2Economic Impact of the Adoptionof Enterprise Resource Planning Systems:A Theoretical FrameworkWai-Ching Poon, Jayantha Rajapakse and Eu-Gene SiewMonash University Sunway CampusMalaysia1. IntroductionAccording to Deloitte Consulting, Enterprise Resource Planning (ERP) systems arepackaged business application software suites that allow an organization to automate andintegrate the majority of its business processes, share common data and practices across theentire enterprise, and produce and access information in a real-time environment. The scopeof an ERP solution includes financials, human resources, operations logistics, sales andmarketing modules (Ragowsky & Somers 2002).The benefits that ERP brings to organization are multidimensional and include tangible andintangible benefits (Shang & Seddon, 2002). One of the key characteristics of ERP systems isthe potential for data and process integration across different units of an organization(Deloitte, 1999; Ross & Vitale, 2000; Markus et al., 2000; Volkoff et al., 2005). Such integrationenables real-time decision-making based on ready access to reliable up-to-date information.ERP also allows centralization of data and streamlining of business process. This results inefficiency of business process and reduction in cost (Spathis & Constantinides, 2004). Manystudies have shown the benefits of ERPs, ranging from improving productivity (Hitt et al.,2002; Ifinedo & Nahar, 2006), decision support benefits (Holsapple & Sena, 2005) andintegration benefits of various information systems (Hsu & Chen, 2004).According to Huang et al. (2004), ERP generates tremendous amount of information goods,helps create value chain and increases value-added activities by categorizing availableinformation, such as information about customers, suppliers, transactions cost, and the priceof unit sold. Information could be categorized according to cost-benefit information withrespect to logistic and shipping, marketing, sales and purchasing, and resource allocation,after sale service support, and resource optimization. A few assumptions are requisite. Forexample, the assumptions of constant returns to scale and perfect competitive in the productmarket are often imposed in the estimation of input shares. Constant returns to scale refer tothe output increases at the same rate as the inputs in the production function. To build upinformation goods, there involves high level of fixed cost and these cost of productionsremain constant in the future. That is to say, all information goods are replicated with zeroor very low marginal cost. With information goods in the marketplace, firms with ERPsystems are able to gain competitive advantage, a more practical coordination

16Advanced Topics in Applied Operations Managementinteraction between supplier-customer and hence minimize cost and ultimately optimizemarket efficiency.In this paper, to further extend the above study, we propose an economic analysisframework of the impact of ERP at the firm level. We will use economic production theoryto examine ERP role in this regard. This is important because it extends the understandingof ERP system’s impact and this framework can be used as a basis for research.This paper is organized as follows: Section 2 describes related research in this area,Section 3 presents the conceptual framework, Section 4 provides a brief discussion andSection 5 concludes the chapter.2. Related worksMany research studies examine the relationship between IT and economic performance orproductivity growth. These studies on economic impact are on firm level, sub-plant level,and country level. Productivity is the elementary economic measure of a technologycontribution. There has been considerable debate whether information technology (IT)revolution was paying off in higher productivity (Dedrick et al., 2003). However, results areinconclusive. The Nobel Laureate economist Robert Solow said that “we see computerseverywhere except in the productivity statistics” (cited in Brynjolfsson, 1993). Prior to 1990sstudies found productivity paradox between IT investments and productivity in the U.S.economy. Thereafter, many studies found greater IT investment and revolution observed inhigher productivity gains at both firm and country levels. However, there were studies whofound IT capital has marginal impact on technical progress (Morrison & Siegel, 1997), andsome claimed that IT has insignificant contribution to output growth (Oliner & Sichel, 1994;Loveman, 1988).Four explanations for this productivity paradox include mis-measurement of outputs andinputs, lag effects as a result of adjustment, relocation and rakishness of profits, andmismanagement of information and technology. According to learning-by-using model, theoptimal investment strategy sets marginal benefits lesser than marginal costs in the shortrun. But firm will only see the impacts after sometime due to lag effect and increasingeconomies of scale might only be experienced