The Organic IT Department: Strategic Cost Analysis to Unlock a Sustainable Competitive Advantage (Working Paper)

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This paper was submitted as final exam substitute for the International Business Strategy course at UNSW. It is a research paper illustrating how transaction cost economics (TCE) can be used to quantify the hidden cost of running in IT department. The resource-based view (RBV) is then used to explain how a salient IT department can be viewed as a resource to enable a sustainable competitive advantage amongst competitors. This paper is a work in progress awaiting feedback from a senior lecturer.

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The Organic IT Department: Strategic Cost Analysis to Unlock a Sustainable Competitive Advantage (Working Paper)

  1. 1. <br />The Organic IT Department<br />Strategic Cost Analysis to Unlock a Sustainable Competitive Advantage<br />Juan Carbonell<br />3306413<br />STRE5603<br />International Business Strategy<br />Table of Contents TOC o " 1-3" h z u 2Introduction PAGEREF _Toc138848577 h 23TCE and the Hidden Cost of Operating IT PAGEREF _Toc138848578 h 44Strategic Modular Analysis of the IT Department PAGEREF _Toc138848579 h 54.1IT Customers (Business End Users) PAGEREF _Toc138848580 h 54.2Process & Procedure PAGEREF _Toc138848581 h 64.3IT Infrastructure PAGEREF _Toc138848582 h 74.4Applications (IT Soft Infrastructure) PAGEREF _Toc138848583 h 84.5IT Service Function PAGEREF _Toc138848584 h 85RBV and Leveraging IT as a Business Enabler PAGEREF _Toc138848585 h 106Conclusion PAGEREF _Toc138848586 h 117References PAGEREF _Toc138848587 h 13<br />Introduction<br />Information Technology (IT) is defined as “the technology involving the development, maintenance and use of computer systems, software and networks for the processing and distribution of data”; IT was defined in 1978 by Merriam-Webster (2010). Since this time, IT has enabled organisations to amass information, dissect this information collaboratively and report on it in real-time. Most people would hail IT as the saving grace of modern business, yet the typical firm considers IT a cost centre instead of a business facilitator. Why?<br />The answer is clear, but complex: IT can either be a powerful tool to support the organisation’s ability to manage information or, conversely, make the coordination of an organisation’s processes more complex and difficult. Several studies clearly argue that IT supports firms because it makes more information available and easier to use, which in turn reduces uncertainty. On the other hand, the problem of information excess highlights the greater level of complexity faced as a consequence of unmanaged information, which increases both operational and administrative costs (Cordella 2001). <br />Many organisations now face a tipping point from piecemeal building practices that have evolved into overly complex infrastructure issues. The purpose of this paper is to decompose the above productivity paradox and create a rational model (Organic IT Model - OITM) that breaks down why this phenomenon exists. The two questions this paper will answer are:<br />RQ1 - Does transaction cost economics give insight into the hidden costs of running an IT department?<br />RQ2 - Can optimising your IT department lead to a sustainable competitive advantage?<br />Transaction Cost Economics (TCE) and the Resource-based View (RBV) are two leading economic and managerial frameworks. While TCE focuses on the costs associated with conducting exchanges between two separate entities, RBV concentrates on those factors that enable firms to gain a competitive advantage and sustain them (Aubert 2001). Together both frameworks shed light on why management should leverage IT to stay ahead of its competitors.<br />Furthermore, IT strategy acts as a mediating force between the technological issues within an organisation and its external environment, which in turn creates business value. IT business value is commonly used to refer to the organisational performance impacts of IT including productivity enhancement, profitability improvement, competitive advantage, inventory reduction and data leveraging (Melville 2004). It should be noted that IT can only generate business value if deployed to leverage pre-existing business and human resources in the firm. For example, a robust and flexible IT infrastructure tied together with strong IT technical skills may help a firm manage its operations more efficiently in the face of environmental complexity (Wade 2004). This compliments the strategic necessity hypothesis, which states that IT assets in the form of firm-specific capabilities and competencies such as knowledge, skills and experience cannot be easily copied and therefore offer the prospect of a sustainable competitive advantage (Clemmons & Row 1991).<br />This paper is unique in that it analyses the IT department as a holistic system; the components analysed within are the IT Customer, Process & Procedure, IT Infrastructure, Applications and the IT Service Function. While analysing each individual component, it is important to clearly understand the optimisation objectives of the firm and ensure that they are in sync with the firm’s overall IT strategy. Accordingly, I propose the use of IT not solely to focus on internal transaction cost minimisation, but as a powerful tool to enable the reduction of transaction volume. Therefore, minimising and filtering information enables a firm to reduce internal coordination (and related costs). This is turn keeps the firm more efficient than the market (Cordella 1997). Hence, optimising IT allows a firm to stay salient amongst competitors.