Proceed With Caution

Dec. 21, 2004
The early hype over B2B trading exchanges may have stirred unrealistic management expectations and blurred potential pitfalls.

Log on to the home page of the FreeMarkets Inc. trading exchange, which bills itself as "the original and world's leading B2B e-marketplace," and your eyes are immediately drawn to a white-on-black exhibit trumpeting some eye-catching statistics:

  • $10.6 billion in market volume -- the total value of deals transacted through the exchange since its inception five years ago.
  • $2.0 billion in customer savings -- which suggests that buyers typically save about 20% on purchases made through the exchange. Coupled with all the hype that has accompanied the emergence of B2B e-commerce in the last few years, such numbers help to explain why senior executives in many manufacturing companies are prodding their firms to get into the act. But, while industrial trading exchanges may become an important fixture for certain types of buy-sell transactions, the early versions fall well short of the most visionary conceptions of e-commerce. And with the independent exchanges rapidly burning through their start-up capital, it is doubtful that many of these dot.coms will survive long enough to get there. Meanwhile, executives looking for big-time cost reductions could be in for major disappointments. Perhaps worse, the infatuation with auction-based, first-generation exchanges threatens to sidetrack supply-chain management initiatives that offer the greatest promise for long-term results. "Management's mouth waters at the promise of 20% savings," says Michael R. Katzorke, senior vice president for supply-chain management at Cessna Aircraft Co., Wichita. "But if they're expecting 20% savings across the board, that isn't going to happen." Often, Katzorke asserts, the investment required to install B2B systems is understated and the return is overstated. "The lion's share of the return is purported to come from auction bidding. While there may be some short-term benefit from it, long term it can damage important supplier relationships." John Fontanella, a senior analyst for B2B issues at AMR Research Inc., Boston, concurs that many top-level executives may have unrealistic expectations about potential cost savings. "The IT managers and business managers that I talk to," he says, "are very much afraid of a senior-management backlash on B2B technology because their expectations aren't being met." As he sees it, the maturing process for B2B systems is still in the early stages of what will prove to be a 10-year evolution. At the moment, he quips, it has barely entered the "terrible twos." Strategic View Reverse auctions, in which supplier firms compete in an online bidding process, can be a useful way to source nonstrategic commodity items. But, when it comes to more critical parts and materials, manufacturers that have worked diligently to establish long-term relationships with key suppliers aren't eager to sacrifice the benefits of those relationships for the sake of a temporary price cut. "B2B auction bidding is a tactic looking for a strategy," asserts Cessna's Katzorke. "There is a place for that tactic, but it is not a way to take out huge cost components. If the product you're buying is one of low complexity, maybe B2B auctions apply. But where you are dealing with high complexity -- and high dollar amounts -- you need to develop strategic relationships." Over the last three years Cessna has worked hard to do just that. Its supply-chain strategy has four cornerstones: rationalizing the supply base; strategic alignment with suppliers, using long-term contracts; helping suppliers to improve; and integrating suppliers into the design and manufacturing process. "With auction bidding," Katzorke says, "alignment is damaged. And integration into design and manufacturing is out the window." For companies pursuing lean-manufacturing initiatives -- including the use of pull signals to trigger supplier shipments -- it is critical to integrate suppliers into the manufacturing process, he stresses. "But how am I going to do that if one guy has the part today and somebody else will be making the part tomorrow?" Maintaining an ongoing relationship is just as important, perhaps even more important, where suppliers participate significantly in product-design efforts, he stresses. "If you ask a supplier to help you on a design and then turn around and shop it on the Web, that isn't going to work. How is that guy going to be motivated to give you his best design ideas the next time?" Such misgivings aside, Katzorke emphasizes that there is a role for B2B technologies. In fact, Cessna has implemented an e-procurement system, using the Ariba Inc. software platform, as a pilot project for Textron Inc., its parent company. The system is targeted to the "nonproduct" area, including MRO items. "It truly is a very good tool, provided that it is used within the context of an overall supply-chain strategy," he says. "It is a tool that has to be used the same way you would any other sourcing approach -- as part of a strategic, analytical decision process." Dell Computer Co. has conducted a number of auctions through the FreeMarkets exchange. "For products that were very 'commoditized' -- that is, standard or common -- and where there were a lot of companies competing, the auctions worked great," reports Dick Hunter, vice president for fulfillment and supply-chain management. "However, for more 'customized' products, where a strong relationship with a supplier is required, auctions were not effective." Dell expects to continue to use auctions, Hunter notes, "but not for high-volume custom components like monitors." In one instance, the Round Rock, Tex.