in the long run. Kiley (1999, 2001) argues thatadjustment costs have contributed to some negative relationship between IT andproductivity and he further argued that adjustment costs have created frictions that causeinvestment in IT capital to be negatively associated with productivity. Meanwhile Roach(1998) argues that much of the productivity stimulation is due to the secular trend towardservice related industries that are caused by rising mis-measurement errors, such as overallow work flexibility, causing unnecessary longer overtime labor hours claims. Thus, actuallabor hours in the IT related industries may not be reflecting the true productivity growthfigure.Some studies have analyzed firm level data and find evidence of significant and positivereturns from IT capital investment (e.g., Brynjolfsson & Hitt, 1996; Dewan & Min, 1997). Theadvantage of the firm level approach is that it gives better measurement of IT contributionsto both quality and variety of products that covered at aggregate level. Some others haveexamined economy level time series data to quantify the contribution of IT toward outputgrowth of a single country, with mixed findings on the contributions of

Economic Impact of the Adoptionof Enterprise Resource Planning Systems: The Theoretical Framework17The above discussion is on IT in general. Now turning to ERP as a specialized area of IT,from the extant literatures, many studies examine the relationship between ERP systemsand its economic impact. Research on the impact of ERP can be broadly divided into level ofanalyses (for example, firm level and sub-plant level) or the different dimensions of impact(for example, financial, operational and managerial). Studies on firm level focus on theeffects on the whole organization. These can be financial impacts, or the five classification byShang & Seddon (2002); namely operational benefits, managerial benefits, strategic benefits,IT infrastructure benefits, and organizational benefits.Studies on financial impacts of ERP typically measure performance of financial statements(Poston & Grabski, 2001), financial ratios (Hendricks et al., 2007; Hunton et al., 2003;Matolcsy et al., 2005; Poston & Grabski, 2001; Wieder et al., 2006; Wier et al., 2007) and shareprice of the company (Hendricks et al., 2007; Hitt et al., 2002). These performances areusually compared for a group of companies that adopted ERP against those companies thatdo not over a period.Results from these research listed above have consistently indicated that financialperformance will be negatively affected in the first two to three years during the ERPimplementation and only after two to three years, will the firm see improvements(Hendricks et al., 2007; Hitt et al., 2002; Hunton et al., 2003; Matolcsy et al., 2005; Poston &Grabski, 2001; Wier et al., 2007). From the list above, only one study that seem to contradictthe claim that there is no significant differences between adopters and non-adopters (Wiederet al., 2006). However, that study did not account for the time after the ERP implementationhas taken place and the small sample size.Besides the financial impact, it was found that the benefits of implementing ERP systemsextend to the operational (Cotteleer & Bendoly, 2006), managerial, strategic and planningand control process integration of supply chain management (Su & Yang, 2010). Managerial,operational and IT infrastructure benefits was observed one year after implementation ofERP (Spathis & Ananiadis, 2005). ERP was also shown to improve the accounting process(Spathis & Constantinides, 2004).Research into sub-plant level found that the benefits of ERP is more when the sub-units(“business function or location”) are more dependent on each other and less when the subunits are vastly different (Gattiker & Goodhue, 2005). Analysis and research of the impact ofERP at the firm aggregate level has been scarce although there are many similar IT researchat this level. Huang’s (2004) economic analysis of ERP as information goods generatedpositive externalities value which will increase as more numbers of suppliers and customersof the firms are interconnected. This has been called the network effect. The authors alsoargue that although the cost of implementation of ERP is high but the cost supplyinginformation is almost zero once the adoption of ERP system is on.3. Conceptual frameworkThe purpose of this section is to explain and justify the conceptual framework proposed bythe authors. The framework is based on a synthesis of the economic production theory andnetwork externalities. In other words, the framework classifies economic impact based on aproductivity function and the network

