Japanese Companies, Particularly SMEs, Fall Behind in Strategic Use of IT - Procedural and organizational reforms are essential

Senior Fellow, RIETI

In the degree of spread and penetration of information networks, there is no big difference between Japan and the United States. Yet when it comes to productivity, Japan lags far behind. This is attributable to the fact that many Japanese companies have been unable to fully use information technology (IT) in a truly strategic way. One factor behind this is that these companies have yet to reform their business processes and organizational structures. Promotion of effective IT use is necessary, particularly among small and medium-size enterprises (SMEs) in order to improve productivity.

Improvement of productivity as anchor for growth

Despite the steady recovery of the Japanese economy, the mid- to long-term prospects for future growth are not necessarily bright given the declining fertility. Seen from the supply side, an economic growth rate can be broken into the contribution of factor inputs, such as labor and capital, and an increase in total factor productivity (TFP). Of these, labor input will make a negative contribution due to the decrease in Japan's working-age population; while a significant rise in capital input is unlikely. Thus, as we look toward the future of the Japanese economy, our hopes and expectations are pinned on the improvement of productivity as an anchor for growth. This is why there has been a chorus of calls across the country for productivity improvement through innovation.

To provide a clearer picture of the relationships between macroeconomic productivity and IT, I will, by type, clarify the concept of innovation.

First, there is technological innovation which stems from the development of new technologies within individual companies or through industry-university collaboration. The outcomes from research and development (R&D) efforts, whether in the form of new products or enhanced production processes, are directly linked to the improvement of productivity. However, technological innovation is an activity observable primarily in manufacturing companies and very much concentrated in the major ones. Japan's private-sector expenditures on R&D amount to some ¥12 trillion and those by the top 10 spenders account for nearly 40% of that amount. Ranking high on the list of R&D spenders are automakers such as Toyota Motor Corp. and electronics-related companies such as Matsushita Electric Industrial Co.

Second is service innovation. Non-manufacturers such as banks and retailers are also engaged in innovation activities on a daily basis; not in the form of R&D but in other forms such as Internet banking and supply chain systems. In the U.S., the banking and retail sectors are among the major driving forces for boosting macroeconomic productivity.

The final type of innovation is organizational innovation. By implementing effective knowledge management systems and through business reengineering, many companies have been improving their productivity. Organizational innovation of this sort, which is a cross-sectoral activity and broad in nature, is quite important when considering macroeconomic productivity.

As discussed, the concept of innovation covers a broad range of activities. However, particularly close relationships can be observed between the use of IT and the last two types of innovation; service and organizational innovation. All the cases I mentioned of these two types have been realized through the effective use of IT. As such, innovation using IT helps a broad range of companies improve their productivity and therefore closely relates to the performance of macroeconomic productivity. Examining the relationships between IT use and productivity is particularly meaningful for Japan where productivity in the non-manufacturing sector is conspicuously lower than in the manufacturing sector.

Japan and the U.S. are no different in information network building

So, what kind of relationship exists between IT investments and macroeconomic growth in Japan? A Japan-U.S. comparative analysis I conducted with Professor Dale W. Jorgenson of Harvard University found that while the contribution of IT capital to the growth of the Japanese economy has been increasing since the later half of the 1990s, the TFP growth rate in that same period has been declining. In other words, Japanese companies have been accelerating IT investment, hence the levels of IT capital stock per worker have been rising. But productivity as a measurement of the actual outcome of such efforts has been on the decline. This indicates that there is some sort of problem with the way Japanese companies utilize IT.

Meanwhile, in the U.S., the TFP growth rate has been increasing in tandem with the increase in IT capital's contribution to economic growth. Although the U.S. economic growth rate fell temporarily following the burst of the IT bubble in 2001, productivity is continuing to show strong growth and effective use of IT is cited as a major contributing factor for such robust performance. As such, Japan and the U.S. show contrasting trends in their relationships between IT and productivity at a macroeconomic level.

To further clarify this, I conducted a comparative analysis jointly with the U.S. Department of Commerce, Center for Economic Studies, Bureau of the Census, using large-scale databases containing data on some 10,000 companies in Japan and some 20,000 in the U.S. We found that U.S. companies, as compared to their Japanese counterparts, have been realizing far greater productivity by using information networks.

