When managers within the same company compete for internal resources such as machines, consultants, and workspace, how does top management figure out who should get what? Recently, some organizations have embraced creating markets within firms to let managers duke it out by buying and selling resources. Hewlett-Packard has created markets for allocating computing power and conference rooms, and Ford uses an internal market for distributing cars to dealers.
A recent study of internal online auctions finds that, in some cases, auctions indeed can streamline the process of resource allocation. But researchers caution there are other instances when resources allocated through the auctions will not benefit the bottom line.

“The problem of resource allocation has been solved before by a mathematical application known as the ‘optimal revelation mechanism,’ which uses extremely complicated rules,” says Richard Saouma, Stanford Graduate School of Business PHD ’06, one of the authors of the recent study and an assistant professor at the Anderson School of Management at UCLA. Two divisions that want a single resource—such as specific machinery—might lay out their case to the CEO—describing in quantitative fashion how badly they need the machine to complete a job. The CEO must decide which division gets the machine, how to compensate each manager for completing their respective projects, and whether both divisions are even worth being in the competition.

The optimal revelation mechanism uses the quantitative information submitted to make every decision. It spits out figures dictating who should receive the resource, who should be asked to carry out the project, and how much each party should be compensated upon successful completion. The problem is that decisions may seem arbitrary. A manager may be a loser in any category without having a clear picture of what information the other side gave. Because of this, Saouma says, some firms hesitate to use these mechanisms.

The researchers, including Saouma and Madhav Rajan, the Gregor G. Peterson Professor of Accounting at the Stanford Graduate School of Business, used mathematical models to see what effect on company profits a simple resource auction would have compared to the optimal revelation mechanism. In many cases, they found, auctions were just as efficient and significantly simpler to implement. “This implies that ‘simple’ works,” says Saouma.

But not in all cases. For instance: A defense contractor has two divisions: one bidding for a project with the Air Force, and one making a pitch to the Navy. The same piece of machinery is essential to both projects, yet the machine can’t be split between both. Both contracts are worth a lot of money to the company.

When the competing projects are big money makers, or when the resource being auctioned is extremely critical to project success, the researchers found using a simple auction results in lower firm profits than what could theoretically be achieved by using the optimal revelation mechanism. In this case, Saouma observes, “a company is better off using the optimal revelation mechanism.”

“In cases like this, a resource bid through auction may not end up going to the division that would have made the most money for the firm,” says Saouma. “Or, the division that wins the resource may not end up paying the firm as much for the resource as it would have if the optimal revelation mechanism had been used.”

Thus in high-stakes cases, organizations will want to exert more control over how scarce resources are allocated. Leaving it up to the internal market could have a negative affect on the bottom line. In these cases the more complicated optimal revelation mechanism is the best way to calculate who gets what.

Given that auctions do prove useful at least some of the time, and given their relative simplicity, straight auctions hold promise for companies looking for ways to take the hassle out of parceling out pieces of the finite pie. “British Petroleum, for example, used an auction to allocate pollution permits across business units, which worked very well,” says Saouma.

The study also suggests that corporate software designers and consulting firms may stand to profit handsomely by creating new products and services to assist companies in implementing internal auction mechanisms. Such services could include adjusting how the affected managers are compensated to guarantee that the internal market operates smoothly, or even hosting the electronic auction altogether.

(This story reports on research at the Stanford Graduate School of Business and appears in this week’s Stanford Knowledgebase, the free monthly information source for thoughts, ideas and lectures at the Stanford Graduate School of Business.

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Posted: 11|23|07 at 9:57 am. Filed under: Press Release.