18Advanced Topics in Applied Operations ManagementHow inputs are transformed to output is commonly illustrated in a production function. Asseen in the Section 2 many studies examine the effect of ERP on productivity growth byexamining stock prices and profitability. The more recent studies use panel analysis and thelongitudinal approach to estimate inputs to Gross Domestic Product (GDP) outputs and itsreturns from IT investment in the aggregate level. Generally, output growth in firms,sectoral and the country level may be due to an increase in input level, improvement in thequality of input, and productivity growth of inputs. Furthermore, the effect of IT adoptionin a neoclassical theory rests on labor productivity and can be explained using capitaldeepening effects (Stiroh, 1998; Jorgenson & Stiroh, 1999), embodied technological change,and productivity spillovers. Capital deepening refers to the growth of capital (e.g.information processing equipment and software) that workers have available for use in afirm. ERP systems may allow total factor productivity gains since it allows production ofimproved capital goods at lower prices via some production spillovers or positiveexternalities effects (see Bresnahan, 1986; Redmond, 1991; Bartelsman et al., 1994).A positive network externality has been widely used in the study of technology adoption. Itis an economic concept describing a consumer's demand may be affected by other peoplewho have purchased the good, and gained the benefit in consumption due to thewidespread adoption of physical goods and services. Earlier studies (eg. Jensen, 1982) oninternet and e-commerce have shown that people are more likely to adopt certaintechnology if others within the same industry or region likewise use it. An ERP adoptingorganization can integrate the ERP system with its suppliers and customers thereby creatingan electronic market. The ERP that enables electronic markets comprised of supply anddemand networks to facilitate information exchange (Huang et al., 2004). The suppliers andcustomers may or may not be using ERP systems. However, they can access the informationgoods generated by the ERP. Thus, ERP in the electronic markets serves as the informationprocessing function to generate and exchange information among suppliers and customers.This electronic transfer of information goods can reduce the cost of paperwork andprocessing requirements of all the parties involved. Hence, marketable information goodsproduced by ERP would bring additional profits to organization. Next section, we discussthe production theory and network effects respectively in detail. The proposed framework isdepicted in Figure 1 below.ExternalityNetworkEffectsERP uctivityFig. 1. The proposed

Economic Impact of the Adoptionof Enterprise Resource Planning Systems: The Theoretical Framework193.1 Network effectsNetwork effects impact technology choice (Katz & Shapiro, 1994). Network effects arisewhen there is interdependence between different components of an economic system(Young, 1928). We may ask questions such as how does a change in technology affect theincrease in output and will this become an incentive for firms to exploit the increasingreturns for adopting this technology (Arthur, 1996). Integrated with e-data interchange, ERPcan be used to restructure supply chain operations via B2B e-hubs with supply chainpartners to run transactions in real time (Zeng & Pathak, 2003). As more supply-chainpartners become integrated with the ERP systems, the entire supply chain can be integratedand streamlined with other functions to be more competitive, reduce the marginal cost ofproductions, increase the profitability of the organization, and maximize productivity of thefirm. To enable electronic markets, internal networks structures are important fundamentaleconomic characteristic.According to Majumdar and Venkataraman (1998), there are three network effects in theliterature. The first is conversion effect, driven by operations-related increasing returns toscale that firms enjoy in converting from one system to another. The second is consumptioneffect, driven by demand-side increasing returns to scale that it is a firm-level effect thatarises where customers are interconnected. The third is an imitative effect that arises whenthe inter-firm information flows are induced by imitation pressures between firms.The conversion effect arises when there are increasing returns moving towards the usage ofadvanced technology. Cost-benefit analysis hypothesizes that inputs affect outputs todetermine the identifying statements of organization goal such as maximization revenue,minimize cost, and maximize profits. An initial ERP adoption is likely to involve high cost.There are incentives to convert to the new technologies because of the possibilities ofenhancing operating efficiencies. The greater the relative size, the higher the incentive toexploit conversion effects since there are larger numbers of customers and suppliers whoprovide the means to write-off adoption costs.Consumption effect exists when there is demand interdependence among customers. Thiseffect is enhanced by the density and composition of customers in the network. When thereis high network density and variety of user population in a