The Effects of Inter-Firm Cost Correlation, IT Investment, and Product Cost Accuracy on Production Decisions and Firm Profitability

Abstract

ABSTRACT: Using analytical and simulation techniques, we investigate the effect of inter-firm cost correlation, IT investment, and product cost accuracy on production decisions, and ultimately firm profitability in an imperfectly competitive market. Along with an unprecedented growth in investments in information technology (IT) over the last two decades, firms have made significant investments in IT to increase product cost accuracy. Yet, a variety of studies present mixed evidence as to the linkage between IT investment, product cost accuracy, and organizational performance. Further, while previous research has shown that IT may contribute to the improvement of organizational performance, contextual factors are important. We reexamine this issue in an imperfectly competitive market and product cost setting. We assert that knowledge of inter-firm cost correlation may be used to reduce the IT investment needed to achieve product cost accuracy and thereby optimize production and ultimately firm profit. To motivate our hypotheses, we develop and analyze an analytical model which incorporates IT investment, a costly, endogenous, imprecise product cost report, and inter-firm cost correlation. Using simulation techniques, we illustrate that production decisions informed by inter-firm cost correlation require less IT investment and result in higher firm profitability. Our emphasis on the initial design of product costing systems and the related IT requirements definition phase suggest that our result could be helpful to firm managers in establishing the optimal levels of IT investment and product cost accuracy in their specific product market setting.