<br />Figure SEQ Figure * ARABIC 1 – Component Interdependence of the Organic IT Model (OITM)<br />TCE and the Hidden Cost of Operating IT<br />TCE belongs to the New Institutional Economics paradigm. TCE views the firm as a governance structure and not just a production function. Coase proposed that under certain conditions the cost of conducting an economic exchange in a market may exceed the cost of organising exchange within a firm. A firm, therefore, consists of a system of relationships that comes into existence when the direction of resources is dependant on an entrepreneur (Coase 1937). Therefore, transaction costs are the costs of running the system and include ex ante costs such as drafting and negotiating contracts and ex post costs such as monitoring and enforcing agreements (Rindfleisch & Heide 1997). <br />The unit of analysis in TCE is a transaction, which “occurs when a good or service is transferred across a technologically separate interface” (Williamson 1985, p. 1). Williamson suggests that transaction costs include both direct costs and the opportunity costs of making inferior business decisions. IT transaction costs therefore relate to issues that affect the opportunity cost of time lost, searching, training, etc. Managers must weigh up production and transaction costs associated with executing a transaction within their departments versus the costs associated with executing the transaction in the market (Aubert 2001); this is the fundamental logic of TCE in reference to IT.<br />Williamson’s TCE framework (1985) rests on the dynamics of two main human behaviour assumptions and three environmental factors. These behavioural assumptions interact with specific transaction dimensions to create transaction costs. The two behavioural factors are (Aubert 2001):<br />Bounded Rationality: People are unlikely to rationally consider every state-contingent outcome associated with a transaction<br />Opportunism: The assumption that decision makers may seek to serve their own self-interests and that it is difficult to know beforehand who is trustworthy<br />The three environmental factors are:<br />Uncertainty: A problem in uncertain environments where circumstances surrounding an exchange cannot be specified (environmental) and performance cannot be easily verified (behavioural)<br />Partner Frequency: If only a small number of players exist in a marketplace, a party to a transaction may have difficulty disciplining the other parties via the threat of withdrawal or use of alternative partners<br />Asset Specificity: The value of an asset may be attached to a particular transaction that it supports. The party who has invested in the asset will incur a loss if the party who has not invested withdraws from the transaction (safeguarding dilemma)<br />There are also three features of firms that compliment the organic IT model: first, firms have more control and monitoring mechanisms available then do markets (efficiency). Second, firms are able to provide rewards that are long-term in nature (incentive). Third, Williamson (1975) acknowledges the secondary effects of a firm: socialisation processes may create convergent goals between parties that increase efficiency (cooperation) (Rindfleisch & Heide 1997). Hence, IT can be used to leverage these firm features and reduce environmental variability.<br />Successful IT optimisation should therefore make it easier for a firm to:<br />Anticipate and manage change (reduce uncertainty)<br />Reduce architectural complexity (lower interaction cost)<br />Integrate, standardise and automate IT processes (reduce redundancy) <br />Enhance on the value of existing investments through virtualisation and consolidation (lower capital requirements)<br />Increase the value and efficiency of revenue-generating services (maximise ROI)<br />In closing, using TCE to evaluate the components of the OITM should allow us to reduce internal transaction costs. An optimised IT department minimises the transaction cost of operating within the firm allowing its employees to leverage superior information and systems. Next we will evaluate how optimised IT components interact to create an efficient organic IT department.<br />Strategic Modular Analysis of the IT Department<br />IT Customers (Business End Users)<br />The IT customer is the focal point of IT strategy formulation. All other components support the IT customer and should theoretically increase strategic flexibility while reducing interaction costs. The IT department therefore needs to minimise complexity and optimise productivity to enhance the firm’s production capability.