Online reverse auctions look like a silver bullet that cuts costs quickly using e-business tools. Reverse auctions are fixed-duration bidding events hosted by a single buyer, in which multiple suppliers compete for business. Proponents claim reverse auctions can lower the cost of procuring products and services as much as 20 percent, making them the e-business application of choice for companies faced with declining sales and margins. However, the raw savings overstate the value of this vaunted online procurement technique.

Reverse auctions achieved fame when General Electric, the poster child for e-business, touted phenomenal savings from using the method. GE CIO Gary Reiner claimed the company saved approximately $600 million by using reverse auctions in 2001, which was a net savings of 8 percent. In the public sector, the U.S. General Services Administration reported that a pilot program in which the Defense Finance and Accounting Service, Air Force and Coast Guard used reverse auctions resulted in savings of 12 percent to 48 percent. And in its 2001 annual report, the leading auction software and services company FreeMarkets reported that it had saved its customers an estimated 20 percent on a total of $30 billion worth of purchases since 1995.

These numbers are compelling. Unfortunately, they are also misleading. Like any tool, reverse auctions, when properly used, can provide value. But when they are overused or misused, the savings they promise can be illusory, and they can inflict real damage on supplier relationships.

The Dark Side of Reverse Auctions

Two of the most outspoken critics of reverse auctions are David Stec and M.L. (Bob) Emiliani from the Center for Lean Business Management at Rensselaer Polytechnic Institute. In a paper published last year, they argue that online reverse auctions rarely deliver savings that are as great as advertised by auction service providers. In addition, they contend that savings from reverse auctions are difficult to measure and that they do not teach buyers and sellers how to solve problems jointly. They conclude that reverse auctions are toxic for buyer-supplier relationships.

Stec and Emiliani observe that in the case of GE, the company actually netted only half of the savings initially generated through bidding. Their conclusion: 50 percent of the savings from using reverse auctions disappear because of factors such as errors in supplier data, postauction negotiation, and changes in specifications or quantities. In addition, Stec and Emiliani report that GE does not account for extra expenses resulting from problems such as poor quality, late deliveries and supplier nonperformance. When these losses are added up, net savings from reverse auctions look far less appealing than buyers expect.