The TFP of Japanese companies using information networks is 2.0% higher than the TFP of those that are not. The corresponding TFP gap in the U.S. is 4.4%, more than twice the gap observed in Japan. This also suggests that there exists some sort of problem in the way Japanese companies utilize IT, given the fact that there is no great difference between Japan and the U.S. in the degree of spread and penetration of information networks.

A look at the situation of Japanese companies by type of information network reveals that the contribution of inter-company information networks to productivity remains as low as 1.0% as compared to 2.4% contribution by intra-company. This suggests that many SMEs have been unable to fully utilize new inter-company information systems introduced at the request of their client companies. In contrast, in the U.S. the effect of inter-company information networks on productivity has been visible in various business processes including ordering, production management, and inventory management.

There are some possible reasons why Japanese companies have not sufficiently realized the effective use of IT. One reason is their inability to smoothly carry out necessary procedural and organizational reforms following the introduction of information systems. IT systems tools necessary for productivity improvement but they are nothing but empty boxes if they are not used effectively. For instance, even if a company implements sophisticated supply chain systems, nothing will change as long as the procurement department, which has been in charge of paper-based ordering, continues to perform its tasks in the same old way with the exception of doing them online.

The implementation of highly sophisticated supply chain systems may eliminate the need for the presence of a procurement department as an intermediary between production floors and suppliers. Yet, is it not the case that many companies, even with the knowledge that they no longer need a procurement department, have been unable to push forward organizational reforms in the face of strong internal resistance? In order to fully derive the intended benefits of supply chain system implementation it is also necessary to promote standardization of parts and components, examine production processes, and consolidate and reduce the number of suppliers, which collectively involves massive amounts of work. The benefits from IT implementation only become a reality when all these challenges are overcome through companywide efforts.

In connection with this, Japanese companies are said to have been unable to optimize IT systems because typically the different divisions within a single company use different kinds of IT systems. Even if the divisions computerize their operations such as accounting, ordering, or business support systems, this will have only a limited impact on the business performance of the company unless all these IT systems are integrated companywide. This is probably related to bottom-up decision-making, an approach widely observed among Japanese companies, and the resulting difficulty of implementing any top-down reform.

Productivity to increase stage by stage

The Ministry of Economy, Trade and Industry is proposing a model to describe a stage-by-stage process in which companies deepen the use of IT, starting from the introduction of IT (stage 1) and moving onto division-wide effective use (stage 2), company-wide effective use (stage 3), and finally to group-wide optimization including affiliated companies (stage 4). A survey conducted by the ministry has found that the vast majority of Japanese companies are in stage 2. Based on my estimations, the later the stage of the company, the greater tends to be the productivity growth. It is expected that this stage-based theory provides an important perspective in considering the linkage between IT and productivity.

An increasing number of companies have been establishing the position of chief information officer (CIO) with an aim of promoting companywide operational innovation. Yet in Japanese companies the CIO is often not of a member of the executive board. And in cases where the CIO is an executive, (s)he tends to be concurrently responsible for other tasks. This is probably because many companies consider IT a tool for improving operational efficiency, not a weapon for enhancing competitiveness.

In the U.S., many companies regard informatization as a strategic investment to increase their capacity for analyzing the market to explore new business opportunities and enhance their response to market needs. It is hoped that Japanese companies will follow suit and embark on the strategic use of IT as a means to improve their competitiveness. In order to strengthen the linkage between IT and productivity, it is also important to promote the use of IT among SMEs, which are the lion's share of the Japanese economy.

Policy measures have been put in place to promote IT investment, including special tax incentives for SMEs to invest in software and digital machines. Yet, "soft" measures, those designed to improve efficiency of IT use, remain insufficient. It is particularly important to enhance advisory and consulting services to SMEs as well as to foster human resources capable of providing such services.

>> Original text in Japanese

*Translated from the original Japanese "Keizai kyoshitsu" column published in the November 24, 2006 issue of the Nihon Keizai Shimbun.

December 25, 2006