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Beyond the Hype: Making B2B E-Commerce Profitable

Research by Luis Garicano and Steven N. Kaplan

Back in 1999 when Time named Jeff Bezos person of the year, business-to-consumer (B2C) e-commerce and business-to-business (B2B) e-commerce were two of the hottest buzzwords around. Financial pundits extolled the virtues of B2B in particular, and entrepreneurs acted as if B2B had near-infinite capacity for growth. Then came the tech wreck of 2000, the folding of thousands of dot-coms and a growing distrust of all things Internet. In the new new economy, does B2B e-commerce still stand a chance?

Yes, say Luis Garicano, assistant professor of economics, and Steven N. Kaplan, Neubauer Family Professor of Entrepreneurship and Finance at the University of Chicago Graduate School of Business. Their latest research argues that the Internet still has the potential to radically change the ways corporations provide and trade goods and services with each other. "We think that the impact of B2B on the economy overall is almost certain to be very positive," they write in their paper, "A Framework for Analyzing B2B E-commerce."

For B2B to work, however, business no longer can afford-if it ever could-to believe blindly in the Internet hype. It is time for a more critical eye. The key to the success of B2B e-commerce, Garicano and Kaplan explain, is for companies to be sure that using the Internet will reduce transaction costs relative to traditional tools and methods such as catalogs and phone calls.

After researching firms that have transferred their B2B transactions from a physical marketplace to an Internet-based one, the professors devised a framework for analyzing existing and potential B2B e-commerce strategies. This method works for B2B startups as well as established companies taking their B2B transactions online, and it helps businesspeople judge whether a strategy has measurable benefits for both the company and its customers-important concerns that often were discarded in the initial wave of excitement over e-commerce.

Garicano and Kaplan's framework identifies five ways in which B2B e-commerce potentially affects transaction costs: changing business processes, altering the nature of the marketplace, modifying decisions by buyers and sellers, altering the amount of information available to buyers and sellers, and changing the ability of buyers and sellers to go through with a transaction.

It's the Way that You Do It

The biggest impact of B2B e-commerce will likely be improving business processes, say the researchers. Reducing the costs involved in a process is one way to increase efficiency. On a basic level, communicating via e-mail usually is cheaper than making long-distance phone calls. For a deeper exploration, Garicano and Kaplan looked at Ariba, Inc., a software company and service provider with headquarters in Mountain View, California. In addition to using B2B e-commerce to sell its own goods and services, Ariba's software applications allow other companies to streamline operations and create B2B marketplaces and online auctions. A buyer using these applications saves money on each purchase thanks to reduced processing costs, say the professors.

Another way for the Internet to increase efficiency is by allowing a company to redesign an existing process. Autodaq Corp., for instance, offers online auctions for wholesale buyers and sellers of used cars. Taking the auction to the Internet means that the Menlo Park, California, B2B doesn't have to ship the car to a physical location, saving transportation costs and time for both buyers and sellers.

A company easily can determine whether implementing B2B strategies is worthwhile based on process improvements: just describe and measure in detail the time and costs of the existing process versus the time and costs of the B2B e-commerce process. But process improvements aren't the only factor to consider.

Making Waves in the Market

Certainly the capabilities of the Internet have affected the marketplace. The question for an entrepreneur or executive, though, is whether those changes are advantageous-and if so, for whom. In many ways, B2B e-commerce has made the marketplace more efficient. The Internet can reduce costs for buyers. It is cheaper and quicker to search for products and compare prices over the Internet than to read catalogs and make phone calls. As for sellers, the Internet allows them to reach more potential customers at a lower cost. Buyers and sellers can make connections and transactions otherwise unavailable without the Internet. eBay has proven the potential for this kind of interaction on the consumer-to-consumer (C2C) side. In the B2B world, Autodaq helps buyers find a wider range of vehicles and helps sellers reach customers from across the country.

The amount of available information over the Internet can also affect the marketplace. Buyers may receive better information about product characteristics (including price and availability) because it is less expensive to obtain such information online than through other means. The Internet also may provide more thorough and accurate information about buyers and sellers, which is particularly important when it comes to establishing credit.

The authors caution against overestimating the positive effects of the Internet on the marketplace, however. For some goods and services, using an e-commerce approach can actually increase transaction costs since buyers cannot physically inspect the merchandise or speak face-to-face with the service provider. For instance, in the B2C world, the real estate industry has not actively pursued selling homes over the Internet, as few buyers wish to purchase a home without seeing it in person.

Additionally, estimating the costs and benefits of marketplace improvements is more difficult than estimating the effect of process improvements, but Garicano and Kaplan offer some general markers.

