PROPRIETARY AND OPEN SYSTEMS ADOPTION: A RISK-AUGMENTED TRANSACTIONS COST PERSPECTIVE

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1 PROPRIETARY AND OPEN SYSTEMS ADOPTION: A RISK-AUGMENTED TRANSACTIONS COST PERSPECTIVE Robet J. Kauffman Pofesso and Chai, Infomation and Decision Sciences Diecto, MIS Reseach Cente Calson School of Management, Univesity of Minnesota kauffman@csom.umn.edu Hamid Mohtadi Pofesso of Economics Depatment of Economics, Univesity of Wisconsin mohtadi@csd.uwm.edu Last evised: Novembe, 003 ABSTRACT This aticle pesents an economic model that enables the study of incentives fo business-to-business (BB) e-pocuement systems investments which pemit inventoy coodination and impoved opeational contol. We focus on the infomation technology (IT) adoption behavio of fims in the pesence of tansaction costs, agency costs and infomation uncetainty. But we conclude that it is appopiate to ethink the pio theoy and develop an extended tansactions cost theoy pespective, following Clemons, et al. (1993), but with the possibility of shocks included. We distinguish among thee kinds of BB e- pocuement systems platfoms. Popietay platfom pocuement systems involve taditional electonic data intechange (EDI) technologies. Open platfom pocuement systems ae associated with e-makets Web technology. Hybid platfoms involve elements of both. The key dives appea to be fim size and uncetainties that deive fom the inability of a buye fim to pefectly pedict final etail demand and actual supply. We find that lage fims tend to adopt costlie solutions, but ely upon pocuement technologies with moe cetain-to-delive value, such as popietay EDI. Smalle fims tend to adopt less costly pocuement technologies that entail geate supply uncetainties, such as open platfom pocuement systems. We aive at ou findings though the specification of an analytical model that captues the key elements of ou pespective tansaction costs, agency costs, infomation uncetainty, and shocks and specifies the conditions unde which stong conclusions can be made about the likely obseved equilibium e-pocuement solutions of fims. KEYWORDS: BB, economic analysis, e-pocuement, IT adoption, IT infastuctue, open platfoms, popietay platfoms, pocuement, isk, supply chain management, tansaction costs, uncetainty. ACKNOWLEDGEMENTS The authos thank thee eviewes and paticipants of the BB E-Commece Mini-Tack fom the 35th Hawaii Intenational Confeence on Systems Science, Kona, Hawaii, Januay 00, whee an ealie vesion of this pape appeaed, fo useful input on an ealie vesion. We also thank Eic Clemons, Judith Gebaue, Michael Shaw, Qizhi Dai, Kunsoo Han and Yois Au, as well as paticipants in the Infomation and Decision Sciences Wokshop at the Univesity of Minnesota, and Jounal of Management Infomation Systems eviewes. Rob Kauffman thanks the MIS Reseach Cente fo patial suppot.

2 1 Electonic commece is a egime tansition. It is now evident that the challenges of BB e-commece ae moe daunting than fist imagined. Moe than just delive technology, a BB platfom must addess fundamental poblems of stategy, coopeation, behavio, and finance. Even the simplest sevice a standad tansaction platfom equies enomously complex inteactions. Quoted fom SueFoods Web site, July 001 ( INTRODUCTION The application of Intenet technologies to supply chain management and e-pocuement tansactions has led to significant gowth in an emeging segment of the U.S. economy in the past seveal yeas (Kuma, 001). The Gatne Goup, fo example, estimated that the aggegate value of woldwide business-to-business (BB) tansactions in 000 eached moe than $433 billion, nealy thee times the 1999 level. The new technologies that ae being employed in electonic BB pocuement epesent an IT-diven tansfomation of a taditional business pocess that needs to be bette undestood (Gebaue and Segev, 000; Venkataman, 1994). The E-Tansfomation of Pocuement In spite of the ealy optimism (Kaplan and Sawhney, 000), and pojections of its damatic gowth (Demes, 001; Ryback, 001), signs wee emeging as ealy as 001 that the maketplace fo BB electonic maket sevices would not be as obust as the pojections (SPS Commece, 001). The maket was pojected to each $. tillion by 003, and $7.4 and $8.5 tillion in 004 and 005, espectively (Mahoney, 001). Yet no one can deny the changes that ae taking place in fundamental business pocesses in global supply chain management (Reutes, 001; Seidmann and Sundaajan, 1997). A epot eleased by New Yok-based emakete.com epots that IBM has done moe than $43 billion in electonic pocuement duing 000, while Boeing is now pocessing moe than 0,000 daily tansactions via its Web site" (BusinessWie, 001). Indeed, many obseves view the new technologies in this aea as a hook up o lose out stategic value poposition (Clemons and McFalan, 1986). Boston Consulting Goup epots that by 004, most fims that implement these kinds of technologies will save 1% to % of sales evenues (Foeste Reseach, 001). Othes ecognize the extent to which the maket fo BB e- maket technology sevices is evolving (Tomak and Xia, 00). Among the most attactive featues of BB pocuement tansactions on the Intenet is that buyes no longe need to make costly long-tem commitments to dedicated and had-wied popietay pocuement systems associated with popietay solutions. (See Table 1.) Yet the available evidence points to the pesistence of such popietay pocuement systems, despite the highe costs of pocuement (Dai and Kauffman, 00a), even though they wee not the pedominant foms fo pocuement platfom and systems suppot that fims most often adopted duing the last five yeas.

