Value Creation in Supply Chains through Internal Capabilities versus External Capabilities: The Case of Electronic Marketplaces

Transcription

1 Value Creation in Supply Chains through Internal Capabilities versus External Capabilities: The Case of Electronic Marketplaces Markus Biehl Schulich School of Business, York University, 4700 Keele St., Toronto, ON M3J 1P3, Canada Abstract. Anecdotal evidence suggests that the use of business-to-business electronic marketplaces (EMPs) results in improved efficiencies and reduced costs in supply chains. Anecdotal evidence also suggests, however, that most benefits offered by EMPs can be achieved through increasing a firm s internal capabilities. Hence, firms have to decide whether to seek supply chain efficiencies though internal capabilities, participation in EMPs, or a combination of both. Biehl (2001) investigates this problem. However, a major drawback of that research is the assumption that, if the firm does not have sufficient levels of internal capabilities, it must complement those using EMPs. In this paper, the firm has the choice of using internal capabilities (ICs) and determining the degree to which it wants to use external capabilities (ECs) through EMPs. This dynamic, non-linear decision problem is formulated and analyzed using optimal control theory. The insights derived from the analysis include the interaction between ICs and ECs and conditions that influence the mix of ICs and ECs. Major findings include the fact that firms are not able to use EMPs as quick-fixes for inefficient ICs, an increase in ICs has a self-reinforcing positive effect, and that the firm needs to balance its portfolio of ICs and ECs along the supply chain process. Key Words: supply chain management, business-to-business e-commerce, electronic marketplaces 1. Value Creation in Inbound Supply Chains Traditionally, the sourcing process is characterized by great inefficiencies, resulting in increased costs, lower profits, and decreased competitiveness. For example, in a typical firm, once demand is recognized, a number of steps involving staff from up to three functional areas is performed until an order is actually placed (e.g., see Turban et al., 1999). Those internal inefficiencies may be alleviated in two ways. First, a firm may simplify its processes and implement an enterprise resource planning system (ERP) to automate inventory management and order generation, including the associated approval processes. As ERP systems are common in medium and large sized firms, and many of such systems support various EDI standards, an ERP system may also facilitate the direct transfer of orders to pre-selected suppliers or to an e-marketplace (EMP). Alternatively, for smaller firms, in particular, streamlining operational procedures and the information flows, and empowering employees may also suffice. No matter what the choice, the reduction of internal inefficiencies results in an increase in internal supply chain capabilities (ICs). Second, a firm may rely on the capabilities of an EMP or a set of EMPs to gain access to additional supply chain capabilities (Grewal et al., 2001). For example, MRO-type firms such as Staples or Office Depot offer the implementation of electronic catalogues that give access to a customized range of products at pre-negotiated prices. During the implementation process, the EMP also sets up an automated authorization processes for sourcing activities. Purchase orders are then only reviewed and approved by the purchasing department in exceptional cases. Such an option gives the firm access to external supply chain capabilities (ECs).

