November 08, 2007
Richard Saouma Finds Internal Auctions a Profitable Approach to Asset Allocation
Auctions are a relatively simple solution for firms with indivisible resources
LOS ANGELES - Imagine that a firm has a single, plush conference room and several divisions continually fighting to use it. This is essentially an information problem according to UCLA Anderson associate professor Richard Saouma. The firm is unable to allocate the conference room efficiently because it does not know how much value the resource represents to its competing divisions.
Saouma says that one way for the firm to make optimal use of this resource is to create an internal auction. "There has been some recent excitement in both the academic and business communities about bringing markets into firms," says Saouma.
There are also real world examples at firms such as British Petroleum where managers trade pollution credits, Intel where auctions allocate production time for certain products and the Ford Motor Company where dealers can bid to acquire preferred vehicles1.
Saouma and colleagues at three business schools began a formal study of internal auctions. "We started looking at the literature on how to solve resource allocation problems," he recalls. They found a variety of mathematical approaches to the problem but relatively little about auctions.
"There’s a lot of math, and people have come up with so-called optimal revelation mechanisms to allocate resources," Saouma explains. "These are rather complicated procedures that require multiple rounds of communication between employees and their supervisors. The issue with such schemes is that you frequently find one employee being compensated on the basis of what a different employee said. Such policies tend to breed discontent, as managers prefer to be compensated on the basis of outcomes they can control. Auctions allow for minimal interaction 'from above,' allowing all the managers to participate in the resource allocation via a simple, transparent and familiar medium."
So Saouma's team performed mathematical comparisons of auctions and more complicated, so called, 'optimal' allocation mechanisms. "We were surprised to find that, in some circumstances, our simple internal auction replicates the profits that you could obtain with the more complicated, optimal resource allocation," he says. "When we missed the mark, we were within five or ten percent of the optimal profits."
"Let me give you an example," says Saouma. "Perhaps a CEO hires a consultant who can be allocated to a project in one division or another - and the question becomes who can make the best use of the consultant's services? We'll say, 'Look, your division can bid for this consultant using real money and whoever bids the most gets allocated the consultant.'" So the cost of the consultant is charged to the winning division and, ultimately, those whose compensation is based on divisional profits.
Placing a price on the resource solves the CEO's information problem by indicating how the divisions value the resource. Essentially, the problem is de-centralized and moved from the CEO level, to the divisional level, allowing the internal market to value the resource.
The fact that an internal auction can be a reliable allocation tool will be valuable to firms with a variety of allocation problems according to Saouma. "Whenever you have to allocate something that cannot be split, this auction mechanism seems to perform quite well. The problem of allocating consulting resources, for example, is actually quite common," he says.
Although auctions are simpler than other allocation mechanisms, they still require some parameterization. "It’s not as simple as just holding an auction," Saouma explains. "You need to have some ground rules such as how you are going to expense the bids to each division and so forth."
This could provide opportunities for software developers and consulting firms. "On the software side, auctions are relatively easy to implement, and a number of companies are looking into it," says Saouma. "Moreover, we believe that internal auctions could become a profitable product for business consulting firms. Consultants could propose and implement internal auctions to any client with indivisible resources," he says.
Click here to read Resource Allocation Auctions within Firms by Stanley Baiman, Paul Fischer, Madhav V. Rajan and Richard Saouma.
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