network, there will be anincrease in network functionality. This implies a larger potential market, and thereforebrings about higher utility to the customers. Hence, network density and user populationare expected to be positive at all times. Meanwhile imitation effect is salient in industrieswhere firms share a common infrastructure, and that many channels are available fordissemination of information between those interconnectivity firms and the nature ofequipment. Therefore there are increasing returns to the inter-firm spread of information(Markus, 1992). When managers face a new technology with uncertain trade-offs, imitationprovides a solution with low risk (Majumbar & Venkataraman, 1998). Therefore, theimitative effect will have positive effect on the new technology, the ERP system adoption, atall times.3.2 Impact of network externality on the adoption of ERPThere are many models to test for the presence of network externalities on the adoption ofERP process (Katz & Shapiro, 1986; Farrell & Saloner, 1986; Cabral, 1990). For instance,

20Advanced Topics in Applied Operations ManagementCabral’s (1990) model allows for heterogeneity in the benefits available from networkdynamic. The benefits from membership upon adoption are B(h,n,t), where n is the measureof adopters at time t, h is a parameter that characterizes a technology (the higher the h for afirm, the higher is the benefit from adopting ERP membership, all other things remainequal), and t is time. The assumption that there are externalities in network participation iscaptured by Bn 0, Bh 0, and Bt 0. The latter assumption reflects the exogenous trend toincrease benefits from adopting the shared network technology, reflecting improvements inthe ERP technology itself.Since information can be reproduced at zero or very low marginal cost, and supply chainnetwork using ERP system can be connected in constant returns to scale, all inventoryinformation can be stored in the system and causing information supply networks to exhibitpositive network externalities of production. Market dynamic works in such a way that thesupply curve with network externalities of production starts high and decreases towardzero. The impact of network technologies on financial institutions depends on assets,number of employees, and number of branches (Zhu et al., 2004).Positive network externalities of consumption are a kind of demand side network economicsof scale. It is highly dependent on the number of organization already connected to the ERPsystems. If there are large numbers of organization connected to ERP systems, the willingnessto pay for the marginal organization is also low because every organization that valued ithigher has already connected to ERP systems. Therefore, an organization’s demand for theinformation goods depends on the marginal willingness to pay. The reservation price forinformation goods is determined by the marginal willingness to pay, which at first increasesand then decreases with the number of organizations connected to the demand network(Huang et al., 2004). Therefore, the demand curve for information goods with networkexternalities of consumption is hump-shaped. Hence, for market dynamics, the supply anddemand curves with network externalities will intersect only if there is a small number oforganization connected to the markets and information good exchange are low, i.e., happenwhen there is a low equilibrium level (Majumdar & Venkataraman, 1998).3.3 Economic production theoryEconomic evaluation orientation to IT impact ranges from relatively simple cost-benefitanalysis (King & Schrems, 1978) to rigorous production function (Kriebel & Raviv, 1980) thatmostly focuses on profit of the organization. Mapping major microeconomic productionindicates that ERP has been used in operational or management control decisions forproduction modeling. ERP systems have been used in diverse areas of transactionprocessing in accounting, finance, marketing and management.The production function is a commonly use tool in analyzing the process of economicgrowth and performance of a firm. A production function relates the inputs of theproduction process. A firm production function uses decisions and firm resources (e.g.labor, raw materials, information, IT capital, non-IT capital, decisions, inventory decision,and etc) as inputs and the attainment of organization goals (eg. profit maximization, salemaximization, revenue maximization, or cost minimization) as output to achieve economicperformance outcomes (eg. economic growth, labor productivity, profitability, or overallwelfare). A productive firm will generally enjoy higher profitability, or a firm is perceived