3 Table 1. Buye-Supplie Fim Benefits in BB Electonic Pocuement Systems Small ode aggegation SUPPLIER BENEFITS Lowe custome acquisition costs Lowe tansaction costs Reduced time to maket Diminished need to invest in buye-focused IT infastuctue Reliance on maket competition to establish appopiate standads BUYER BENEFITS Lowe cost to find/select supplies Impoved negotiation due to lage odes and geate tanspaency Lowe tansaction costs Diminished need to invest in supplie-focused IT infastuctue Reliance on maket competition to establish appopiate standads, instead of thid-paty softwae solution vendo Balanced contol of technical development tajectoy fo the technical solution Balanced contol of technical development tajectoy fo the technical solution Souce: Adapted fom Tansoa ( Diminished concens about infomation poaching by supplie The pocuement tansaction pocess is at the heat of all the changes. Today, all of the paties that ae typically involved in supply chain tansactions believe that the impotance of leveaging the capabilities of the Intenet fo pocuement activities is citical. In this eseach, we will make a boad distinction between popietay pocuement systems and open platfom pocuement systems. Ou definition of popietay platfom pocuement systems petains to those infomation systems capabilities developed by individual fims (especially buyes o selles), who have an incentive to specify the softwae and hadwae infastuctue equiements so that they best match thei own pocuement infastuctue o supply sevices infastuctue capabilities. Popietay systems pio to the Intenet wee typically offeed via secue dedicated lines and pivate netwoks. Pe-Intenet electonic data intechange (EDI) systems constitute the most ecognizable example, howeve, today thee ae still many fims that ae using popietay softwae togethe with the capabilities of the Intenet in the fom of Web-based popietay EDI. 1 The key distinction that we make involves the extent to which an individual fim o a small goup of fims woks towad defining the exchange potocols, tansaction fomats, and intenal opeations. 1 We thank a eviewe fo pointing out that taditional EDI-based pocuement systems should also be consideed as pat of the oveall set of BB pocuement system and platfom choices, since they continue to be a pat of the solution mix used in industy today. Indeed, EDI-based pocuement systems have taditionally been popietay, since they equied specific kinds of hadwae and softwae solutions depending upon whee they wee implemented (egion of the county and wold, industy and poduct aea). The spiit of EDI, howeve, was to focus on the development of elatively common tansaction sets and communication potocols to suppot the mecantile exchange. This emphasis tanslated into elatively common database elements in the oveall technical solutions that have been used among fims that chose EDI solutions, and so, in this sense at least, ealie EDI solutions shae some of the chaacteistics of open systems solution. Today s Intenet-focused open platfom pocuement systems solutions go significantly beyond tansaction and database design standads.

4 3 Open platfom pocuement systems ae defined by the use of a diffeent appoach. They tend to be developed in a moe neutal manne with espect to the infastuctue capabilities of buyes and supplies, both by industy consotia and by thid-paty electonic intemediaies. They ae obseved today in maket settings, whee an electonic intemediay o BB e-maket fim (instead of a buye o a supplie) develops an open platfom that is intended to take advantage of the standads-based appoaches of the Intenet and non-popietay (single o multiple fim-owned) e-business softwae capabilities. To explain why this may be occuing, eseaches have pointed to buye-supplie coodination as a desiable popety fo downsteam fims Baua, et al. (1995). Howeve, thee has been significant debate as to the natue of the inteplay among the playes (e.g., Clemons, et al., 1993; Sten and Kaufmann, 1985). Some authos ague that BB e-commece has the potential to change the undelying tansactions costs of pocuement, impoving inteoganizational coodination (Lee and Clak, 1996; Gaicano and Kaplan, 001). Buye-supplie coodination is also an attactive featue of popietay EDI systems, and this may keep fims fom switching to the open BB supply chain and pocuement platfoms. Delayed adoption may be einfoced by the supply isks and technology, fim and maket uncetainties that ae associated with this new geneation of Intenet-based systems suppot. We will ague in this aticle, extending the move-to-the-middle theoy of Clemons, et al. (1993), that fims make these kinds of consideations in a manne that is consistent with a new theoetical pespective that incopoates some consideation of shocks in final demand in the etail maket and upsteam shocks in supply. Both eflect somewhat diffeent aspects of uncetainty that may affect oganizational decisionmaking with espect to open and popietay platfom pocuement systems. Conside the fequency of pocuement puchases and the extent to which the paties involved ae able to tansact on a egula basis. Pocuement activities may occu on a egula o iegula basis, involving the same o diffeent tade patnes. In addition, supply items whose pices ae elatively stable o tend to float in a wide enough band so as to ceate financial isk in pocuement will also affect the buye s peceptions of value. Othe concens elate to the potential fo Intenet secuity beaches, supply discontinuities due to the bankuptcy of a smalle on-line supplie, and pocedual difficulties in financial settlement. These isks faced by the fim go beyond those that a buye faces when she consides eithe a focal o a spanning stategy of engaging just a few o many supplies. In othe wods, they go beyond the opeational isks and oppotunism isks, and the coodination costs descibed by Clemons, et al. (1993) as tansactions costs. We conside othe souces of isk that eflect exognenous shocks fo the buye in supply chain management. Dai and Kauffman (00a) discuss some of these tadeoffs and conclude that the success of the open platfom pocuement systems maket, in tems of the ange of technology platfom connectivity that it suppots, depends on the extent to which it can adapt to existing popietay platfom pocuement