2 The choice of developing ICs versus using ECs is neither new nor trivial. There are multiple ways of approaching the subject, the most pervasive one being the analysis of value creation. The literature widely discusses how process simplification (business process reengineering) and ERPs impact the firm's internal value creation along the various stages of the supply chain (see Figure 1). Value creation through EMPs, however, is not as straightforward (e.g., see Kaplan and Sawhney, 2000, Gotschall, 2000, or Amit and Zott, 2001). McKinsey and CAPS (2000) propose a classification of marketplaces based on how they create value along the supply chain. As the result of a large study of 350 B2B e-marketplaces (EMPs) and the application of value chain analysis to existing EMPs, the authors find that EMPs create value by providing information and capabilities that support decision-making during the entire sourcing process. They propose five generic types of EMPs, each of which creates value in a different way. Most are particularly helpful in one of the four stages of the inbound supply chain (see Figure 1) and offer peripheral services in one or more of the other stages. Hence, it is possible for firms to pinpoint which type of EMP would suit their particular need to complement their set of internal capabilities. Figure 1: The Stages of the Inbound Supply Chain Process Planning Order Transaction Control Design Planning Search Negotiation Selection Purchasing process Order tracking Invoice payment Bill of lading Logistics Inventory management Reordering A second problem is that even the use of the right types of EMPs does not necessarily add much value to the firm's supply chain process. Grewal et al. (2001), for example, find that, to use EMPs effectively, a firm needs to have successfully reengineered its business processes, possess extensive knowledge about its EMPs and their procedures, understand the cause-and-effect relationships for their EMP activities, and keep abreast of changing technology and markets. Therefore, regardless of the firm s choice, a certain level of ICs is needed to effectively use ECs. While these papers highlight factors that influence the choice of capabilities, none attempts to gives concrete advice regarding the levels of internal versus external capabilities to be implemented over time. In other words, given that a firm possesses a certain level of internal IT and sourcing capabilities as well as experience with EMPs at the present time, how should it change its level of internal capabilities and involvement in EMPs in an attempt to increase its competitive and operating efficiency? Biehl (2001) investigates this problem but assumes that the firm will make full use of EMPs and, in reaction, adjust its internal capabilities accordingly. This paper attempts to close the gap by introducing a dynamic decision model that allows the firm to adjust its internal inbound supply chain capabilities and its involvement in ERPs over time. Factors influencing this decision include the firm s initial levels of internal capabilities and use of EMPs as well as the capabilities structure of EMPs. Moreover, the firm s competitive environment, including the capabilities of its competitors and industry trends are also considered. In addition to the competitive cost, the firm's choice is impacted by the costs of changing ICs and the use of ECs, the cost of maintaining ICs ( system maintenance cost ) and the cost of using the services of EMPs ( subscription cost ). In the following section, a model is formulated to optimize a firm s decision between the two alternatives over time. In the third section of this paper, the optimality conditions are explored, upon which, in the fourth section, insights are derived through analyzing the optimality conditions of the model. A discussion of the findings and recommendations for future research conclude the paper.

3 2. A Decision Framework for EMP Involvement To remain competitive, the firm needs to reach a certain overall level of capabilities for each of the above supply chain activities (Finkelstein, 2001). According to social capital theory, the firm s external networks, including suppliers and EMPs, complement its ICs in its quest to produce products and services at competitive prices and quality (Lee et al., 2001). Clearly, the level of total capabilities available to the firm is a mix of ICs and the ECs used. However, the effectiveness with which ECs can be used depends on the level of ICs. Given the notations shown in Table 1, the firm s total level of effective capabilities is defined as L i + ε i M ij V j. Note that, while the levels of ICs are expressed as a vector of state variables, the