Economic Impact of the Adoptionof Enterprise Resource Planning Systems: The Theoretical Framework21be productive if a firm is able to produce the same output level with fewer inputs and thusexperiences a cost advantage, or produces higher quality output with the same level ofinputs and enjoys a price premium.Many scholars have examined the relationship between IT-economic performance or ITproductivity growth. Input productivity is important determinants of economic growth.Productivity is a measure of how efficient resources are converted into goods and services ina production process. It can be calculated as the ratio of output to input. Hence laborproductivity is the output produced per unit of labor, and it can be calculated using totaloutput divided by the total unit of labor employed. Labor productivity always meansaverage product of labor or average productivity. Therefore, average productivity (AP) iscalculated by output/labor input, and it is often used as a measure of efficiency. When afirm experiences productivity increases, it means that output per unit of labor input hasbeen increased. However, as more and more of one input (eg. labor) is added with a givenamount of another input (eg. capital), the increases in output will eventually decline. This iscalled the law of diminishing returns. Similarly, as worker acquires more capital, there isdiminishing return to that capital. If this process continues in a longer period, the growthwill gradually slow to zero.Total factor productivity pertains to the efficiency of the inputs mix to produce output.Efficiency gains could be achieved through more effective distribution arrangements,greater economies of scale, better management, shift from low productivity production tohigh productivity activities, the adoption of new technology, innovation and intervention,or the replacement of old capital, or retrained the workers that enable greater outputproduction using the same level of input mix. There are generally two factors that affectproductivity. The first is human capital and the second is technology. Human capital refersto worker’s investment in education and training that could upgrade the skills of theexisting labor force and improve the quality of labor force, with more IT literate and morecongenial staff, they are able to easily adapting newly installed technologies, and theincrease in human capital investment is a major contributor to the long-run economicgrowth. This is also called the embodied technical progress. Meanwhile, investment intechnology involves the way inputs are mixed in the firm, such as innovation and inventionof new products, improvements in organize production, advances in management andindustrial organization, and better manage economic factors of productions that increase theoutput level even when the amount of labor and capital are fixed. Adoption of ERP systemscan produce all such benefits as identified in extant literatures, such as Shang and Seddon(2002), Huang et al. (2004), and Wieder et al. (2006). This is also called disembodied technicalprogress. The productivity gain resulting from technological progress seem unlikely to besustainable over the very long run whenever we reach the point of diminishing returns tothe technology investment (Sharp et al., 2006). In terms of ERP systems, it is necessary toupgrade the system quite frequently to keep up with the technological and businesschanges. Such upgrades require new capital infusions.3.4 ModelEconomic theory shows that the basic way to measure productivity is the standard firmproduction model that is based on a gross output production function that relates firm grossoutput to the factors of productions such as capital and labor, intermediate inputs such

22Advanced Topics in Applied Operations Managementenergy and raw materials, and total factor productivity. The simple model of productionshows the relationship between inputs and outputs is formalized by a simple productionfunction as:Yt f(Ki,Li,Mi, .)(1)where Y represents the firm’s output or return on assets (ROA) or return on sales (ROS)(Wagner et al., 2002) during a period, K denotes the capital usage during the period, Lrepresents hours of labor work, M represents raw materials used, and notation representsthe possibility of other variables influencing the production process.The same level of output can be produced with fewer inputs. For example, with a level ofcapital input of K, it previously took L2 unit of labors to produce Y0, now it takes only L1.Output per worker has risen from Y0/L2 to Y0/L1. However, it is noteworthy that anincrease in capital input to K2 could also lead to a reduction in labor input to L1 and producesimilar level of Y0. If this is the case, output per labor would also rise, but there could havebeen no technical progress. To measure technical progress we could write in a simpleequation as follows:Y Z(t)f(K,L)(2)where the term Z(t) represents technical progress as a function of time that shows the factorsthat determine Y other than K (capital hours) and L(labor hours). Technical progress in theCobb-Douglas production function could be represented by Y Z(t)f(K,L) Z(t)K L1- , forsimplicity, we assume constant returns to scale and that technical progress occurs at aconstant exponential