<br />The adaptability of employees to organisational change is another factor that determines the strategic flexibility of a firm, which in turn affects performance (Grant 1991). Organisation architectural elements such as autonomous system design teams, shared jobs, team processes and incentives for collaborative learning serve as key enactors in building organisational resources & capabilities. These IT design elements serve to create an environment in which IT customers can leverage not only their own skills, but also effectively leverage the assets of the entire firm’s social network to which the IT customer belongs to. IT also allows IT customers to become more self-sufficient in finding and utilising business and support information, which reduces redundant interactions with the IT service function. This in turn increases efficiency for both parties. <br />The IT customer is paramount in the strategic analysis of the organic IT department model, but further efficiencies can be gained by analysing subsequent components of the department where flexibility exists.<br />Process & Procedure<br />The Process & Procedure (P&P) component entails any tacit portion of the firm that facilitates and governs ongoing operations. A more detailed definition is proposed by AT&T (1988, p. 5) “a process is a set of interrelated work activities that are characterized by a set of specific inputs and value-added tasks that produce a set of specific outputs”.<br />Firm's can therefore theoretically be analysed as a set of P&P (Melan 1993). Processes underlie all intra-firm activities and are found in all functions of a firm. Krajewski and Ritzman (2000) state that decisions on P&P management are strategic and can affect a firm's ability to compete over the long run; efficiency can therefore be affected by choices made when P&Ps are designed. Furthermore, Krajewski and Ritzman (2000) stress that P&P management is an ever-ongoing activity that must me managed holistically.<br />Hammer (1996) claims that many of firm's current P&Ps are the result of a series of ad hoc decisions made in the past with little attention to effectiveness across the entire structure. Therefore, many problems that a firm faces are actually P&P problems, not IT problems. Davenport and Short (1990) argue that rather than maximising the performance of particular individuals or business functions, corporations must maximise interdependent P&Ps within and across the entire firm.<br />The synergistic benefits of IT exist through cross-functional P&Ps spread out across various components. A P&P management perspective can help clarify the benefits of IT and its relationship to the firm, hence reducing transaction costs. P&P management should also govern how information (knowledge) propagates through applications. Lack of a well-defined P&P environment leaves ambiguity, which increases search costs to the IT customer. Also, P&P ambiguity increases reliance on the IT service function, which in turn creates inefficiency. <br />IT optimisation is not just about cost saving on infrastructure. Optimisation is the process of creating a highly efficient and dynamic IT department to render maximum IT business value. Effective optimisation continually analyses the firm for opportunities to improve responsiveness and ROI. It is an ongoing process that can result in lower asset costs and reduced operational expenses. For example, IBM restructured CIB Bank’s (Hungary) P&P management process and actualised an ROI of 91 percent or US$1.75 million. Efficiencies were gained through productivity savings, improved monitoring and reduced unplanned impact losses to the bank (IBM 2009).<br />IT Infrastructure<br />The physical assets that define the firm’s IT infrastructure are comprised of computer and communication technologies supplemented by shareable technical platforms and databases (Bharadwaj 2000). IT infrastructure is a major business resource and a shared information delivery base; it is also a critical component in attaining a Sustainable Competitive Advantage (SCA). <br />IT infrastructure underpins a firm’s competitive position by enabling benefits such as task cycle-time improvement and cross-functional synergy opportunities (Sambamurthy & Zmud 1992). Creating an integrated IT infrastructure requires considerable time and expertise, which creates experiential learning opportunities. It has been noted that the individual components that make up the IT infrastructure are commodity-like, but the process of creating an infrastructure tailored to a firm’s strategic context is complex and imperfectly understood (Weill & Broadbent 1998). Hence, the holistic benefits of a well-integrated system are hard to imitate; time compression diseconomies make it difficult for newcomers to catch up by simply investing in IT infrastructure.<br />IT infrastructure enables firms to:<br />Identify and develop key applications rapidly (lower development costs)<br />Share information across products, services and locations (reduce search costs)<br />Implement common transaction processing across the business (creates consistency)<br />Exploit opportunities for synergy across business units creating a casually ambiguous resource (hard to imitate)<br />It is therefore critical for an IT department to keep its infrastructure highly available and easy to use. Infrastructure downtime directly correlates to a loss of internal value creation for the firm. Firms should therefore consider investing in proven technologies such as virtualisation and unified communication platforms to reduce the potential of downtime and increase intra-firm communication capability respectively. For example, The ‘University of Pittsburgh Medical