effectively used ECs are a function of EMP capabilities, the firm s ICs, and the firm s use of EMPs. To increase its profits and remain competitive the firm wants to minimize its total cost over time. The costs relevant to this framework consist of three components: (i) the competitive cost, which is a penalty for operational inefficiencies at time t as compared to those of the firm s competitors (C 1 >0); (ii) the system maintenance cost of ICs as well as the subscription cost to EMPs at time t (C 2 >0); and (iii) the cost of changing the levels of ICs and use of EMPs at time t (C 3 >0). Note that we make no assumption regarding the C 3ll or C 3vv. Depending on the firm and the type of change, it may be positive (complexity of larger projects) or negative (economies of scale). The firm may increase the level of ICs by investing into the simplification of its administrative processes, IT systems to support every-day decision-making (e.g., an ERP system), etc. Due to economies of scale, the cost of doing so increases at a non-increasing rate with the rate of change in the level of ICs, l(t) (i.e., C 3l >0, C 3ll 0). The cost maintaining ICs increases with the level of ICs available (i.e., C 3L >0). Similar relationships hold for changing the firm s involvement in EMPs and the subscription cost (i.e., C 3v >0, C 3vv 0, C 3V >0). The firm also has an explicit incentive to invest in ICs and the use of ECs: the salvage values of ICs and use of ECs at the terminal time of the planning horizon, S i L i (T)>0 and Z j V j (T)>0, respectively. These salvage values capture the value of the firm s internal competitiveness and experience with ECs at the terminal time and prevent a policy geared towards shutting down business during the later part of the planning horizon. In conclusion, the firm wishes to maximize its terminal time competitiveness and experi- Table 1: Notation L i (t) = Level of internal supply chain capabilities the firm possesses to execute the i th supply chain process at time t (state variable); L i (t) [0,1] i; L i (0)=L i0 M ij (t) = Level of inbound supply chain capabilities a type j EMP possesses to execute the i th supply chain process at time t (exogenous, changes with EMP capabilities); M i (t) [0,1] i ε i (L i (t)) = Effectiveness with which external capabilities of process type i can be used at time t; ε i (L i (t)) [0,1], ε il > 0, ε ill 0 V j (t) = Firm s level of use of type j EMPs at time t (state variable); V j (t) [0,1] j; V j (0) = V j0 l i (t) = Change in the level of internal capabilities (control variable); l i (t) = L i '(t) and l i (t) [l - i (t), l + i (t)] i v j (t) = Change in the level of involvement in EMPs (control variable); v j (t) =V j '(t) and v(t) [v - j (t), v + j (t)] j C 1 [L i (t), ε i (t)m ij (t)v j (t)] = Competitive cost due to operational inefficiencies at time t; C 1L 0, C 1LL > 0, C 1V 0, C 1M 0, C 1MM > 0, C 1t > 0 C 2 [L i (t), V ij (t)] = Cost of maintaining the levels of internal capabilities and use of EMPs at time t; c 2L > 0, c 2LL 0, c 2V > 0, c 2VV 0 C 3 [l i (t), v j (t)] = Cost of changing the levels of internal capabilities and use of EMPs at time t; C 3l 0 if l i 0, C 3l < 0 if l i <0, C 3ll 0; C 3v 0 if l i 0, C 3v < 0 if l i <0, C 3vv 0 S i L i (T) + Z j V j (T) = Salvage values of internal capabilities and use of EMPs, respectively, at the terminal time, T; S L > 0, Z V > 0

4 ence with ECs, minus the costs of becoming and remaining competitive over the planning horizon, t [0,T]. The objective function is subject to changes in the levels of ICs and use of ECs and the conditions shown in Table 1. Since the analysis takes place at a strategic level and, therefore, the time horizon may span a number of years, all values are discounted at a rate ρ. T e (1) 0 Max [ ( ) ( L, V, ) ( l, v, ρt ρt C L + ε(l)mv, t C t C t) ] e dt + [ SL(T) + ZV(T) ] 3. Analysis of Optimality Conditions The dynamic and nonlinear model is solved using optimal control theory. Two new variables, the adjoint variables σ 1 (t) and σ 2 (t), are introduced. They are interpreted as the marginal value at time t of a unit increase in the level of internal capabilities (level of use of external capabilities) through time t, L(t) (V(t)). The necessary conditions for defining the extremes require that Equations 2 to 4 hold simultaneously (see Table 2). The interpretation of these equations allows for rich insights regarding the firm s optimal behavior. While the discussion in this section is restricted to ICs, due to their mathematical analogy, equivalent results hold for ECs. The change in the marginal value of ICs (MVICs) is determined by the first derivative of the firm's competitive cost with respect to the level of ICs, C 