5 4 systems technologies. This helps to induce fims to switch platfoms and still maintain easonable costs. The authos point to some of the one-time BB maketplace automation leades, such as Aiba, Commece One and i, and thei adaptability to existing EDI technologies. A ecent Jupite Reseach epot also points to the impotant ole of pivate tading netwoks in helping fims to tansition fom popietay EDI systems to the new technologies of the Intenet (Pelaez and Clak, 001). Plan of the Pape The emainde of the pape is oganized as follows. We next povide the backgound liteatue and efeent theoy that establishes ou theoetical pespective. The thid section pesents the basic fomulation of a isk-augmented tansactions cost model that pemits us to bing tansaction costs, demand and supply uncetainty, and pocuement isk into focus. The fouth section discusses the technology suppot context that is pesent in e-pocuement, and discusses the diffeence between popietay and open platfom systems solutions. This pemits us to fomally analyze the model to develop the new esults. The fifth section extends the fouth by consideing how adoption outcomes change when thee is the possibility that a pio adopte of one technology platfom solution can switch to anothe type, as well as what happens when it is possible to have adoption of hybid platfom solutions. We also conside the manageial elevance of ou popositions. We conclude by assessing the contibutions and limitations of this wok, and offe thoughts about some futue extensions in this line of eseach. The emegence of co-existing netwoks an impotant esult of ou model and analysis paallels the findings of Belleflamme (1998), whose wok examined netwok technology adoption unde oligopolistic competition maket stuctues. BACKGROUND THEORY AND LITERATURE We next conside the theoetical backdop fo the pespectives on pocuement systems solutions adoption that we pesent in this pape. Tansaction Costs, Risk, and Exongenous Maket Demand and Supply Shocks We biefly compae and contast how open and popietay platfom pocuement system solutions ae peceived in tem of thei tansaction cost, financial isk, and maket demand and supply uncetainties by the buyes and supplies who invest in and paticipate in them. (See Table.) We will develop an economic model that shows how tansaction cost, isks and maket uncetainties ae likely to lead to the co-existence, in equilibium, of both open platfom and popietay platfom pocuement systems. Ou pimay emphasis will be on modeling the buye s concens in decisionmaking. The key dependencies, as we will shotly show, ae fim size and the impact of peceived maket isk involving shocks in supply and demand. The dependency of a buye s decision about open o popietay platfom pocuement systems choice on fim size aises in the context of diffeential tansaction costs, and paticipants who

6 5 have diffeent sensitivities to isk. It also is influenced by the pesence of uncetainties about maket demand and supply shocks. Ou model focuses on uncetainty fo both the demand and supply side of pocuement, and the contasts that occu in the pesence of open and popietay systems solutions. We study how choice of infomation technology (IT) may educe pocuement uncetainties and, in tun, how aggegate demand side uncetainties may influence the fim s choice of a pocuement systems platfom. A key emphasis is on the ole of unanticipated inventoies that occu due to shocks. Table. Open and Popietay Pocuement Systems: Costs, Risks and Uncetainties Compaisons ISSUE AREAS Tansaction costs Risks Maket uncetainty PROPRIETARY SYSTEM SOLUTIONS Buye Side Supplie Side Costs highe than fo open system solutions. Reduces benefits of competitive maket. Value-shaing may diminish benefits of wide supplie seach. Pimay isk is inability to switch. Seconday isk is commitment to a popietay infastuctue, when technology is changing. Multi-peiod shaing of uncetainty costs. Lock-in may lead to insufficient supply. Must accede to info shaing in opeations. Costs highe fo buye seach. Shot-tem costs lowe fo business patnes. Longe-tem costs may be highe, due to supplie lock-in. Pimay isk is technology standing. Seconday isk is uncetainty about futue maintenance and enhancement. Multi-peiod inteaction encouages isk shaing, so buye will not switch. Buye shaes info to help supplie foecast demand effectively. OPEN SYSTEM SOLUTIONS Buye Side Supplie Side Lowe costs fo supplie seach due to infomation and communication technology effects. Lesse need to distust supplie s/ e-intemediay s technology. Switching ability is impoved, diminishing potential cost pessue Commitment isk to popietay infastuctue is avoided. Supplie paticipation diminishes isk of insufficient supply. Diminution of stong ties to focal supplie unlikely. Lowe costs though seach fo buyes. Reduces eliance on decisionmaking to detemine appopiate exchange standad. Lock-in diminished. Shift fom contacts to spot maket buying. Geate pice and quality competition. Buyes may switch. Uncetainty in competitive pocuement maketplace affects supplie s solution. Moe info shaing. Move-to-the-middle. Note: The contasts shown in this table ae high-level. They do not eflect the ways that owneship of a popietay platfom pocuement system by a buye o a supplie will shift the isks between the paties. No do they eflect govenance aangements in open platfom pocuement systems. We thank Qizhi Dai fo suggestions on the contents of the table in light of this distinction. Fo a elated pespective, the eade should see Han, et al. (003), who examine issues of who should own IT in inteoganizational infomation systems. Thee ae obseves in the business pess who suggest that the DotCom meltdown has seved to focus many fims' attention on opeational cost eduction by educing inventoy though the adoption of moe effective supply chain technologies. In 001, BusinessWeek epoted that with the Intenet exubeance baely cold in the gave, a fa moe sobeing peiod has aived: the ea of efficiency Today s executives ae no longe asking about technology that will help them launch new businesses but