-based computer maker did identify a lower-cost monitor supplier, but it elected not to change vendors due to "concerns about quality and capacity." Interestingly, Dell found that auctions don't always deliver price reductions. After one auction it discovered that "the lowest price was higher than we were already paying, and our current supplier was a participant in the auction," Hunter notes. "So auctions are not a silver bullet. "Auctions and exchanges have fueled the thinking that price is everything," he adds. "But there is more to procurement of materials than just price. Quality, service, technology, responsiveness, and the willingness to improve common processes also are very critical to driving down the total cost of material." Under The Gun Many purchasing organizations are under heavy pressure from the corporate brass to implement some form of e-commerce, observes Philip L. Carter, professor of purchasing at Arizona State University, Tempe, and executive director of the Center for Advanced Purchasing Studies (CAPS), which is cosponsored by Arizona State and the National Assn. of Purchasing Management. "The least risky thing you can do," Carter says, "is the reverse auction for nonstrategic items. If it doesn't work out, you probably haven't jeopardized a strategic relationship." However, he asserts, the most significant procurement savings typically are achieved internally, "by standardizing what you buy, aggregating internal demand, and negotiating master contracts with selected suppliers. Companies do get amazing savings -- but these savings come from changes in how they buy. And they can do this without using trading exchanges." Any price cuts realized through online auctions may come back to haunt the buying company, suggests Dave Oppenheim, Cessna's e-business director, who also has responsibility for indirect materials sourcing. If a seller agrees to margin-based price concessions during a buyer's market, he notes, "when the pendulum swings and the market returns to a seller's market, he is going to remember any concessions that he made. He'll get his money back -- plus interest." Manufacturers that are tempted to source key parts and materials through a trading exchange may find it difficult to connect with the most innovative, quality-conscious vendors, since many likely will boycott the auction bidding process, viewing it as "a margin-squeezing play," says CAPS' Carter. "Your sources do become somewhat limited," agrees AMR's Fontanella, "because many suppliers don't want to participate. They're afraid of the market dynamics that come into play once they do start to participate." However, none of the supplier companies queried in a recent AMR survey indicated that they had encountered significant pricing pressure stemming from aggregation of demand. "The only thing I can attribute that to," says Fontanella, "is that the exchange represented a way for them to use their excess capacity to fill empty [production] schedules. It indicates that seller companies are very careful in how they participate." Missing Links Cessna's Oppenheim contends that the "core value" of second-generation exchanges -- those with capabilities beyond auction bidding and disseminating requests for quotation -- will come from linking buying companies to an established supplier base to streamline transaction processing. But, he fears, many small suppliers may rebel when confronted with the challenge of implementing enabling systems such as Ariba or Commerce One. The hefty instruction manuals, he suspects, will be intimidating to small mom-and-pop businesses, especially if they are "left to their own devices to figure out how to get connected." The key to success in integrating suppliers into an e-commerce system, Oppenheim asserts, is to achieve a high adoption rate. Cessna has done that by creating its own Web-based system, a private exchange of sorts, for such transactions as transmitting purchase orders and shipment triggers. Suppliers with long-term agreements also can access customized Web pages to view MRP forecasts of requirements for their parts. Cessna underwrote the cost of the system. "Since we are providing this tool for free, it takes away the excuse for not using it," Oppenheim says. "Within 90 days we were conducting 92% of our transactions over the Web." It is important, he