Reverse Auctions Cutting Costs

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.

Even more dangerous is the deterioration of buyer and supplier relationships when reverse auctions are used to beat up suppliers on price. Fundamentally, reverse auctions are zero-sum games—the buyer’s savings is the seller’s loss of revenue. In a separate study of the aerospace industry, Stec and Emiliani found that suppliers that are forced to bid in reverse auctions look for opportunities to retaliate. More than 70 percent of suppliers in the study said they would charge higher prices to their customers as a direct result of their participation in reverse auctions—if they had a chance to do so in the future. Considering that 43 percent of the suppliers reported recapturing 20 percent of the orders they lost to new suppliers in reverse auctions because the new suppliers did not deliver, these suppliers have ample opportunity to retaliate.

Finding the Middle Ground

While I agree with the critics about the downside of reverse auctions, I believe that they overstate their case when they say that reverse auctions are fundamentally a bad idea. Here are four tips that can help you find the middle ground.

1. Think beyond price. While buyers may feel good about getting the lowest price, ultimately it is the greatest value that matters. Price is only one element of the buyer’s value equation. Other variables that buyers need to consider include quality, reliability and value-added services. To account for these variables, buyers should move away from price-only auctions to multiattribute auctions that allow suppliers and buyers to trade off nonprice variables against price. Software vendors such as Perfect Commerce and IBM are responding to the need for more sophisticated online bidding with tools that allow buyers to conduct auctions and evaluate bids on multiple variables.

2. Use where appropriate. Reverse auctions are appropriate for transactional sourcing situations characterized by one-time purchases—typically for commodity products available from multiple suppliers. On the other hand, reverse auctions are generally not appropriate for strategic sourcing of differentiated parts and components, where suppliers have specialized capabilities and few suppliers can meet quality and reliability standards. In strategic sourcing situations, relationships with key suppliers are very important, so buyers need to think carefully about the risk of eroding these relationships by overusing reverse auctions.

3. Understand hidden costs. Savings from the first few reverse auctions a buyer conducts often overstate the eventual savings in two ways. First, as GE’s numbers suggest, there is a big difference between the savings measured at the time the auction closes and savings measured at the end of the transaction. To get a more accurate picture, buyers need to account for the direct as well as indirect losses that could arise over the life cycle of procurement. Second, pilot auction programs produce much higher savings because new suppliers may engage in “loss-leader pricing” to get the buyer’s business. These prices may not be sustainable because suppliers will look for opportunities to raise prices or add hidden costs once they have won the business.

4. Follow the Golden Rule. Squeezing suppliers because you are in a buyer’s market is dangerous. When the economy turns around and demand exceeds supply, suppliers will be tempted to retaliate against buyers that they feel have taken advantage of them by charging higher prices or by refusing to do business with them. It is easy to pressure suppliers on price. It is much harder to maintain prices by creating innovative and differentiated products so that you as well as your suppliers can make a fair profit. If your suppliers don’t make money, ultimately you won’t reliably be able to make money either.

Reverse auctions are only one of the tools in a portfolio of procurement mechanisms that can include exchanges, catalog purchasing, negotiated contracts and strategic purchasing. It is neither a silver bullet nor is it evil. Remember the proverb: “If all you have in your hand is a hammer, the world looks like a nail.” By using reverse auctions judiciously, you can move your sourcing strategy forward.