7 6 about gea that will cut costs and wing moe efficiency out of wokes (Buows, 001). These issues ae ecognized in the supply chain management context, as the example of Canada-based Celestica Inc. s investment in popietay supply chain management infomation shaing suggests. (See Text Box.) Text Box. Demand Uncetainty and Pocuement Cost Risk Shaing at Celestica, Inc. In the past couple yeas, Toonto-based electonics manufactue, Celestica Inc. ( was identified by BusinessWeek magazine as being at the top of the 100 most pofitable fims in the United States. The fim s outstanding pefomance is attibuted to its focus on inventoy management in the supply chain context. Fo example, as the economy slowed in Mach 001, the company faced a decline in demand fo its poducts of CAN$700 million, but it was able to hold the line on excess inventoy, which inceased by only CAN$300 million. This outcome was achieved at a cost of CAN$60 million in supply chain management systems that wied its plants togethe acoss 1 diffeent counties, enabling plant manages to see supplies and spae pats on hand, and whee they might be used. Even moe inteesting is that the fim fields a Supply Chain SWAT Team at its Toonto headquate, which is chaged with leveaging the cental epoting capabilities of the fim s supply chain system. In this instance, the SWAT Team was able to see an inventoy glut developing in the system in eal-time, and it used the fim s maket powe with espect to supplies to oll back pe-submitted odes based on infomation supplied by the system (Buows, 001). This bief anecdote suggests the impotance of extending the tansactions costs pespective to incopoate demand and supply shocks, and why it is helpful to undestand the kind of technology-based pocuement solution in which the fim was willing to invest. The fim s investment in the supply chain management system plays the dual ole of a financial isk management system. Clealy, the solution that was adopted eflects a blend of consideations, including tansaction costs, isk shaing, and the management of demand and supply uncetainty. Despite the positive impession that is ceated by Celestica s stoy, thee ae still numeous manageial issues and challenges. Chief among them is the issue of how the business value that accues to IT investments in the supply chain aea is split among paticipants, so that they can optimize thei paticipation and investments. Fo example, Hwang, et al. (1993) identified initiatos and followes in EDI adoption, to distinguish between fims that adopted fo thei own benefit and fims that wee foced to adopt to achieve compliance with a stong buye. Economics has been widely applied in IS eseach to undestand how IT ceates value (e.g., Baua, et al., 1995; Bynjolfsson and Yang, 1996; and Dos Santos and Peffes, 1995). Additional analysis has been done by economists in the netwok context (e.g., Economides, 1996; Faell and Salone, 1985; Katz and Shapio, 1986; and Shapio and Vaian, 1999). With the exception of the 1990s steam of eseach on IOS and EDI fom Canegie Mellon (e.g.,

8 7 Mukhopadhyay, et al., 1995; Mukhopadhyay, et al., 1998; Riggins, et al., 1994; and Riggins and Mukhopadhyay, 1999), the Univesity of Rocheste (e.g., Wang and Seidmann, 1995), and the ecent wok on BB electonic maket technology investment and adoption fom the Univesities of Calgay and Bitish Columbia (e.g., Bakos and Nault, 1997; Nault and Dexte, 000) and the Univesity of Minnesota (e.g., Dai and Kauffman, 00a, 00b, 004; Han, et al., 003), thee ae still elatively few analytical and empiical economics models in this aea. Moeove, few addess the issue of technology adoption in BB electonic makets and supply chain management with a pespective on technological choices, and the ole of the value of infomation that becomes available to management to deal with uncetainties. The Dynamics of Buye-Supplie Relationships IT investments have been ecognized as having the capability to tansfom the way that makets wok, and how fims inteact with makets and among themselves. Howeve the natue of this tansfomation has been subject to diffeent intepetations. The key issues that the leading authos have consideed ae the extent to which geate outsoucing is likely to occu, and the extent to which buyes tend to deal with a focal set of supplies o a boade set of supplies that epesent moe of the maket at lage. In the development of a new electonic makets and hieachy hypothesis, Malone, et al. (1987, 1989) offeed new theoy about the pedicted changes in the stuctue of maket exchange in the pesence of electonic communication technologies. They pedicted that the impacts of IT would be to induce fims to inceasingly tansact in electonic maket settings. Late, Clemons, et al. (1993) poposed a move-to-themiddle hypothesis. The essence of thei view was that, as IT inceases the oganizational capacity available to a fim to meaningfully pocess this infomation, coodination costs, and opeational and oppotunism isks would all fall. They cogently pedicted the move to a focal set of supplies, in spite of the new electonic communication technologies, eflecting some balancing of isks and benefits, and matching what we actually see in industy today. The numbe of supplies that ae likely to be obseved to paticipate in inteoganizational pocuement has been an impotant theme in IS eseach. Fo example, Riggins, et al. (1994), and Wang and Seidmann (1995) epot on how maginal etuns to supplies ae lowe when moe supplies ae involved in pocuement netwok. Buyes, theefoe, must offe incentives to induce supplie paticipation. This would include accepting some limitations on the numbe of supplies, seving as potection against inceased competition to foce supplies to offe lowe pices. Nevetheless, as the numbe of supplies paticipating in an IOS inceases, the bagaining powe of paticipating individual supplies declines. This diminishes thei willingness to invest in systems assets and inteoganizational business pocesses that have non-contactible elements that dive payoff (Bakos and Byjolfsson, 1993; Raupp and Schobe, 1999). In tun, this tends to exet geate pessue on the buye fims to own coss-oganizational systems assets fo pocuement puposes, with the esult that

9 8 moe outsoucing will occu. Thus, a leading pediction associated with this liteatue is that educed tansaction costs will lead to moe inteoganizational coodination (Han, et al., 003). Related to this is the development of inceased infomation shaing and collaboation between buyes and supplies, both in stategic and in opeational tems, to ensue that the fims business pocesses ae taking appopiate advantage of one anothe s capabilities. As the foegoing discussion hints, thee is likely to be geate collaboation when co-investment in the pocuement system platfom occus. This will povide the infastuctue fo the exchange of demand and supply foecasts, as well as infomation about existing inventoy levels, upon which both patnes can maximize the value of thei espective supply chain actions. The diffeences that aise seem to be moe elated to the locus of the collaboation, athe than the absolute magnitude of collaboation we obseve. In taditional pocuement settings whee EDI is the key means fo inteoganizational tansaction-making, thee may be an immediate incentive fo the buye to have its supplies co-invest in IT. In an electonically-intemediated maket setting, the incentive still exists, howeve, the locus of IT investment will shift, since buyes and supplies both wok though an intemediay. Now the locus of coinvestment fo collaboation moves to two dyadic elationships: the buye with the electonic intemediay, and the electonic intemediay with the selle. Howeve, one expects to obseve some fiction in the pocess. Systems integation is an impotant consideation between oganizations and within electonic exchange envionments (Tuman, 000). Dai and Kauffman (00a) have agued that the costs fo technological adaptation that foste inte-platfom standads may even be unacceptably high. Also, inteoganizational infomation shaing tends to ceate some discomfot even among value-maximizing patnes, as Lee and Whang (000) and Clemons and his coauthos have pointed out (Clemons and Hitt, 004; Clemons, et al., 1993; Clemons and Row, 199; Clemons and Webe, 001). Thus, a citical issue is how to achieve contols fo tansaction isk, quality assuance and infomation shaing, while identifying a value-maximizing scale size fo the shaed business pocess infastuctues and activities. Othe dimensions that pose a isk to the vaious playes ae also woth pointing out. Fo example, an issue is the extent to which inte-fim coodination is made contactible and explicit, as opposed to loosely govened and chaacteized by incomplete contacts (e.g., including such consideations as poduct quality, timely delivey, willingness to lay off pe-specified pocuement in the face of diminished demand, etc.). IOS and consotium-based e-makets often have equity shaing aangements that involve the constuction of incentives fo optimal contibutions by the patnes. Examples include situations in which the equity owneship aangements ae favoable to the paticipants, with the esult that lage fims may migate towads open solutions povides who povide the ight mix of inducement. In addition, Dai and Kauffman (00b) epot on the kinds of equity and non-equity paticipation aangements that aise in the stategic alliances of BB e-makets, and note the vaiations in foms of