1L, and the first derivative of the system maintenance cost with respect to the level of ICs, C 2L (Equation 2a). As the level of Table 2: Optimality Conditions σ 1 ' = (C 1L + C 2L ) e -ρt = C 1 [(L+ε(L)MV, t) + C 2 (L, l, t)]e -ρt / L (2a) σ 2 ' = (C 1V + C 2V ) e -ρt = C 1 [(L+ε(L)MV, t) + C 2 (V, v, t)]e -ρt / V (2b) σ 1 (T) = S L(T) e -ρt = S e -ρt (3a) σ 2 (T) = Z V(T) e -ρt = Z e -ρt (3b) C 3l = σ 1 /e -ρt = (C 1L + C 2L ) (4a) C 3v = σ 2 /e -ρt = (C 1V + C 2V ) (4b) ICs increases (decreases), the firm's competitive cost decreases (increases) at a decreasing rate, reflecting improved (reduced) efficiencies. At the same time, the system maintenance cost increases (decreases). Note that the MVICs is also impacted by changes in the level of use of ECs. In particular, as the use of ECs, V(t), increases, the marginal competitive cost, C 1L, decreases, lowering the firm s incentive to further pursue ICs. Also note that, since the terminal time value of the MVICs is given (Equation 3a), the more the MVICs decreases over time, the higher its starting value at time zero and the greater the firm s terminal level of ICs. Moreover, the more ICs the firm pursues, the higher the salvage value of ICs at the terminal time. The firm reaches an equilibrium (with σ 1 '=0) when the marginal competitive cost of ICs equals the marginal system maintenance cost. Depending on the firm's initial levels of ICs, two cases are possible. First, if the firm's capabilities are low (i.e., there is substantial room for decreasing the competitive cost), the firm will invest in ICs until it reaches its equilibrium. Second, if the firm's capabilities are high such that considerable cost reduction potential exists through diminishing the system maintenance costs, the firm will do so until it reaches the equilibrium. The rate of change in the level of ICs is determined by the equilibrium of the marginal investment cost and the MVICs (Equation 4a). The rate of change in the level of ICs is negative (positive) if the MVICs is negative (positive), allowing the firm to increase or decrease its ICs for purposes of either efficiency improvements or downsizing, outsourcing, or shifting to an in-

5 creased use of EMPs. The level of ICs increases (the rate of decrease in ICs diminishes) as either the MVICs increases (becomes less negative) or the investment cost of ICs decreases. Keeping the optimality conditions in mind, sensitivity analysis can now be used to investigate a firm s behavior under various conditions. As it is now fairly obvious how the cost components impact the firm s strategy, we focus the discussion on the optimal use of ICs versus ECs. 4. Internal and External Capabilities As the level of ICs increases, the total level of effective capabilities increases in two ways: (1) directly through the increase in ICs and (2) indirectly through an increase in the effectiveness of using EMPs. The direct effect increases the total level of effective capabilities linearly whereas the indirect effect increases the total level of effective capabilities at a decreasing rate. As a result, the firm pursues fewer ICs in the future as it approaches the optimal level and it becomes more expensive to maintain them. The increase in ICs also leads to a higher terminal time salvage value of ICs and, hence, a higher overall investment volume over the planning horizon. Hence, a tradeoff takes place between the positive effect of the salvage value and the negative effect of the lower marginal value of ICs (MVICs). Clearly, if the salvage value is comparatively high, e.g., since competition is intense, the firm is likely to increase its ICs to a higher average rate. In general, the above analysis of ICs also holds true for the use of EMPs. However, one important difference stems from the fact that an increase in the use of EMPs only has a direct effect. In particular, an increase in the use of EMPs increases the total level of effective capabilities only directly and linearly, proportional to the effectiveness of using EMPs. Clearly, there is considerable interaction between the levels of internal capabilities (ICs) and use of EMPs (ECs). For example, an increase in the level of ICs also lowers the marginal value of using EMPs directly and indirectly. Hence, an increase in the level of ICs lowers not only the MVICs but also the marginal value of using ECs (MVECs). The only difference in the magnitude of change between the MVICs and the MVECs is a result of the difference between the marginal system maintenance and subscription costs. For example, if the system maintenance costs increase at a faster rate than subscription costs, then the MVICs decreases slower (or increases faster), thus leading in a