One is an increase in trade in the marketplace as a result of B2B e-commerce. Also, if sellers receive higher prices for their products online, it probably means that the cost of reaching and matching customers has indeed been reduced. Lower prices for buyers, however, could indicate any one of several possibilities, say the researchers. While these lower prices might mean that B2B has reduced the costs of finding suppliers, they also could relate to reductions in seller processing costs or reallocation of the transaction surplus, neither of which has anything to do with the efficiency of the marketplace.

Indirect Effects of Reduced Costs

Clearly, any reduction in transaction costs caused by increased process and marketplace efficiency results in direct economic gains. But careful analysis of a B2B e-commerce strategy should also consider indirect benefits. As the costs of undertaking spot market transactions decrease, participants in these transactions may begin altering their decisions and behavior in hopes of increasing efficiency still further. According to the authors, these changes may be revealed in two key ways: better information processing and modifications to organizational structure.

For example, better information about future demand through B2B e-commerce may allow a seller to improve its demand forecasts, then use that information to change production decisions to better match demand. Conversely, a buyer might obtain better information about existing and future supply, then use that information to change inventory decisions. B2B commerce might also affect a firm's "make or buy" decisions-whether to carry out transactions internally or go to an outside market. If the Internet can greatly reduce the "buy" costs, Garicano and Kaplan predict that "fewer transactions will be undertaken inside firms and more will be undertaken in the market or outsourced."

Although these changes in decision-making patterns are difficult to measure, the authors note that their impact is potentially quite large, and the benefits and pitfalls closely examined.

Information Highway or Information Exit Ramp?

The fourth piece of the framework looks at the potential of e-commerce to change the informational positions of buyers and sellers. Because they usually do not share the same information about a particular transaction, one party may be at a disadvantage to the other in evaluating the desirability of a transaction. The Internet can turn a disadvantage to an advantage, though, and vice versa. For example, a used car wholesaler might know that 5 percent of its cars sound like they're on their last legs-clearly a disadvantage in selling those cars. Selling them through the Internet gives the wholesaler the advantage, though. The pictures look great while potential buyers can't hear the sputter of dying engines.

From the individual seller's perspective, this might be an argument in favor of B2B e-commerce. Not so for everyone else. The problem: If sellers offer this type of product more frequently over the Internet, buyers' willingness to purchase the average object decreases as do high-quality sellers' desire to participate in the market.

Commitment Issues

One final point for consideration: B2B e-commerce has the potential to both increase and decrease the ability of buyers and sellers to complete transactions. The standardized processes and electronic trail provided by e-commerce may make online transactions more appealing than traditional transactions and increase the likelihood of a transaction being completed. On the other hand, buyers may use the Internet to avoid intermediary fees by viewing a product online and then contacting the seller directly. Or buyers may go online to determine the market price for a particular good and then trade with an existing supplier.

Overall, the authors find that the Internet does seem to foster gains in efficiency without increasing concerns about the quality of goods being bought and sold. Returning to the Autodaq example, the price of cars bought through online car auctions, as compared to physical auctions such as those held by rental car companies, is currently slightly more expensive. But with more buyers using the Internet, dealers could save approximately $200 per car, in time and transportation costs, say the authors.

In addition, buyers seem willing to pay a premium for a greater selection of cars, despite the fact that they are not able to "kick any tires." Based on research by Garicano and Kaplan, Internet auction buyers outside California were willing to pay an average of $242 more per car to transport cars to their location compared with buyers in California. Also, contrary to the common expectation that sellers are more likely to dump their "lemons" on the Internet, cars are not necessarily cheaper when bought online, nor do prices fall faster than in the physical auctions as the number of miles the car has been driven increases.

The Next Five Years

Companies that want to succeed in B2B e-commerce must follow two crucial steps, suggest Garicano and Kaplan. First, firms should avoid using B2B solutions that focus on price discovery without requiring a purchase commitment. Easier said than done, the authors acknowledge, but they explain that in the past many marketplaces worsened the situation by charging transaction fees that were a percentage of the transaction, while buyers' and sellers' savings from using the marketplace tended to be fixed rather than a percentage. "In response to this, many B2B marketplaces are now changing their business models and incorporating other functionality to deliver process improvements and value-added services," write the professors.

Second, bricks-and-mortar companies should choose B2B solutions that provide measurable benefits (in excess of the price charged for them) that they cannot obtain otherwise. Online B2Bs need to provide those measurable benefits and to charge customers appropriately: fixed fees for fixed savings and sliding fees for sliding savings.

B2B e-commerce and the business process improvements it brings promise "substantial increases in productivity over the next five years," say the researchers, who also predict that "process improvements, marketplace changes and changes in decisions will all put downward pressure on costs and inflation." After a tough 2000, look out for B2B to make a comeback in 2001.

Luis Garicano is assistant professor of economics at the University of Chicago Graduate School of Business. Steven N. Kaplan is Neubauer Family Professor of Entrepreneurship and Finance at the University of Chicago Graduate School of Business.

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