10 9 IOS govenance. Owneship options constitute a key issue and dive of the outcomes that ae obseved, howeve, fo the puposes of the cuent wok we will assume no complexity aound this consideation. The pesence of non-contactible activities ceates additional fictions in inteoganizational elationships, binging into question the extent to which the popety ights of the fim ae popely undestood in IT investments that suppot exchange tansactions (Gossman and Hat, 1986; Hat and Mooe, 1990). Nault and Dexte (1987) have agued in favo of mechanisms that pemit fims that become involved in inteoganizational systems investments to ecognize the citical assets that pemit value to flow, and on that basis, detemine owneships and investment levels. Oveall, as Clemons, et al. (1993) have agued, the maket stuctue in electonic pocuement is likely to evolve towads longe-tem buye-supplie elationships with a smalle focal goup of supplies. The Role of Risk and Uncetainty Ou pespective goes beyond this aleady-contingent intepetation to ague that the citical dive in makets fo pocuement with destabilizing o aleady unstable demand conditions is the extent to which the fim is sensitive to isks elated to the oveall financial consequences of pocuement. Noncontactibility in buye-supplie elationships is the stating point fo such ecognition of isk. We know, fo example, that as the size of the supplie netwok inceases, the bagaining powe of any individual supplie in the netwok will decease (Raupp and Schobe, 1999). As we have discussed, this will educe fim-level incentives fo the supplie fo investing in non-contactible investments (Bakos and Byjolfsson, 1993). If the fim faces cyclical maket demand (as with automobiles), o long lead times fo pocuement (as with the clothing industy), the situation will typically be complicated by how a fim peceives that it is able to insulate itself fom isks in the aangements that it makes fo e-pocuement. Fo example, conside a fim that faces stable custome demand, but views the costs of stocking out o of deliveing infeio goods due, in tun, to poo supplie delivey coodination o supplie quality, to be unacceptable. This pespective may impact the fim s willingness to engage in maket-based e- pocuement aangements, if they expose the fim to an unacceptable level of uncetainty egading the supplie s pefomance. To the extent that e-pocuement aangements move fims to the lowest cost supplie, isks in delivey and quality ae especially magnified. Othe consideations may be moe dominant fo a fim that faces highly unstable demand. Such a fim may equie the supplie to shae some of its isk (fo example, by absobing some of the costs associated with excess pe-contacted supplies, o changing delivey schedules, etc.). In this case, the buye may favo a smalle numbe of supplies as well, and be somewhat eluctant to pocue supplies at lowest cost fom supplies who have no isk-shaing and cost absoption capacity. In shot, we ague that fims ae likely to be obseved to exhibit a isk-augmented tansactions cost pespective in the choices that they make about pocuement systems platfoms and the buye-supplie

11 10 aangements that they make. Fims will account fo the potential effects of investments in maximizing the value of thei pocuement activities, but the exact natue of the solution that is adopted will have a complex intedependence on factos beyond those that tansaction costs theoy, electonic makets and hieachies theoy and even the move to the middle hypothesis would suggest. The Role of Fim Size Fim size is ecognized as an impotant consideation elated to the pefomance of IT investments in moden oganizations (e.g., Bynjolfsson and Hitt, 1994; Im, et al., 001; Stassmann, 1999). Vaious eseaches have examined IT value in a numbe of industies, whee fim size plays an impotant ole in modeating the business value outcomes of IT investments, including valve manufactuing (Weill, 199), insuance (Hais and Katz, 1991), and etail banking (Dos Santos and Peffes, 1995). Thee ae a numbe of aguments to suppot the potential effects of fim size on technology adoption choices in the pocuement systems platfom context. Lage fims tend to have geate access to esouces. Chief among the citical esouces is the manageial skill base of the oganization. Stassmann (1990) conceptualizes the ability of senio manages in the fims to effectively decide upon, implement and manage IT investments in tems of manageial poductivity, with the intention to emphasize the impotance of management s capabilities with IT. Lage oganizations may have a competitive advantage fo lage, moe complex softwae pojects, inceasing thei willingness to choose solutions fo which they must bea significant cost uncetainty. In addition, oganizational knowledge and technology-elated competencies have sensitized IS eseaches to ecognize the impotance of such capabilities, especially when thee is apid technological pogess occuing (Winte, 1987). Anothe fim size issue occus when IT adoption decision making involves technological standads and the potential fo netwok effects (Katz and Shapio, 1994). Lage fims have the capability to ceate thei own inta-fim netwok extenalities, fo example, as we have seen with electonic banking netwoks (Kauffman, et al., 000), the intenational adoption of SAP entepise system solution appoaches by lage fims, as well as the adoption of open standad Web seves (Gallaughe and Wang, 00). In addition, they also tend to benefit fom having thei adoption influence the choices of othes, in a pocess that Au and Kauffman (003) have descibed as ational expectations-based IT adoption decision making. But lage fims still etain the ability to go thei own way, committing to lage-scale IT investments that they believe ae in the best inteests of thei fims. We speculate that lage fims may be moe willing, as a esult, to take on popietay systems solutions pojects. In contast, smalle fims may not have the sufficient funds fo investment, and geneally may expess moe eluctance to adopt pocuement-elated technology as othe lage fims adopt (Iacovou, et al., 1995). Thei smalle size may pedispose them to select solutions with moe immediate netwok extenality benefits (Au and Kauffman, 003) o equie fewe costs fo customization (Gebaue and Segev, 00).

