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10 January 2007

Efficiency v effectiveness

There is much ado these days about the potential of information technology to make government more efficient and effective. Unfortunately, the debate is generally biased to the former; the priority is cost-cutting, not value creation.

This is unfortunate because IT offers a much greater potential return for investment in government if the focus is on effectiveness first, efficiency second.

In the world of commerce, it is well understood that you establish a market for a product or a service by meeting (or exceeding) the expectation of customers. Having secured a place in the market and with production increasing as a result, you can gradually wind down costs, for three reasons: first, as volumes grow, unit costs generally fall; second, once you have amortised (or recovered) your initial investment, your profit margin per unit increases; and third, it becomes possible to secure repeat custom; and repeat customers are cheaper to keep than new customers are to acquire.

Following this type of reasoning, it is argued that investing in new IT, for example to build a new system, replacing an older, less efficient system, will reduce the cost of government. That is a flawed argument.

Let us say that the old system produces widgets at a rate that is twenty per cent more expensive than a new system. Let us also assume that the old system had cost one million dollars to develop, now fully depreciated. The new system will cost three million dollars to develop and will have an operating life of seven years.

Simple, you say, with a unit saving of twenty per cent, we will make our money back and more over seven years. This may be so in the private sector, but it is not so simple in government.

First, depreciation is meaningless in government. Depreciation makes sense only where you can claim a taxation benefit as you gradually write off the asset. Government does not pay tax, which means that a million dollar cost is a million dollar cost, not a million dollars less any tax rebate or deduction. Also, government does not make money by providing services, which means that there is no revenue produced by the use of IT to support service delivery.

This means that the true unit cost when the new system is commissioned is not twenty per cent less than for the former system, because when you have built the new system and spent three million dollars on it, you still have one million dollars of investment on the old system that you have not recovered.

I know that accountants will cringe when they read this, because that is not how accrual accounting operates. However, in government at least, accrual accounting, in my opinion, does not represent reality accurately.

To make this plain, let me put it to you this way. In 2000, I buy a washing machine for $1,000; it costs me $1 dollar per wash to run, and it still works. Now, in 2007, I want to keep up with the Joneses and I buy a new washing machine, for $3,000. I will keep it for seven years, just like the first one, and it will cost me $0.80 per wash. Note that if I do a hundred washes every year (about standard, I think in a household with no children), the savings will be small by comparison with the cost of sourcing a new machine. However, the new washing machine is easier to use and it looks a lot better than the old one; the value of this purchase to me is not financial.

After all, is anyone going to give me back the $1,000 I have already spent on the first machine, when I buy the second machine? I doubt it (no one gives that much for a trade-in!), so I start the second sourcing cycle with a sunk cost of $1,000. It is not a good deal financially; and the same logic applies to government use of IT.

And here you might say, ah, well the problem is volume. The new IT system will support many more units of service, thus filling the cost gap. I wish it were so, but, in government, rising volumes do not necessarily result in reducing costs. Sometimes they even generate a higher total cost, because hidden demand is suddenly revealed by the introduction of the new service or by lifting service quality.

If you make government benefits or services more visible and easier to get, the cost to government (to taxpayers) goes up. As is the case with my washing machine example, because no revenues are being generated, the cost of the initial investment cannot be recovered easily, if at all. Lastly, repeat custom for government is a source of expense, not revenue or efficiencies.

So, in this sense at least the private sector and the public sector differ dramatically – there is a much weaker case in the latter to justify an investment in IT on the basis of efficiency.

However, by investing in new IT, government may be able to provide a greatly improved service to the community: easier to access, cheaper for the user, better protection of personal information (and so on). If so, for a three million dollar additional investment, taxpayers and citizens would get much greater value, which means, in turn, that government would also get value in the form of appreciation of its efforts on behalf of the community.

The problem is that these forms of value are very hard to quantify; the metrics, if they exist at all, are of poor quality. Until there are better metrics, arguments will continue to be made on efficiency grounds, unfortunately, and investment decisions will continue to be biased by the wrong drivers.