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A Dell for every industry

Companies, like species, are competitive beings, and while evolving on an absolute basis is nice, relative evolution is the only thing that really counts.

Economists love to argue about a phenomenon known as the productivity paradox.

The optimists aver that America is in the midst of a long boom cycle resulting from increased productivity brought about by technology. In other words, by replacing humans with software, companies win higher profits, higher return on equity, and, as a result, higher stock prices.

The skeptics champion the notion of a paradox. They argue that return on equity, margins, and profits have not improved markedly since the advent of high-tech. Chief skeptic Paul Strassmann argues in his book Facts and Fantasies about Productivity that computer technology in fact detracts from productivity. He suggests that companies keep a tight lid on technology spending unless they can specifically tie that spending to profits.

The problem with both the optimists and the skeptics is that they are having the wrong argument. Tech spending needs to be considered in light of the evolution of American and global business, because companies exist as part of a competitive capitalist ecosystem. Technology extends the capabilities of the members of this ecosystem. Playing out the evolution metaphor, a good accounting system is equivalent to being able to walk erect--add a Web site that's ready for e-commerce, and the corporation's got the equivalent of an opposable thumb.

Companies, like species, are competitive beings, and while evolving on an absolute basis is nice, relative evolution is the only thing that really counts. If you only improve as much as your natural enemy, you've done nothing to ensure your survival.

Considered from this evolutionary perspective, it's clear that arguing about the productivity paradox is pointless. The optimists say that we should all benefit somehow. But if one company uses technology to become more fit, everyone else in the competitive landscape must do so as well.

Let's say the first mover goes after market share by lowering its price in line with the efficiency gains it has won. Other companies will quickly match its moves, to ensure that they don't lose too much market share. The result? Profits and return on equity do not increase at all--in fact, the only result is some temporary market-share shifts from the less efficient to the more efficient.

As for the pessimists, well, choosing not to adopt technology is like choosing not to evolve. As an example, consider the effect that the oversized racket had on tennis. Old-timers scorned the new idea as somehow improper, almost illicit. Now, however, every pro on the circuit uses such a racket.

Are tennis players now more productive? Sure, they hit more aces--but so do each of their competitors. The technology advantage is shared by both sides. The game has absorbed the advantage, and the only person with a demonstrable disadvantage is a fool who insists on using the small wooden racquet of yesteryear.

Those still mired in the productivity paradox debate need to face facts. No one can start a bank today with paper accounting ledgers. You wouldn't dare try to build a competitive insurer, utility, manufacturer, or even retailer without some form of information technology infrastructure. Imagine a global company trying to manage its back office without technology--the odds that big errors would occur are enormous, while the chance that this company would effectively manage its balance sheet is next to zero.

In evolution-speak, the term "fitness" is often used to describe a species' capacity for survival. From a corporate perspective, the best measure of fitness is return on invested capital (ROIC), which measures a company's true cash output relative to the total cash value of the assets deployed in the business. The reason this measure matters most is that, over the long haul, capital flows away from investment opportunities with a low ROIC, and toward investment opportunities with a high ROIC. Inefficient companies are eventually starved from the cash that they need to survive.

To truly understand just how indispensable technology has become, you have to break down ROIC into its two key components: The numerator is its cash-adjusted operating profit, while the denominator is the cash value of the company's net capital investments. Divide both numbers by sales, and you'll see that ROIC can be restated as operating margin multiples divided by asset turnover.

In other words, the two critical components that define a company's fitness are an ability to charge a higher spread between price and actual cost, and the ability to generate more sales from a smaller base of invested capital.

Now let's take a look at how these two components are affected by technology: A company can earn a higher profit margin if consumers think its product is differentiated from others. That's why commodity products have low margin and specialized products have high margins. Obviously, the most differentiated product is something designed specifically for one person. Technology is now helping companies do this efficiently.

The concept, known broadly as mass customization, is best exemplified by Dell Computer, which builds millions of computers a year, each to the specifications desired by the buyer. For one big customer, Ford, Dell has established different PC configurations designed to suit different employees in many different departments. When Dell receives an order for a PC via the Ford intranet, it knows immediately what type of machine the worker is ordering and what kind of machine he or she should get.

Ford pays a premium for such personalized service. Is the price worth it? Consider the alternative. Ford could purchase its PCs from a local distributor. The distributor would send boxes over to Ford. Those boxes would need to be opened and configured by a systems worker. This process, which is common at most companies, typically requires four to six hours of a professional's time for each computer and often results in configuration errors. Clearly, Dell's customization is worth the higher price.

The same is true for other custom products. Levi's is able to charge more, not less, when it customizes a pair of jeans, and Mattel can be sure that little girls will pay a higher price for a personalized Barbie doll. So there's no doubt: companies are beginning to use technology to push margins higher.