Center’ (UPMC) created an IT infrastructure that was more flexible, robust and secure. It reduced its server count from 931 to 310 using virtualisation, which also improved system capacity. UPMC also deployed a common application toolset across platforms and generated an overall IT cost saving of 20 percent (IBM 2007). This cost saving was then reinvested to fund future IT projects and enhance operational efficiency. <br />Applications (IT Soft Infrastructure)<br />An application is the information (business) logic interface available to IT customers. Applications can be bought as a package or developed in-house; in-house applications have a higher potential to create imitable resources. Application development skills such as those needed for large software development projects often require interactive teams of IT staff that are far more immobile than individual members. These teams develop distinctive styles and coordination mechanisms, which are perfected overtime through repetition.<br />When new IT customers join the firm, they are trained not only in firm-specific application systems, but also in P&P methodologies unique to the firm. Thus, there are increasing returns to the firm as they add qualified professionals to an existing network of IT customers. Furthermore, such team-embodied knowledge also suffers a slower decay rate as it is passed on without much degradation to successive generations of team members (Bharadwaj 2000). There is no known way to bypass these path dependent processes, hence creating a valuable ‘resource’ for the firm.<br />Applications enable firms to create new information and P&Ps quicker; more importantly, applications simplify connecting IT customers to reduce transaction costs. Today’s applications are often described as composite; that is, they are composed from a wealth of existing application assets. Such composite applications are very powerful as they enable businesses to transform existing P&Ps without having to redevelop existing applications (IBM 2009). Hence, composite applications can shorten development time freeing resources to work on other pressing tasks. For example, a recent survey by IBM verified that 50 percent of firms that responded have declared SOA projects (a form of composite application framework) have already paid for themselves. Of these same firms, 60 percent report they are meeting or exceeding their cost reduction objectives (IBM 2009).<br />IT Service Function<br />The IT service function is responsible for the support and well being of the IT department. Services rendered generally comprise of troubleshooting, training, relationship building and knowledge accumulation (Wade 2004). Firms with a strong IT service function are better able to (Capon and Glazer 1987): <br />Integrate IT and business planning processes more effectively (lower search costs)<br />Develop reliable and cost effective methodologies that support the firm’s business needs quicker than rival firms (increase efficiency) <br />Communicate and work with business units more efficiently (reduce time costs)<br />Anticipate future business needs of the firm and innovate valuable new product features before rivals (produce value)<br />Several frameworks exit to guide an IT service function in the creation of P&P, such as ITIL. ITIL gives a detailed description of important IT practices and provides comprehensive checklists, tasks and procedures that any IT department can tailor to create an efficient IT service function. Structuring the IT service function allows information to be collected, which in turn enables trend analysis of internal issues. Structuring also reduces transaction costs by standardising P&Ps that IT customers will follow to interface with the IT service function.<br />Viewed from an empirical perspective, IT service ‘resources’ are difficult to acquire and complex to imitate due to path dependency; they thereby serve as a potential source of competitive advantage. In fact, differences in organisational and economic benefits that companies’ gain from IT has been largely attributed to the management of these IT service resources as they aid to reduce operational costs (Wade 2004).<br />For example, in just eight years operational labour expense has risen from less than 40 percent of IT labour budgets to nearly 70 percent. It is therefore not surprising that employment of network analysts and system administrators has grown by 14 percent and 8 percent, respectively, as more people are needed to administer a firm’s IT environment. By making the IT service function more efficient, organisations can practically grow their IT infrastructure using the same level of service staffing (IBM 2007).<br />Figure 2 - Change of IT Staff Requirements in US re Complexity, 2004 - 2006 (IBM 2007)<br />RBV and Leveraging IT as a Business Enabler<br />RBV proposes that firms compete on the basis of ‘unique’ corporate resources that are valuable, rare, difficult to imitate and non-substitutable. RBV operates under the assumption that the resources needed to conceive, choose and implement strategies are heterogeneously distributed across firms and that these differences remain stable over time. Resources tend to effectively deter competitive imitation when protected by isolating mechanisms such as time-compression diseconomies, historical uniqueness, embeddedness and causal ambiguity (Barney 1991).