12 11 A RISK-AUGMENTED TRANSACTION COSTS PERSPECTIVE As we can see fom the foegoing suvey of the liteatue, the oppotunity to make a new theoetical contibution lies in efining tansactions cost theoy as Clemons, et al. (1993) have peviously done with thei move-to-the-middle hypothesis intepetation elative to what should be obseved when buyes have an oppotunity to adopt new technologies fo pocuement. The contast between ou pespective and the one offeed by Malone, et al. s (1997) electonic makets and hieachies theoy and tansaction costs intepetation elates to fims peceptions of isk in the pesence of the possibility of unexpected supply and demand shocks. IT clealy impacts tansactions costs fo the fim. But in the pesence of a numbe of othe potential cost dives, it is clea that senio manages of buye and supplie fims look at othe issues. They include ove-supply and unde-supply supply isks, technology standads and functionality isks, elationship and business patne IT co-investment isks, and exposue to othe stochastic and changes in the maket and competition factos. As a esult, it is natual that they will modify the basis fo any decision involving changes in the opeation of thei business pocess activities that ae not well attuned to the natue of the isks that they have to face. The contast is plain. In supply chain management senio manages should be obseved to adjust othe aspects of thei economic behavio, decisionmaking choices and IT investments beyond the pedictions of Clemons, et al. (1993) elative to buye and supplie inteactions. This will occu when thee ae unexpected shocks to its pocuement activities and thee is potential fo significant costs. Some shocks that may dive cost include exposue to supply chain disuption in seasonal business (i.e., one-shot deal pocuement), unexpected exploitation of a buyes demand infomation when final demand infomation is shaed by the buye with the supplie, o the failue of a key supplie. Thee ae also isks associated with insufficient quality of the pocued supplies o quick shifts in demand fo peishable poducts. Othe moe endogenous cost dives include the extent of the sunk costs that ae put at isk in a switch to a diffeent pocuement system platfom and the size of the fixed costs that must be bone acoss the pocuement opeation. In addition, senio manages may be sensitive to the difficulties associated with technology co-investment with othe fims at a scale-size that equies continuous commitment of a lage amount of financial capital (i.e., uncetainty about the non-contactible aspects of inteoganizational elationships). We believe that these cost dives will change senio manages decisionmaking pespective towads being moe focused on the isks. Thee ae many decisionmaking contexts in which these consideations will develop, diminishing the value of elying entiely on the pedictions of tansactions cost theoy to undestand what happens in supply chain management settings. This occus, fo example, in industies with seasonal cycles (e.g., fashion appael, spoting goods and outdoo equipment), whee the annual financial pefomance of the fim is lagely iding on getting the pocuement ight and shocks have the potential to damage a yea s

13 1 financial pefomance. It also occus when thee is the possibility of poblems with negotiating o bagaining fo the benefits flows when multiple fims must be involved in making joint investments. A typical setting is financial isk management systems, whee buye-boowes and supplie-lendes make joint investments to povide a basis fo monitoing the changing isk position and ceditwothiness of the boowe, and to ensue that thee is up-to-date infomation available to suppot on-the-spot cedit decisions. Still anothe context occus when the numbe of equied supply patnes fo a buye is so lage that thee ae scale economies and opeating isks that weigh heavily on an economical solution fo detemining how the fim should opeate. An example of this situation occus in the pesonal compute industy, with fims such as Apple Compute, Dell and Gateway. These fims have so many othe industy patnes who supply them that it is difficult to imagine that naow consideations about maket pices fo the diffeent components that go into a compute would be value-maximizing. This leads us to popose a isk-augmented tansactions cost theoy: DEFINITION (RISK-AUGMENTED TRANSACTIONS COSTS): This pespective enhances the pedictions of the standad tansactions cost theoy in supply chain management and inteoganizational elationships to ecognize the impotance of unexpected shocks, especially technology, fim and maket uncetainties (e.g., demand and supply foecast vaiances in supply chain management, isk and valuation vaiances in financial isk management, etc.). These act as dives of obseved fim behavio and outcomes in inteoganizational elationships that involve, fo example, IT investment, contacting and outsoucing, and oganizational design and govenance of shaed business involvement. To illustate the efficacy of the new theoy, we next develop and analyze a model that applies its geneal insights to decisionmaking fo e-pocuement systems platfoms in supply chain management. AN ADOPTION DECISION MODEL FOR PROCUREMENT SYSTEMS PLATFORMS Ealy effots to suppot pocuement using IT emphasized management of demand uncetainty though inventoy demand foecasting and eduction of inventoy and tanspotation costs. Cycle times also wee educed though the use of optimization algoithms (Kuma, 001). Duing the last decade, inceases in computing powe have enabled the use of these algoithms in supply chain settings, and pemit fims to manage uncetainties that aise as neve befoe. These capabilities ae now being extended to the IT solutions fo BB e-commece. Ou focus is on the economics of uncetainty in the supply chain pocess, specifically supply and demand shocks. We next develop a model that incopoates this consideation and enables us to undestand BB pocuement systems platfom adoption. Modeling Manageial Uncetainties in Supply Chain Management Conside a competitive etail fim (a supply chain buye ) that is able to exet some pice contol on its poducts (i.e., a pice sette), but faces citical demand uncetainties. We assume that the buye pocues its supplies in a competitive maket subject to supply uncetainties fom the supplie. The etail electonics secto, a long-tem and significant sectoal use of EDI, is a good case in point.

