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A reverse auction (also called procurement auction, e-auction, sourcing event, or e-sourcing) is tool used in industrial business-to-business procurement. It is a type of auction in which the role of the buyer and seller are reversed, with the primary objective to drive purchase prices downward. In an ordinary auction, buyers compete for the right to obtain a good. In a reverse auction, sellers compete for the right to provide a good.
History
Reverse auctions gained popularity in the mid-to-late 1990s as a result of the emergence of Internet-based online auction tools. Employees from General Electric left to form the company FreeMarkets Online, Inc. The companies that provide reverse auction services to buyers are called "market makers".
Dozens of start-up and established companies rushed to fill the reverse auction marketspace due to FreeMarket's rapid growth, driven in part by the manufacturing down-turn in the late 1990s which compelled suppliers to reluctantly participate in the online reverse auctions.
FreeMarkets was acquired by California-based Ariba, Inc., in 2003, which now markets the reverse auction as one tool in their suite of several electronic sourcing and spend management offerings.
Early adopters of this online purchasing tool included General Electric, United Technologies Corporation, General Motors, Raytheon, Owens Corning, Commonwealth of Pennsylvania, to name a few.
Fortune magazine article (March 2000) describing the early days of reverse auctions*.
Introduction
Reverse auction is a tool used by many purchasing and supply management organizations for spend management, as part of strategic sourcing and overall all supply management activities.
In a typical auction, the seller puts an item up for sale. Multiple buyers bid for the item and depending on the nature of the auction (English or Dutch), and one or more of the highest bidders buy the goods at a price determined at the conclusion of the bidding.
In a reverse auction, a buyer contracts with a market maker to help make the necessary preparations to conduct the reverse auction. This includes: finding new suppliers, training new and incumbent suppliers, organizing the auction, managing the auction event, and providing auction data to buyers to facilitate decision making.
The market maker, on behalf of the buyer, issues a request for quotation (RFQ) to purchase a particular item or group of items (called a "lot"). At the designated day and time, several suppliers, typically 5-20, log on to the auction site and will input several quotes over a 30-90 minute period. These quotes reflect the prices at which they are willing to supply the requested good or service.
Quoting performed in real-time via the Internet results in dynamic bidding. This helps achieve rapid downward price pressure that is not normally attainable using traditional static 3-quote paper-based bidding processes.
The prices that buyers obtain in the reverse auction reflect the narrow market which it created at the moment in time when the auction is held. Thus, it is possible that better value - i.e. lower prices, as well as better quality, delivery performance, technical capabilities, etc. - could be obtained from suppliers not engaged in the bidding or by other means such as collaborative cost management and joint process improvement.
The buyer may award contracts to the supplier who bid the lowest price. Or, a buyer could award contracts to suppliers who bid higher prices depending upon the buyer's specific needs with regards to quality, lead-time, capacity, or other value-adding capabilities. However, buyers frequently award contracts to incumbent (i.e. current) suppliers, even if prices are higher than the lowest bids, because switching costs are zero. This outcome, while very attractive to buyers, is often strongly criticized by both new and incumbent suppliers.
Reverse auctions are used to fill both large and small value contracts for public and private commercial organizations. In addition to items traditionally thought of as commodities, reverse auctions are also used to source buyer-designed goods and services, and has even been used to source reverse auction providers. The first time this occurred was in August of 2001, by America West Airlines (now US Air) using FreeMarkets (now Ariba) software.
The majority of purchasing spend subject to reverse auctions over the years has been in the category of buyer-designed goods, followed by services, and then commodity items. Today, an average of 4% of total corporate spend is sourced using reverse auctions. This figure was higher in past years, indicating the goods and services to which reverse auctions can be successfully applied is limited.
Issues and Opportunities
Buyers and sellers should carefully consider if reverse auctions are appropriate, as there are many issues and problems that can occur. Importantly, the issues and problems are not generally known to new users of reverse auctions - so be very careful.
Buyers, sellers, and market makers should adhere to auction rules and industry codes of conduct for the use of reverse auctions, if they exist. Problems arise when one or more parties fail to conform to auction rules. This can range from simple cries of "foul" to litigation.
Buyers should not assume that reverse auctions will, in every case, deliver cost savings - either on a unit or total cost basis. Reverse auction savings can range from negative (i.e. it costs the buyer money) to neutral (i.e. no savings) to positive savings (average gross of 10-20%, but net savings is typically half or less).
A true representation of savings can not be achieved if unit price-focused purchasing metrics such as "purchase price variance," "purchase order variance," or "material price variance" are used. Instead, total cost savings must be calculated, inclusive of direct and indirect losses associated with using reverse actions, implementing reverse auction results, subsequent procurement activity, and related activities such as customer returns, defective goods or services, warranty expense, litigation, etc.
Buyers are advised to carefully fact-check reverse auction market-maker claims, which in the past have been inflated.
Suppliers are advised to determine if a value proposition exists for them that would warrant their participation. Historically, the value proposition for suppliers has been missing.
Some have characterized reverse auctions as a technologically-assisted form of zero-sum power-based bargaining, or as "going in reverse" with respect to developing buyer-seller relationships, collaboration, and purchasing process improvement. Reverse auctions have also been criticized as "bid shopping" - when a buyer uses a supplier's bid to obtain lower prices from other suppliers.
Suppliers seeking to avoid reverse auctions can create unique intellectual property, expand the value propositions for its customers by creating new products and services, or seek to extend or improve collaborative activities with their customers.
Reverse auctions used in industrial business-to-business procurement and spend management activities remains controversial, both within buying organizations, among suppliers, and including the academics who study them. As such, buyers considering the use reverse auctions should carefully evaluate all available information, both favorable and unfavorable, to help ensure informed business decisions are made.
External links
Links to non-commercial sources of reverse auction research and general information:
- Research on various aspects of reverse auctions by professors in the School of Technology at Central Connecticut State University
- A-to-Z bibliography of reverse auction papers from Louisiana State University, Department of Construction Management
Information on Buyer-Seller Collaboration
• Bounds G., "Toyota Supplier Development", in Cases in Quality, G. Bounds, Editor, R.D. Irwin Co., Chicago, IL, 1996, pp. 3-25
• Bounds G., Shaw, A., and Gillard, J., "Partnering the Honda Way", in Cases in Quality, G. Bounds, Editor, R.D. Irwin Co., Chicago, IL, 1996, pp. 26-56
• Dyer, J. and Nobeoka, K., "Creating and Managing a High-Performance Knowledge Sharing Network: The Toyota Case," Strategic Management Journal, Vol. 21, 2000, pp. 345-367
• Liker, J. and Choi, T., “Building Deep Supplier Relationships,” Harvard Business Review, Vol. 82, No. 12, December 2004, pp. 104-113
• Womack, J., Jones, D., and Roos, D., The Machine that Changed the World, Rawson Associates, New York, NY, 1990, Chapter 6
See also
- Request for Quote RFQ
procurement | supply chain management | spend management | strategic sourcing
"Reverse auction"