<br />A requirement for a SCA is that resources be imperfectly mobile or non-tradable (Barney 1991). IT capital assets such as infrastructure and applications are relatively easy to acquire (commodity-like). Technical knowledge, managerial experience and IT skills/abilities are less easy to obtain. Other resources, such as company culture and P&P knowledge assets may only be available if the firm itself is sold (Grant 1991). Hence, we look at a firm’s assets and capabilities together as a set of resources available to that organisation. These resources are useful in detecting and responding to potential market opportunities and threats (Wade 2004).<br />The ultimate question then is how do investments in technology create superior intangible resources for the firm. Merely purchasing IT infrastructure will not ensure competitiveness because it is the socially complex link between IT and other parts of the organisation that serves as the source of SCA (Barney 1997). Sceptics of IT's direct effects on firm performance have long argued that firms benefit from IT only when they embed IT in a way that produces valuable, sustainable resource complementarity. A key aspect of a firm's intangible resources is its intellectual capital or knowledge assets. This is embedded in the skills and experience of its employees, as well as in its P&P and information repositories. A firm's knowledge capital is widely recognized as a unique, inimitable and valuable resource. IT is critical to knowledge management as technologies such as groupware assist in clarifying assumptions, speeding up communications, eliciting tacit knowledge and constructing catalogues of insight (Wade 2004).<br />Embedding knowledge into the IT system also enables rapid transfer to new IT customers. IT systems thus enable knowledge formalisation and consolidation of previous knowledge gains. When populated with firm-specific knowledge, applications such as groupware and expert systems are transformed into specialised assets that are almost impossible for competitors to imitate (Bharadwaj 2000). Hence, intelligently investing in IT applications that lower transaction costs is imperative to creating an SCA. <br />The OITM also addresses intra-firm synergies. Synergy refers to the sharing of resources and capabilities across organisational divisions. Beyond operational efficiencies, knowledge and information sharing across business units enables firms to be more flexible and to respond faster to market needs (Bharadwaj 2000). As Brown and Duguid (1998) note, IT geared toward creating organisational synergies can aid in the delivery of needed resources by removing the physical and spatial limitations of communication. More importantly, competitive advantages associated with synergies are also less likely to be imitated, as they are often achieved under a unique set of circumstances and on the basis of firm-specific resources (Bharadwaj et al. 1993).<br />Figure SEQ Figure * ARABIC 2 - Frame Where Synergies Produce a Competitive Advantage<br />Lastly, it should be noted that RBV has been criticized for ignoring factors surrounding resources by assuming that they just simply exist (Stinchcombe 2000). RBV does not consider how resources are developed, integrated within the firm or how they are released. Resource management is important to the IT discipline, hence further research into these aspects is recommended.<br />Conclusion<br />While IT may be essential for firms to compete, IT on its own creates no unique SCA for a firm. This concept is consistent with the Strategic Necessity Hypothesis proposed by Clemons and Row (1991). However, IT assets in the form of firm-specific capabilities and competencies such as knowledge, skills and experience cannot be easily copied and therefore do offer the prospect of an SCA.<br />The RBV of the IT department suggests that firms can and do differentiate themselves on the basis of their IT resources. A firm's IT Customers, Process & Procedure, IT Infrastructure, Applications and the IT Service Function serve as firm-specific resources, which in combination create a holistic firm-wide IT capability. For example, a flexible IT infrastructure when combined with a strong IT service function becomes a potent organisational capability. Likewise, successful firms employ their IT infrastructure and applications for developing IT-enabled intangibles such as IT customer orientation, synergy, and superior firm knowledge (Bharadwaj 2000).<br />Knowledge about the efficient application of IT and the manner in which individual IT resources must be combined to create superior capabilities then becomes embedded in these firms in the form of organisational routines (Nelson & Winter 1982) further pushing up the IT capability of a firm. Firms that are successful in creating superior IT capability in turn enjoy superior financial performance by leveraging firm revenues and/or decreasing firm costs. <br />Thus, a firm's IT capability is derived from the underlying strength of its components. Prioritizing IT optimisation projects allows organisations to use its near-term savings (ex. asset consolidation) to fund longer-range goals. Optimisation is therefore an ongoing process that helps to stretch the life of an SCA. 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