A Methodology for IT Investment Management

1. A Methodology for IT Investment Management FIN 545: Financial Decision-Making for IT May 1, 2000

2. Agenda for Today • Some issues discussed in today’s article have been addressed in this class: • how should investments in IT (infrastructure) be justified? • how can the value of these IT investments be managed over time? • However, we need to take a step back and answer some other critical questions • Capital One • an example

3. Financial Analyst & Project Manager Portfolio of Real Options (e.g., engineering, parameters, etc.) Financial Analyst (e.g., valuation and action plan) Project Manager (e.g., implements action plan on-time and on-budget)

4. The High-Level View:The Missing Links • How should IT investments be designed and managed to ensure alignment with corporate strategy? • we must discuss how firms identify the portfolio of real options that the financial analysts value and the project managers implement • What more (than technology) is needed to realize the full potential of IT? • until now we have assumed that once an investment decision is made, the IT project will be successfully implemented (or there is no internal project risk)

5. Aligning of the Goals of IT Investments with a Firm’s Overall Business Vision Business Vision Identify current and desired business capabilities Design an investment program (e.g., identify a set of real options that will help acquire these desired capabilities) Estimate costs and benefits Determine Market Value

6. Business Capabilities • A business capability: • is a distinctive attribute of a business unit that creates value for its customers • allows a firm to transform its input factors into a set of products and services • The value of these products and services depends on: • market conditions (e.g., consumer adoption rates, legislation) • degree of success in acquiring the business capability

7. Examples • Boeing’s concurrent design and manufacturing approach • helped them to deliver the 777 jetliner to market much faster than traditional “design-then-build” methods • Frito-Lay’s skills in micro-segmentation and micro-marketing • increased ability to respond to local competition • enabled by increased amounts of information made available through supermarket scanners

8. A Business Capability Is Built By Investment in “Operating Drivers” Organizational Component (e.g., relationships with other firms and internal structure) Process (e.g., workflows, procedures, management controls) Technology (e.g., IT) Business Capability

9. An Example Rapid Prototyping Distributed database management Supplier Relationships Team work structure Labor Contracts Communications infrastructure Fast cycle capability

10. Aligning of the Goals of IT Investments with a Firm’s Overall Business Vision Business Vision Identify current and desired business capabilities Design an investment program (e.g., identify a set of real options that will help acquire these desired capabilities) Estimate costs and benefits Determine Market Value

11. Identification of Current and Desired Capabilities Current Business Capabilities 1) 2) Desired Business Capabilities 1) 2) Each business capability --> value Current Operating Drivers 1) 2) Necessary Operating Drivers 1) 2) Each operating driver --> investment Our goal is to manage the investment opportunities to mitigate downside losses and capture upside benefits

12. Design of an Investment Program • Accommodate for contingent values of business capabilities based on: • market-related uncertainties • project-related uncertainties • This is essentially where the firm decides the engineering of the problem • set up the binomial trees (e.g., staged investments, options to abandon, expand, contract, etc. • identify the menu of choices available to the firm at decision points (based on what state you’re in)

13. Estimate Costs and Benefits • Determine value associated with each capability (cash flows) • Evaluation of cash flows • use dynamic programming to fold back the binomial trees and identify action plans (or optimal decision paths) • We are familiar with this

14. Capital One: A Case Example • One of the world’s most profitable credit card issuers • named “1995 Credit Issuer of the Year” by Credit Card Management) • from 1992 to 1996, dollar value of loans managed increased from $1.7 billion to $12.8 billion • at the same time, bad loan charge-offs are among the lowest in the industry • What has led to their success? • “Development of new and different strategies by exploiting fundamental differences between itself and its competitors in technology, organizational structure, corporate culture, and the use of information”

15. The Great Idea • Rich Fairbank and Nigel Morris • in 1988 they were consultants with a vision • they went to a series of banks that issued credit cards and proposed their “Great Idea” • The “Great Idea” (or information-based strategy) • “use of rigorous scientific testing to drive mass customization, enabling them to deliver “the right product to the right customer, at the right time and at the right place”

16. Differences in Customer Costs and Uniform Pricing in the 1980s 14% APR Number of Customers Customer Profitability

17. Bank Capabilities in the 1980s • Small number of credit card products • essentially a “one-size-fits-all” strategy • Economies of scale (--> improve margins) • acquire more market share and more customers to spread fixed costs across more customers --> lower per customer costs and high margins • big goal = increase market share • Outsource customer contact and data processing to lower costs

18. The Desired Capabilities of the “Great Idea” • Micro-segmentation and micro-marketing skills • identify the best, most profitable customers • cream-skim these profitable (or low cost to serve) customers from banks through targeted marketing and differential pricing strategies (as opposed to traditional uniform pricing or one-size fits all approach)

19. Necessary Operating Drivers • Technology • database management systems (infrastructure) • Process • need to determine who the profitable customers are • “test and learn” process • it will be necessary to test different target offerings in order to learn the combination of characteristics that make different products desirable to customers and profitable for credit card issuers • start small since initial offerings may lose money (but learning) • account management skills • rigorous statistical techniques/skills

20. Rich and Nigel Get Dissed • Shopped their idea to 16 banks (help them transform their credit card operations) • e.g., Citibank, Chase, Bank of America, Bank of New York, Chemical Banking • Rejected by all of them • “It can’t be done” - it’s too expensive and the data that you need on individual consumers to make the strategy succeed is simply not available to the bank

21. Signet Gives Them A Shot • Signet • small bank looking for opportunities to grow • brought them into the bank as head of the credit card operations • gave them real control over systems • gave them profit sharing potential • they had real support from the CEO

22. Initial Performance (Oct 1988 - Dec 1991) • Built databases • Learned trade of account management • August 1989 • first rollout of solicitations based on their “test and learn” methodology • run some test marketing activities (send out a small, yet carefully selected, sample of direct marketing mailings) • determine which test made money and which did not (the takes time) -- most tests will be unprofitable • run more tests like the ones that were successful initially

23. Initial Performance (Oct 1988 - Dec 1991) • December 1991 • charge-offs from 1989 solicitations > 9.5% • doubled the charge-offs of the bank’s porfolio (from 2.6% to 5.9%) by the end of 1991 • forecast profits (based on trend) for 1992 of credit card operations were zero • But they continued to increase testing • 1989 - 335 tests • 1991 - 617 tests

24. Middle Period (1992 - 1994) • High growth in accounts • Percent charge-off improved dramatically • better than industry average • Credit card came to account for 2/3 of the bank profits

25. Why the Success? • Achieved a desired business capability • micro-segmentation and micro-marketing • Market conditions were favorable to transform this capability into value • They were able to convince Signet to achieve this capability by investing in, and leveraging,: • information technology • scientific testing (test and learn methodology) • highly flexible operating infrastructure

26. The Balance Transfer Product

27. Aligning of the Goals of IT Investments with a Firm’s Overall Business Vision Business Vision Identify current and desired business capabilities Design an investment program (e.g., identify a set of real options that will help acquire these desired capabilities) Estimate costs and benefits Determine Market Value

28. Next Time • Spin-off from Signet --> Capital One • why did they spin-off? • Discuss the current period • Course wrap-up • Final comments on the final exam