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Online Exchanges: The Death of Innovation?

(originally published by Booz & Company)

Electronic business-to-business (B2B) exchanges allow buyers and sellers to transact business eficiently, often through online auctions, and are the latest manifestation of the need to improve near-term margins by driving supplier prices lower. The natural tendency of most suppliers is to err on the side of overly aggressive price reductions, rather than striking a balance between near-term reductions and long-term investment in product and process innovation. Since every company is a supplier at some level, blind use of electronic auctions threatens every industry's ability and motivation to innovate and grow on a sustainable basis.

Ford Motor Company, for example, recently reported completing a large automotive tire purchase at double-digit price reductions through an online auction. This transaction is surprising in two ways. First, tires would not appear to be auctionable because they are a highly engineered component that plays a significant part in the development of the product, since they affect vehicle noise, vibration, harshness, emissions, and fuel economy. Second, a supplier was willing to win the business at a price so low that it could not possibly survive over the long term if it were to maintain the operating margins generated by the auction. (Although the same behavior could have occurred in a nonelectronic auction, the pressure from observing rapidly declining prices in a short transparent electronic bidding process creates nonrational behavior in suppliers.)

Whether such behavior kills innovation in an industry will depend on the unique characteristics of that industry's supply environment. Where generic, commodity-like, or easily specified products prevail, and where the supply base is fragmented, electronic market exchanges can fulfill buyers' and suppliers' needs to lower prices and increase market share, respectively, with modest incremental investment. In contrast, supply environments characterized by a high degree of customization and/or technology innovation require customers and their suppliers to collaborate closely to develop truly innovative solutions. Taking advantage of the Internet, buyers can share design and engineering specifications in an interactive real-time mode without expensive electronic data interchange linkages, and expand the role of innovation across a broader universe of qualified suppliers. The emphasis is on innovation, not price reduction.

Consequently, the right answer for each company is to separate the elements of its spending into those that should be in an electronic market exchange or auction, and those that should be procured more systematically and thoughtfully. The moral of the story: Do not participate in B2B exchanges that stifle innovation in the critical aspects of your product or service offering.

C.V. Ramachandran,
C.V. Ramachandran is vice president in the operations practice at Booz-Allen & Hamilton and leads the firm's thinking on the impact of electronic commerce on buyer-supplier relationships.
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