costs Costs incurred in ensuring that the agent performs tasks as expected (also called administrative costs) Electronic Commerce Prentice Hall © 2006

Exhibit 15.10 The Economic Effects of EC Electronic Commerce Prentice Hall © 2006

The Economics of EC transaction costs Production Costs Costs that are associated with the distribution (sale) and/or exchange of products and services including the cost of searching for buyers and sellers, gathering information, negotiating, decision-making, monitoring the exchange of goods, and legal fees Electronic Commerce Prentice Hall © 2006

Exhibit 15.11 The Economic Effects of EC: Transaction Costs Electronic Commerce Prentice Hall © 2006

Exhibit 15.12 Reach Versus Richness Electronic Commerce Prentice Hall © 2006

The Economics of EC Reducing Transaction Friction or Risk product differentiation Exploiting EC to provide products with special features to add greater value to customers Electronic Commerce Prentice Hall © 2006

The Economics of EC agility An EC firm’s ability to capture, report and quickly respond to changes happening in the marketplace Electronic Commerce Prentice Hall © 2006

The Economics of EC valuation The fair market value of a business or the price at which a property would change hands between a willing buyer and a willing seller who are both informed and under no compulsion to act. For a publicly traded company, the value can be readily obtained by the price the stock is selling over the exchange Valuation Methods The comparable method The financial performance method The venture capital method Electronic Commerce Prentice Hall © 2006

Factors That Determine EC Success Product Characteristics Industry Characteristics Seller Characteristics Consumer Characteristics Electronic Commerce Prentice Hall © 2006

Factors That Determine EC Success The Levels of EC Management Ultimately, the level of measurement relates to what is of value to the various constituents at each level Electronic Commerce Prentice Hall © 2006

Opportunities for Success in EC and Avoiding Failure E-Commerce Failures At a macroeconomic level, technological revolutions have had a boom–bust–consolidation cycle At a mid-economic level, the bursting of the dot-com bubble in 2000–2003 is consistent with periodic economic downturns At a microeconomic level, the “Web rush” reflected an over allocation of scarce resources—venture capital and technical personnel—and too many advertising-driven business models Electronic Commerce Prentice Hall © 2006

Opportunities for Success in EC and Avoiding Failure Top three factors for EC success B2C EC effective marketing management an attractive Web site building strong connections with the customers B2B EC readiness of trading partners information integration inside the company and in the supply chain completeness of the EC system Overall success proper business model readiness of the firm to become an e-business internal enterprise integration Electronic Commerce Prentice Hall © 2006

Opportunities for Success in EC and Avoiding Failure digital options A set of IT-enabled capabilities in the form of digitized enterprise work processes and knowledge systems complementary investments Additional investments, such as training, made to maximize the returns from EC investments Electronic Commerce Prentice Hall © 2006

Opportunities for Success in EC and Avoiding Failure Cultural Differences Critical elements that can affect the value of EC across cultures are perceived trust, consumer loyalty, regulation, political influences EC in Developing Economies Developing economies often face power blackouts, unreliable telecommunications infrastructure, undependable delivery mechanisms, and the fact that only a few customers own credit cards Electronic Commerce Prentice Hall © 2006

Managerial Issues How do we measure the value of EC investment? What complementary investments will be needed? How do we shift from tangible to intangible benefits? Who should conduct a justification? Should we use the ROI calculator provided by a vendor who wants to sell us an EC system? Electronic Commerce Prentice Hall © 2006

Summary The need for EC justification. The difficulties in justifying EC investment. Difficulties in established intangible metrics. Traditional methods for evaluating EC investments. Understand how specific EC projects are justified. EC investment evaluation. E-marketplace economics. Reasons for EC success and failure. Electronic Commerce Prentice Hall © 2006