lower overall level of ICs as compared to the level of ECs. The same holds true for an increase in the level of use of EMPs. Having discussed the interaction between ICs and ECs, the question arises how a firm s initial capabilities (at time t=0) impact the mix of ICs and ECs to pursue. Recall that a higher level of ICs leads to a more effective use of EMPs (indirect effect). Hence, contrary to popular belief, EMPs are not a quick-fix for firms with a low initial level of ICs. Only as the level of ICs increases, the firm becomes able to effectively use the services of EMPs. In contrast, if the firm starts out with a relatively high level of ICs, it is capable of augmenting them with the services of EMPs very quickly. In this case, the main tradeoff takes place between the system maintenance and subscription costs as well as the costs of changing the levels of IC and use of ECs. Lastly, consider the current trend under which a shakeout and consolidation of EMPs is taking place, leading to improved capabilities of the remaining players. This trend results in an increase in M ij (t) which, in turn, increases the firm s effective total level of capabilities in proportion to its degree of involvement and the effectiveness with which it uses EMPs. Since the increase in capabilities leads to a reduction in C 1L and C 1V, a re-balancing of costs and capabilities

6 takes place that results in a small reduction in the firm s ICs or use of EMPs. At the same time, the net increase in capabilities leads to a reduced incentive to increase either ICs or ECs further. 5. Conclusions and Future Research This paper introduces a decision framework for firms seeking to find a tradeoff between improving its internal supply chain capabilities and using the capabilities of external entities, such as business-to-business e-marketplaces over time in response to a number of factors. An analysis of the decision structure has led to numerous valuable insights. For example, contrary to popular belief, if a firm s internal supply chain capabilities are low, it cannot easily save itself by using EMPs. Well-defined internal processes and an appropriate IT-infrastructure are necessary to effectively use external capabilities. Second, an increase in the firm s internal capabilities has a self-reinforcing positive effect on the total level of effective capabilities. This effect exists due to a direct increase in internal capabilities and an indirect increase in effectively used external capabilities as the result of increased internal capabilities. Lastly, a firm usually joins EMPs because they are more efficient than itself in at least one of the supply chain processes. The firm should, therefore, use a well-defined portfolio of EMPs to complement its portfolio of internal capabilities. The model, however, has room for further improvement. In particular, it would be interesting to use numerical examples to demonstrate different scenarios, the tradeoff between ICs and ECs, and likely configurations of capability portfolios. Moreover, the current model does not explicitly allow for changes in costs to occur over time. For example, how would a decrease in subscription costs or IT investment costs change the firm s mix of internal and external capabilities? Further research might complement the findings with answers to those questions. 6. References Amit, Raphael, Christoph Zott (2001); Value Creation in E-Business, Strategic Management Journal, Vol.22 No.6/7 (pp ) Biehl, M. (2001); The Impact of Business-to-Business Exchanges on Supply Chain Management: The Purchaser s Perspective; in: K. Engemann, G. Lasker (Editors); Advances in Decision Technology and Intelligent Information Systems, Vol. II, The International Institute for Advanced Studies in Systems Research and Cybernetics, Windsor (pp ) Finkelstein, S. (2001); Internet Startups: So Why Can t They Win? Journal of Business Strategy, Vol.22 No.4 (pp ) Gotschall, M. G. (2000); B2B Exchanges, Electric Perspectives Vol.25 No.5 (pp ). Grewal, R., J. Comer, R. Metha (2001); An Investigation into the Antecedents of Organizational Participation in Business-to-Business Electronic Markets; Journal of Marketing, Vol.63 No.3 (pp ) Kaplan S. and M. Sawhney (2000); E-Hubs: The New B2B Marketplaces; Harvard Business Review, Vol.78 No.3 (pp ) Lee, C., K. Lee, J. M. Pennings (2001); Internal Capabilities, External Networks, and Performance: A Study on Technology-Based Ventures; Strategic Management Journal, Vol.22 No.6/7 (pp ) McKinsey and CAPS (2000); Coming in to focus using the lens economic value to clarify the impact of B2B marketplaces; Turban, E. J., Lee D. King, H. M. Chung (1999); Electronic Commerce: A Managerial Perspective; Prentice Hall