What's embedded in the cost of goods sold is what customers recognize as the value they receive. Customers don't care how much a corporation spends on accountants, personnel administration, advertising, lawyers, computers or executives. But IT executives should care greatly, because consultants, IT vendors and most government economists have long assumed that the more IT you have, the lower the transaction costs. Computerization, they claim, accelerates communication, simplifies workflow, automates clerical tasks, delivers improved intelligence, eliminates redundancies and helps integrate diverse activities. In short, the biggest benefits are lower transaction costs. So the tail-to-tooth ratio should be declining.

As I've said before, those claims are myths. Yet their persistence bothers me.

I used the latest compilation of year 2000 annual reports by Compustat to examine financial results. I focused on recent trends in corporate costs while companies were installing computers at a rate that was growing more than three times as fast as spending on all other business equipment. In effect, corporations were placing larger bets on the prospective payoffs from computers than on investments in any other means of production ["A Growing Bubble", April 9, 2001]. When corporations proposed investments in IT, reductions in transaction costs always showed up in projections of "tangible" gains. But from the accompanying chart based on the Compustat data, we can examine the evidence of what more than a decade of exuberant IT spending has delivered.

Tail-to-Tooth Ratio on the Rise The ratio of average transaction costs to the costs of goods sold has risen from 26% to 30% since 1990. Source: Compustat data on transaction costs and cost of goods sold for 6,603 U.S. corporations with total cost of goods in 2000 of $6.3 trillion

The steady gain in the average transaction expenses necessary to support the costs of goods and services caused U.S. firms to spend $273 billion more in transaction expenses in 2000, or 14% more than indicated by the ratio that worked for the firms in 1990 ($1.91 billion vs. $1.64 billion). This estimate offers the most optimistic interpretation of what the additional costs were. If identical calculations were based on the median ratio of transaction costs to the cost of goods - which offers a more conservative view of the situation—that rise would have been slightly more than double that percentage. The chief reason for the large gains in added costs is a rise in pay in the financial services sector, where computerization was most pervasive and consumes about one-third of all IT in the U.S. economy.

Implications:

The past two decades saw the installation of costly information management systems that promised reductions in transaction costs. But the numbers disprove such assumptions. The trend in transaction costs is a telling indicator that will help validate the long-term effectiveness of IT investments ["The 'Right' Spending", Jan. 7]. Given the increased pressure to justify IT payoffs, this metric offers evidence that IT investments haven't improved corporate efficiency, since these numbers can be linked to financial statements on which shareholders, financial analysts and boards of directors rely. What counts today is what benefits shareholders. The prescription for that? Create a trim organization that can make itself more competitive by reducing transaction costs.

In a follow-up column, Strassmann will examine a frequently used and misleading metric: the IT budget-to-corporate revenue ratio. Contact him at paul@strassmann.com.