mode (θt). We can rewrite the function as: Y Z(t)f(K,L) Z(eθt)K L1- .Suppose that Z 10, θ 0.01, 0.5, and the firm uses input mix of 2 units of capitals andlabors each (K L 2) currently (at time t 0), therefore output is 20 (Yt 10e 0.01(0) After10 years, the production function with this input mix becomes 22 (Yt 10 10e 0.01(10), if output increases more rapidly than the inputs, given the fixed technology, thiswould imply that there is an increasing returns to scale. With the adoption of ERP systems,it is believed that technical innovation operates through the positive effects. These positiveexternalities help to generate increasing returns to scale and drive the firm’s performance.To account for total factor productivity or multifactor productivity, term Z is included in thefunction. They can be represented in a function as: Yt f (Ki, Li, Mi, Z i)where Y is real output or ROA or ROS, K is capital, L is hours worked, M is intermediateinputs or raw material used, and Z is a total factor productivity index for firm i.Generally, we perceive competitive market structure exists in capital and labor, thereforeconstant return to scale is assumed. We can rewrite the growth rate of real output equals tothe growth rates of the capital and labor inputs weighted by their shares in real gross outputas follows:ω(Yt) ω(Ki)W(Ki) ω(Li)W(Li) Zi(3)where ω(Yt) is the growth rate of output, ROA or ROS, ω(Ki) is the growth rate of capitalinvestment (including net depreciation), ω(Li) is the growth rate of labor, and W(K) andW(L) are the weighted shares of capital and labor in the firm, respectively. ω(Ki)W(Ki) is

Economic Impact of the Adoptionof Enterprise Resource Planning Systems: The Theoretical Framework23growth rate of capital multiplied by the ratio of capital to labor, which we called as marginalproduct of capital. Similarly ω(Li)W(Li) is the growth rate of labor multiplied by the ratio oflabor to capital, which we called as marginal product of labor, and Zi is the productivityefficiency factor, which is a residual term that is not accounted for by the growth of laborand capital.Suppose that a firm has a growth rate of output of 5 per cent, the growth rates of capital andlabor of 10 and 2 percent, respectively, and the weighted shares of capital and labor are 20 and80 percent, respectively. Therefore Zi has to be equaled to 0.014. This reflects that technicalprogress account for slightly less than 1.5 percent of the output growth of 5 percent.ω(Yt) ω(Ki)W(Ki) ω(Li)W(Li) Zi0.05 0.2(0.10) 0.8(0.02) ZiZi 0.014Past studies present econometric estimates using Cobb-Douglas production function (e.g.Gera et al., 1999; Brynjolfsson & Hitt, 1996; Lehr & Lichtenberg, 1998), cost function (e.g.Morrison & Siegel, 1997) or panel estimation (e.g. Stiroh, 2001). There are somemicroeconomic productions properties apply to the Cobb-Douglas production model forERP systems, assuming a constant elasticity of substitution (CES). The CES productiontechnology exhibits a constant percentage change in factor (e.g. capital and labor)proportions due to a percentage change in marginal rate of technical substitution(MRTS). MRTS is the amount of one input that must be substituted for one unit of anotherinput to maintain a constant level of output. First is marginal productivity. It is the rate ofincrease of the output for a small increase in the input. The Law of Diminishing MarginalProductivity will set in if the marginal product is positive but diminishing. Second is inputsubstitutability, where inputs will be substituted more of one input and less of another toproduce the same level of output. Third, it is assumed that decision making is in steady state(i.e., constant input and output levels, all other parameters remain unchanged).Alternatively, one can study how different types of capital affect labor productivity growth.This can also be carried out using Cobb-Douglas production function that can explicitlydecompose capital into IT-related and non-IT related categories. This can be written usingCobb-Douglas production function in the form of Yit f(ITi,, Kit, Lit). It can be tested formany firms, with i 1, 2, ., N using years of data, in Year t 1, 2, . . ., T. The outputproduction Yit is annual performance of the firm, and the inputs are IT capital stock (ITit),non-IT capital stock (Kit) and annual labor hours employed (Lit). For example, for a data of20 firms over the period of 10 years, then N 20, T 10. Normally, the regression model willbe controlled for firm effect and year specific effect. For the functional form of f(.), we canwrite the Cobb-Douglas production function at the log form as follows:log Yit σt ITlog ITit Klog Kit L logLit Vi eit,(4)wh

framework of the impact of ERP at the firm le vel. We will use economic production theory to examine ERP role in this regard. This is important because it extends the understanding of ERP system s impact and this framework can be used as a basis for research. This paper is organized as fo