14 13 Fo example, despite competitive pessues fom othe fims, the etail electonics giant Best Buy boasts significant egional maket shae fo electonics goods whee it chooses to compete, pemitting it to exet consideable contol ove its picing and maket segmentation stategies elative to othe competitos. Yet, as most consumes know who have shopped at Best Buy s supestoes fo DVD playes and digital televisions, the fim often has insufficient stocks of these and othe popula electonic poducts. The stock-outs stem fom supply acquisition uncetainties as well as demand foecasting uncetainties. In contexts such as this, fou aspects of the buye stand out elative to supply chain management: the fim s elative maket powe at the poduct demand level; its competitive (pice taking) behavio at the poduct pocuement level; its uncetainties elative to supply; and, its uncetainties elative to demand. Demand and Supply Uncetainties. Demand uncetainties aise fom that fact that final sales ae subject to unexpected shocks that the fim s management cannot pedict, so that: s f d s f d q q = δq q = ( 1 δ ) q (1) s with δ f(0,σ δ ) and δ [-1,1]. In this elation, q f d is the final level of sales (o final demand, f d ), q s is the supply quantity eceived fom a supplie s (subject to uncetainty, as descibed below) and δ is the eo in management s estimates of final demand due to andom shocks. We assume that this is a elative eo. Thus, we model it popotional to the magnitude of the supply (so δ q s is included in the ight hand side.) The andom vaiable δ is symmetically distibuted with a distibution f that has mean 0 and vaiance σ δ. A way to ensue a lowe bound on δ is to assume that it has a tuncated symmetic distibution, such as the tuncated nomal distibution, in the inteval [-1,1]. Unexpected shocks in the souce of supply can be modeled in an analogous fashion, but it is elative to a contol vaiable, q o, that epesents the quantity to be odeed fom the supplie. Thus, we wite: q q = q u q = ( 1+ u) q () s o o s o with u g(0,σ u ) and u [-1,1]. Management s eo in estimating the supplies it can acquie is given by Othe aticles on supply chain management emphasize the ole of optimal ode quantity policy somewhat moe than we do (e.g., Cachon and Laiviee, 1999; Chen, 1998; Gavineni et al, 1999; Lee et al., 1997; Lee et al, 000; among othes). A eviewe pointed out that the policy ecommendations that flow fom the single peiod modeling fomulation that we develop may not eflect the possibility of a deceasing peiod ode quantity. No will it adequately eflect the chaacteistics of the poducts that can be taded. In eality, an impotant potential cost that the buye will bea is to unload excess inventoy. But in a single peiod model, thee is no maket stuctue to pemit the sale o the cay fowad of inventoy fo sale at some discounted pice. Also, thee is no consideation of the inteaction effects that may occu between newly-poduced and second-hand, but nealy new inventoy, whee poduct and inventoy type (peishable vs. non-peishable) will matte. Ou tanslation of the cost impacts of stale inventoy in one cost tem is a easonable poxy fo makdowns o cleaance, as well as the discounted cost-of-cay into futue peiods. These issues ae moe fully eviewed in the context of supply chain and pocuement-elated infomation shaing in othe aticles by Kauffman and Mohtadi (003) and Radhakishnan and Sindhi (003).

15 14 u, which is also a poduct of andom shocks. The distibution g can be any symmetic tuncated distibution. The souce of fluctuations in the supply chain is independent of any andom fluctuations in demand so that cov(δ, u) = 0. Then, the vaiable q o is the contol vaiable that management wishes to optimize (simila to what we descibed in the Celestica example). The eade should note that ou choice is to model the impacts of isk and uncetainty on pocuement system platfom adoption choice in a single peiod model. We justify this modeling choice in tems of the ability that we have to use ode quantity levels as a poxy fo fim size and the technology capital that is likely to be employed fo supply chain management. We expect to obtain simila infomation fom a shot modeling hoizon in tems of fim technology capital and investments in pocuement systems. Calculating Retaile Pofits. We calculate the buye's expected pofits E(π ) by integating its objective function ove the two uncetainty dimensions: f E( π ) = g( u) du π ( qs, qd ) f ( δ ) dδ (3) 1 In ode to calculate the expected pofits in Equation 3, we fist evaluate the conditional expectation, E(π (q s )), which holds q s constant but integates ove q f d, based on: E( π ( q s )) = P( qs ) qs f pob( qs < qd ) + P( qd ) qd q < q q > cq s s s( q s d q f d ) pob( q s f > q f d ) f s q d pob( q s > q f d ) (4) whee, P(.) is the invese demand function, c is the unit cost of obtaining the poduct fom the distibuto (both as a unit poduct cost and/o the tansaction pocessing cost), and s is unit inventoy cost. The asymmetic natue of the losses show up in two ways. Fist, they occu in the fom of evenue, which is detemined by whicheve of the two quantities, q s and q f d, is smalle. Second, they also occu as inventoy costs which aise in the event of ove-supply elative to final sales. We use s to denote the inventoy cost, so that stoage costs ae cumulative ove time. (Fo example, in the food secto whee poducts ae peishable and in the etail secto whee obsolescence mattes, time is citical, and inventoy costs may each the point whee they might equal o even exceed the poduct's pice.) The paamete s is capable of epesenting time implicitly, if each poduct line is associated with a diffeent value of s. A manage of a etail fim often tacks inventoy tunove fo its poducts. Thus, diffeent values of s can be attibuted to each poduct as a composite of stoage costs, stoage time and isk of obsolescence. This is how we will intepet s. We expess the pobabilities in Equation 4 with δ and its density function f(δ) fom Equation 1. Note that 0 δ 1 when q s q f d and 0 δ 1 when q s q f d. Conditional expected pofit in Equation 4 is: E( π ( q )) = s 0 1 P( q ) q f ( δ ) dδ + s s 1 0 P[( q (1 δ )] q (1 δ ) f ( δ ) dδ cq s s s 1 s δq 0 s f ( δ ) dδ (5)

