Perils of Reverse Auctions

The reverse auction — where interested parties bid a price down from an amount set by the buyers — is increasingly drawing attention as a tool to drive down procurement costs. Because reverse auctions use the market mechanism to drive the price of an item to its “true market value,” the potential for cost savings from the process seems obvious. And there is evidence in the form of big name companies who acknowledge realizing big savings that the process can work.

p.But there are hazards associated with reverse auctions…
Bob Emiliani and David Stec are outspoken reverse auction critics (more…). They believe that while reverse auctions may drive down unit cost, real savings may be hard to achieve since indirect losses (switching costs, customer dissatisfaction, logistics costs, etc.) may actually increase. Sandy Jan, associate professor of marketing at Emory University’s Goizueta business school believes that there may be long term repercussions to reverse auction overuse. If prices of items continue to fall, suppliers may merge to achieve economies of scale, which could tip the balance of power to the supply base (1).

Reverse auctions can also damage buyer-supplier relationships. In a study conducted by supply management graduate students at NC State University and sponsored by the ISM pharmaceutical forum, an overwhelming majority of suppliers indicated that reverse auctions had a negative impact on their relationships with their buyers. Despite their negative feelings about the process however, suppliers felt forced to participate in reverse auctions in order to retain their customers and remain competitive.

Furthermore, the survey revealed a lack of trust among suppliers about the buyers in a reverse auction situation. Sellers felt vulnerable to their competitors and customers by being forced to reveal confidential cost related information. They also believed that the process may not be fair. Some of the probable causes for losing contracts in reverse auctions suggested by suppliers in the survey included: I) the process may be biased towards incumbent suppliers, II) the process may be influenced by third party recommendations, and III) the exercise may be aimed at forcing price reduction on the existing supplier.

Given these high levels of distrust, suppliers are unlikely to be willing to divulge their real cost information and engage in collaborative behavior. Also, small suppliers that have been driven to bid low in an attempt to retain their big customers cannot sustain sharp price reductions. So although the buyer may enjoy savings for a while, he may risk supply security and huge losses in the long-term.

Still, if used appropriately, reverse auctions can provide great benefits. For example, the NC State student survey showed that reverse auctions can be used by suppliers to obtain market information and data on their competitiveness. Sandy Jan’s study revealed that buyers can use reverse auctions to reach a wide range of suppliers, get a sense of market pricing and encourage incumbent suppliers to remain competitive (2). According to Jan, reverse auctions can also play a role in cementing supplier-buyer relationships. Suppliers are more likely to make investments in training, technology and equipment customized to the buyer’s needs in an attempt to develop a closer relationship with the buyer and move away from endless bidding.

So how do you avoid the pitfalls and use reverse auctions to your advantage?

1. Buyers must integrate reverse auctions with strategic sourcing. A company’s sourcing strategy should determine the use of reverse auctions rather than the other way round. If a detailed sourcing spend analysis reveals opportunities for leveraging across sectors and points to reverse auctions as a viable alternative for achieving cost savings, then the option should be considered.

2. Buyers must assess the appropriateness of reverse auctions for a given product. Reverse auctions are most suitable for commodity type products. Because of the initial nature of communication between the buyers and suppliers, they are inappropriate for products requiring specialized engineering, technical knowledge or flexibility (more…).

3. Buyers must incorporate all associated costs into the bid. Switching to new sources of supply involves many expenses such as administrative costs and new supplier training. Buyers should be able to quantify these switching costs and other costs associated with participating in an online auction in order to realize real savings from the reverse auctions.

4. Practice makes perfect. The study conducted at NC State revealed that continued experience with reverse auctions made the process easier to use. First time users, therefore, should observe several auctions before participating in one to get a feel for the bidding process (more…).

5. Better communication between buyers and sellers is critical. The NC State study on reverse auctions showed that sellers believed that the reverse auction process lacked integrity. 79% of the suppliers who responded in the survey indicated their perception that buyers did not weigh all options and criteria in choosing the supplier. Better communication throughout the auction process and greater transparency into the supplier selection process is critical to reestablish supplier trust and lay the foundation for a closer buyer-supplier relationship. Prior to the auction, component specifications and selection criteria must be clearly defined and conveyed. After the auction, the buyer should inform each supplier of their intent and justification for accepting or not accepting a supplier’s bid.

6. Suppliers should do their homework ahead of time. Suppliers must have an in-depth understanding of their cost structure. They should estimate beforehand how low they can bid and still make a profit to avoid getting caught up in “auction euphoria” and making too low a bid (more…).

References:

(1) Kwak, M. (Winter 2002). Potential pitfalls of e-auctions. MIT Sloan Management Review, 43(2), 18.

(2) Jan, S. (2000). Going, going, gone. Harvard Business Review, 78(6), 30.