emphasizes, to shift a "critical mass" of transactions to B2B systems in order to gain the benefit of reduced transaction costs -- and also to gain agility. But companies dealing through exchanges often focus on the big-dollar items, "rather than automating the bulk of their transactions," Oppenheim says. "So it still takes 45 buyers to conduct their business. The people aren't going away. The work isn't going away. And cycle time is not being reduced, even after spending millions of dollars on these B2B tools." To make best use of a B2B exchange, and get beyond simple browser-based activity, it is necessary to build interfaces to back-office systems, CAPS' Carter points out. Without robust connections to complete the online transactions, companies still will be mired in paperwork, he says. "You need an interface so that purchases are linked to your budget code, and so that your system will recognize the invoices and ship notices." Such linkages, he speculates, are most likely to be facilitated by the "industry portals," consortium-driven ventures like the auto industry's Covisint exchange. He doubts that many of the start-ups will develop the needed capabilities. "The problem with using the dot.coms," Carter says, "is that none of your software, including ERP and Ariba, connects easily with them." Since most companies rely on ERP and legacy systems to drive their processes, "it is absolutely essential to have integration into these systems," asserts AMR's Fontanella. "But right now, integration remains tremendously expensive -- as much as 10 to 15 times the cost of the software license." Fontanella predicts that private, company-developed exchanges, rather than the dot.coms or the consortia, will experience the greatest growth in the years ahead. Some independent start-ups, he notes, are "trying to reinvent themselves as business process facilitators or stream-liners," rather than mere auction platforms. But for any it isn't an easy transformation. "A lot of the early exchanges are so bound by the technology they created that it's very difficult for them to broaden their footprint. And they don't have the money, either." Exchanges that survive the expected shakeout, he says, will have to offer "some level of collaboration, whether it is trading production plans, sharing demand from the channel, or other things." Dell's Hunter is skeptical that the public exchanges will be able to do this. "I believe the exchanges that pass inventory, cost, and other types of data," he says, "will be private exchanges similar to, the portal that Dell established two years ago to share information with its suppliers. Last June the information delivered through the portal was upgraded with the adoption of software from i2 Technologies Inc. "With these exchanges," Hunter says, "we can build a close relationship with suppliers and pass this type of information. But it will be some time before this type of data is passed via public exchanges, if ever." Data Leaks To the extent that public exchanges do develop advanced information-sharing capability, some executives wonder whether security safeguards will be adequate to prevent leaks of confidential data, including pricing information. One of the emerging issues that exchanges must contend with, Carter says, involves the "ownership of data -- and who shares it with whom." This includes information about what companies are buying and what they're paying for it. "This hasn't been a big issue with most companies yet," he says. "But I'm not sure that companies have paid much attention to it." Moreover, some analysts suggest that online auctions raise the specter of collusion among suppliers, since the prices associated with bids are disseminated on a real-time basis. In one case, an electronics component supplier reportedly was caught discussing bid prices with another supplier during a reverse auction. With many of the exchanges struggling financially, there may be risks for companies that opt to rely on them. Many first-generation exchanges are "burning through the last of their venture-capital money, and most are having a very difficult time getting [more funding], because they can't demonstrate a model where they can drive a lot of liquidity, a lot of transactions," Fontanella says. If an independent exchange were to go belly up, he adds, the risk to most users would be minimal, since they use the exchanges only sporadically. "However, if you've invested in integration with an exchange, that investment would be lost," he notes. The greatest financial risk may be borne by firms that take an equity position in an exchange. Some vertical exchanges, Fontanella notes, have approached leading companies in the industries they serve, offering an equity stake in return for a guarantee on transaction volume. Before buying in, however, companies need to closely examine the future viability of such enterprises. "There will be a lot of scrutiny," Fontanella believes. "And most exchanges won't pass the test."
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