16 15 This can be simplified because q s is given at this stage. This means that the tem P(q s )q s is independent of δ in the fist integal. Moeove, since f(δ) is symmetic in δ, and the integal coves half the ange of δ, the fist integal can be evaluated as (1/)P(q s )q s. We define the final tem, the demand eo integal, as Ω δ 1 0 δ f ( δ ) dδ, so that the conditional expectation of pofits is given by: 1 E( π = + δ δ δ δ Ω ( qs )) (1/ ) P( qs ) qs P[( qs (1 )] qs (1 ) f ( ) d cqs sq (6) s δ 0 Unanticipated Ove-Supply in Inventoy. In this expession, Ω δ epesents the mean value of δ, conditional on δ > 0. Recall that we defined δ as the extent to which actual demand falls shot of supply. Thus, Ω δ epesents the extent to which thee will be, on aveage, an unanticipated ovesupply o inventoy build-up. Since δ (0,1), it follows that Ω δ < 1. Although Ω δ is an analytically distinct featue of f(δ), it is likely that Ω δ will be positively elated to the vaiance σ δ so that a moe widespead distibution involves a lage value of Ω δ. Howeve, Ω δ contains a signal value fo the extent of ovesupply while σ δ is pue white noise. At this point, expected pofits ae still conditional on supply. The unconditional value of expected pofits in Equation 3 is elated to this conditional expectation by integating ove the supply vaiance u: 1 E( π ) = E( π ( q )) g( u du (7) s ) 1 We can then use Equation 6, which povides an explicit fom of E(π (q s )). But since q s is teated stochastically now, Equation is used to expess q s in tems of the non-stochastic q o, the etaile's quantity of goods to be odeed up the supply chain. The esulting expession will involve the stochastic paametes δ and u, as aguments of the invese demand function of P[q o (1+u)] and P[q o (1+u)(1-δ)]. As a esult, futhe analysis must involve a Taylo seies appoximation of the invese demand function, aound the non-stochastic ode size q o to lineaize the demand function. This expansion is caied out up to the second tem, and then the esults can be integated ove the appopiate density functions, and simplified. Following this pocess, the etail fim's expected pofits become: E( π ) ( 1 Ω )P( q )q ( c + sω )q + q P' ( q )A( σ, σ, Ω ) (8a) whee the final tem is given by δ δ δ δ o o σ δ σ o 1 A ( σ, σ, Ω ) (1 Ω ) σ + σ ( σ + σ ) Ω. (8b) u u Notice in Equations 8a and 8b that although the supply and demand uncetainties, σ δ and σ υ, affect expected pofits advesely, the ole of the unanticipated ove-supply paamete, Ω δ, is mixed. It affects expected pofits advesely via the evenues and inventoy costs (the fist two tems). u o δ o u σ δ

17 16 But it also affects expected pofits positively via the slope of invese demand P'(q o ), which is negative. This obsevation is tied to the maket powe of the etail fim. In fact fo a competitive fim whee demand is hoizontal and P'(q o ) = 0, unanticipated ovesupply, Ω δ, educes expected pofits unambiguously. By contast, fims with some maket powe ae in a position to educe the pice level to espond to excess inventoy build-up when supply exceeds sales (i.e., q s > q d f, o δ >0), modeating the advese effect of oveestimating the demand. At the same time, howeve, the advese effect of uncetainty, σ δ and σ u, exists only when fims enjoy some maket powe, but disappeas othewise. This leads us to asset the following poposition: PROPOSITION 1 (ADOPTING FIRM S SUPPLY SHOCK ABSORPTION CAPACITY PROPOSITION). Buyes with geate maket powe ae bette able to absob the advese effect of ovesupply shocks, by educing pices, than those with little o no maket powe. They also ae moe advesely affected by supply and demand uncetainties than ae competitive buye fims. To enhance the eade s undestanding of the popositions that we develop in this aticle, we also include an illustative Appendix of industy examples that povide evidence fo the modeling findings. Optimization in the Pesence of Linea Demand As befoe, a etail fim will select ode level q o in its supply chain to maximize expected pofits. We examine the case of a linea demand (so that P" = 0), whee the Taylo seies appoximation fom Equation 8a and 8b is pecise. Specifically, we let P(q o ) = a - bq o. A linea demand stuctue povides a basis fo maintaining the tactability of the line of analysis that we use, and epesents a easonable way to think about the key elationships in the model. The fist ode condition fo optimization yields: de( π ) = 0 dq o 1 ( a c) ( a + s) Ωδ qo* = b 1 (1 + σ )(1 + σ Ω ) u δ δ (9a) e * 1 [( a c) ( a + s) Ωδ ] π = (9b) 4b 1 (1 + σ )(1 + u σ δ Ωδ ) The denominatos of Equations 9a and 9b ae positive due to the concavity condition we impose to ensue optimality. As a esult, a positive value of output and pofit level implies that the numeato must be positive, a ( 1 Ω ) > c + sω > 0. This means the stength of the demand pe unit a, adjusted fo δ δ unanticipated ovesupply, must exceed the sum of costs. The supply and demand uncetainties, σ δ and σ u, advesely affect optimum output and pofits. Howeve, the paamete Ω δ continues to play a dual ole affecting pofits and output; via the numeato it educes both, and via the denominato it inceases both. The latte effect aises fom the negative slope of the invese demand function, and shows that lage fims with maket powe can absob effects of unanticipated inventoy build-up by educing pices.