Love Them or Hate Them, Reverse Auctions Are Here To Stay

David J. Stec is vice president of The Center for Lean Business Management LLC of New Britain, Conn., a management, consulting and executive education firm. The co-author of several papers on the topic of online reverse auctions, he believes they are inconsistent with the "Lean Management" system. Online reverse auctions pit suppliers against each other.PD: How did you first get involved with reverse auctions?During the late 1990s, I was the purchasing manager for United Technologies, and I was required to use reverse auctions as a purchasing tactic. One of the reasons I left was that I didn't like reverse auctions. I didn't feel they were accomplishing what the company set out to accomplish, which was to dramatically reduce its purchasing costs.PD: When did reverse auctions first begin?Manual reverse auctions had been around for years using facilities like hotel rooms and conference centers. They were also done using conventional mail if detailed plans or drawings were required, or by conference call if they could be done verbally. What the Internet did was speed up the process and bring everything, including supporting documents and materials, into real time.PD: Who started them? No one really knows for sure. Rumor has it that they were invented by the founders of Freemarket, one of the leading "Global Supply Management" (GSM) consulting firms, working with General Electric in the aerospace industry. PD: For what were reverse auctions first used?They were apparently first used for commodities, and they worked fairly well as long as specs were carefully spelled out so that a purchase from one supplier would be absolutely identical to the same purchase from another supplier. Eventually, they evolved into services, especially relatively unskilled services that billed by the hour, such as cleaning and temporary labor. Again, they worked fairly well as long as all suppliers offered nearly identical services. The problems began to arise when they started being used for non-commodity items like engineered materials and fabricated or assembled components, then for more highly skilled offerings, such as copier repair and legal services.PD: Why did CPG companies begin to use reverse auctions with P-O-P producers?The reasons are unclear, but my guess is that purchasing departments used them as a "wedge" to get themselves into areas in which they had not been involved before. Management, of course, is always looking for ways to cut costs, and probably perceived reverse auctions as a good way to accomplish that without thoroughly understanding all of the potential pitfalls that could be involved in the process.PD: How does the reverse auction process work?The theory is simple. A potential buyer sends out a request for bids, allowing suppliers who want to participate enough time to study the proposal to determine their costs and decide what profit margin they want to achieve. These potential suppliers then keep bidding the price downward until nobody is willing to go any lower. In practice, of course, it's more complicated than that.PD: How so?Buyers need to do lots of homework before the auction ever begins. There are all kinds of variables. First you need to decide who will be allowed to bid. Will it be open to anyone who wants to bid, or only to suppliers meeting certain minimum qualifications? You also need to decide whether the suppliers will be able to see who they are bidding against, or whether the identities of the bidders will be kept secret from each other. Finally, you need to decide the criteria on which the winning bid will be selected -- and it's not necessarily the lowest price, especially when it requires some degree of creativity and not just the ability to fabricate a display.PD: Are there other variables?Definitely. For example, a supplier might decide to offer something extra to "sweeten the pot." Maybe it's free shipping if the supplier has his own fleet of trucks, or something else in which he has a cost advantage over his competitors, but all of a sudden, you're no longer comparing apples with apples.PD: You mentioned potential pitfalls involved in the process.Yes, a lot of them, for both the buyer and the seller. Let's look at it first from the buyer's perspective. His obvious objective is to drive down the cost of the display as low as possible. Assuming that he is able to achieve this, how does he then make sure that the display will meet his quality standards, especially if the winning bidder is a supplier he has never worked with before? Keep in mind that the buyer has beaten down the supplier's profit margin as low as it can go, and the supplier is well aware that this may well be a one-time project, not a continuing relationship. Where is the supplier's incentive to make sure he has a satisfied customer?PD: What are the risks for the potential supplier?The most obvious risk is bidding so low to get the job that you are unable to make a profit on it, especially when it may well be a one-time shot and not a continuing relationship.As you know, estimating costs accurately is a complex and time-consuming job, to which the potential supplier has now committed substantial resources. The danger is that the buyer may have absolutely no intention of awarding the job to anyone except his current supplier, and is using other bidders only as a means of driving his current supplier's price down. This means that the potential supplier has not only wasted money, but has also wasted time that could have been spent servicing and generating revenues from paying customers.PD: So an incumbent supplier bidding against newcomers could be in an especially vulnerable position?Definitely. If he lowers his prices to compete with the newcomers, his client is likely to ask, "If you can do it for this price, then why have you been overcharging me for however many years we have been doing business?" Obviously, that could put a relationship in a great deal of jeopardy. PD: Who runs these auctions?Buyers almost always use outside sources rather than running online reverse auctions themselves. For one thing, the software you need is very expensive and the outside suppliers already have it. For another, as we discussed earlier, there are any number of pitfalls inherent in the process, and the outside sources have enough experience that they may be able to help the buyer avoid them.PD: Who are these companies?I mentioned Freemarket, which is one of the oldest and largest firms in the industry. There are also Ariba and Commerce One. These three are generally considered the industry leaders.PD: Do they just run online reverse auctions, or do they offer other services as well?All three are consulting firms specializing in "Global Supply Management" (GSM). They study the processes their clients use to purchase goods and services and recommend ways to streamline them and reduce their costs. Online reverse auctions are only one of the services they offer.They do everything from assisting with the preparation of a detailed Request For Quotation (RFQ) to setting up procedures for evaluating potential suppliers to establishing criteria for final selection. The three that I mentioned are all highly respected companies and offer many valuable services, although I question whether running online reverse auctions is one of them.PD: Are there any positives to online reverse auctions?Proponents claim potential net savings of up to 30%, but in my experience, such savings are rarely achieved. In fact, I find 7% to be a more realistic expectation, and from the standpoint of the buyer, I could probably achieve these kinds of savings by finding ways to make it easier for my suppliers to do business with me. I could, for example, agree to be billed and to make payments by electronic funds transfer rather than by paper invoices and checks, which would allow the supplier to get paid faster. Also, by achieving savings through negotiations like these, I don't alienate my suppliers by forcing them to accept lower profit margins.PD: Do CPG manufacturers help or hurt themselves by using online reverse auctions?In the short term, there is no question that online reverse auctions can reduce a buyer's costs, although the extent of the savings that can be realized is debatable. In the long run, however, buyers are definitely hurting themselves by forcing their suppliers to participate. For one thing, with reduced profit margins, the supplier is less able to invest in more efficient tools and other equipment that could drive down his costs and allow him to pass the savings on to his customers. For another, we mentioned earlier that there is a great deal of creativity involved in making a display effective and, with reduced margins, the P-O-P producer is less able to hire the best people. As a result, the buyer cannot expect to get the best work from his suppliers.PD: What should P-O-P producers do?There are three things that P-O-P producers should be doing right now. As an industry, try to educate both buyers and suppliers about the risks of online reverse auctions. At the Center, for example, we do not teach people how to "squeeze" suppliers' margins using destructive power-based bargaining practices. Instead, we teach collaborative approaches to problem solving that result in interorganizational capability building, employment stability, improved customer satisfaction, and higher cash flow. Your readers should be leading the effort to make buyers aware that such approaches can only benefit them in the long run.Preempt the process by submitting unsolicited proposals for savings. Your readers need to demonstrate that they are and want to be valued partners with their clients, not simply suppliers who must be "squeezed until they squeal." In the short term, agree to participate in online reverse auctions when clients insist on it, but avoid chasing the lowest bid. Determine a point below which you simply will not go, and stick to it. Yes, in the short term, this may cost you a project or two. As painful as this may be, it will, in the long term, benefit both you and your client.PD: What's ahead?My experience in the aerospace industry was that the phenomenon of online reverse auctions came and went within about two years. Suppliers took the steps I have recommended, and buyers responded.

Love Them or Hate Them, Reverse Auctions Are Here To Stay

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