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Reverse auctions: How much total supply chain cost savings are there? — A conceptual overview Sameer Kumar* and Christine W. Chang Received (in revised form): 1st May, 2007 *Opus College of Business, University of St. Thomas, 1000 LaSalle Avenue, Mail # TMH 343, Minneapolis, MN 55403-2005, USA Tel: þ 1 651 962 4350; E-mail: [email protected]

Sameer Kumar is a professor of Decision Sciences and Qwest Chair in Global Communications and Technology Management in the Opus College of Business, University of St. Thomas. Major research interests include optimisation concepts applied to design and operational management of production and service systems where issues relating to various aspects of global supply chain management, international operations, technology management, product and process innovation, and capital investment justification decisions are also considered. Christine W. Chang is currently a business analyst within the Optical Systems Division’s Information Technology organization at 3M Company in St. Paul, Minnesota. She has an MS in Software Systems from the University of St. Thomas. She has worked in the IT field for six years and has played various roles including Developer, Data Base Analyst, Project Lead, Quality Auditor, and most recently a Business Analyst.

ABSTRACT KEYWORDS: reverse auctions, online auctions, e-procurement, freemarkets

With companies spending trillions of dollars annually, accounting for the majority of revenues, it is easy to understand why companies are constantly

seeking ways to cut costs in procurement. It is widely believed in the financial arena that the revenue to cost ratio is about 3 to 1; for instance, increasing revenue by $300 has about the same effect as cutting costs by $100. Online reverse auctions emerged in the mid to late 1990s as a method of achieving cost savings in procurement. A reverse auction is a bidding event sponsored by a buyer. The paper provides a background and motivation for the reverse auctions concept. It examines the reverse auctions process consisting of pre-auction, auction and post-auction activities and their role in procurement. A brief summarisation of the evolution of ‘e-auction technology’ is presented. Current professional literature is reviewed that highlights views of opponents on reverse auctions, ethical issues to consider and appropriate market conditions required that enable implementation of reverse auctions. Journal of Revenue and Pricing Management (2007) 6, 77–85. doi:10.1057/palgrave.rpm.5160077

INTRODUCTION This paper introduces the concept of reverse auctions and their role in procurement. The study also examines current professional literature particularly with the intent to see reverse auctions implementation and their specific use by buying organisations. In a subsequent paper, the authors have developed a decision-making generic simulation model that runs numerical experiments based on relevant input parameters

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to determine cost savings for implementing reverse auctions with suppliers. This introductory section will provide background information and give an overview of how reverse auction technology has evolved since its introduction. In the context of Operations Management, organisations focus on efforts committed to reducing costs and improving supply chain efficiency as a competitive advantage. Cost cutting increases net income. An increase in net income leads to a greater earnings per share and ultimately a higher market value (that is, higher market capitalisation). This emphasis on cutting costs internally is further magnified with the onset of globalisation. Companies are experiencing greater competition, making it more difficult to achieve top line growth. This kind of environment is putting increased attention on reverse auctions as an easy solution to keeping buying costs down. This attention on reverse auctions is influenced by reports of 25–50 per cent savings in multimillion dollar procurements and debates over its applicability to the procurement function. Despite the controversy, online reverse auctions are making their way into the e-procurement strategies of Fortune companies and almost every major industry has adopted reverse auctions on a regular basis (Jap, 2002, p 1; Emiliani, 2006). Reverse auctions concept Auctions, in general, have long been a part of negotiations between buyers and sellers. The

Auction type English: Each bidder submits a successively lower bid. The lowest bid ‘wins.’ Dutch: The winning bidder sells at a price equal to the lowest losing bid.

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idea behind a ‘reverse’ auction is that the two parties, buyer and seller, change roles. The buyer is ‘selling’ their forecasted requirements to the seller who can best meet the buyer’s terms and conditions. Simply stated, a reverse auction is a competitive bidding event where multiple sellers compete for business of a single buyer. Throughout the bidding process the price is driven down, as the sellers compete for the opportunity to offer the specified good/ service at a price set by the market environment of the particular auction. The key characteristic to an online reverse auction is dynamic pricing with ‘real-time’ bidding within a fixed time duration. The typical time duration for a reverse auction is anywhere between a half an hour to a few hours. The bidding process works differently depending on the specific rules of the auction. For example, these rules may address:  Privacy — visibility of the identity of the buyer/sellers.  Sealed/unsealed bids — sellers are informed only of the relative rank of their bid if the bids are sealed versus an unsealed auction where bids are visible to everyone.  Starting bid — buyers usually establish a ceiling for opening bids.  Reserve price — represents the price at which the buyer considers switching sources.

Reverse auctions can be categorised using the traditional types common to ‘forward’ auctions:

Advantages K

K

Encourages competitive bidding

Better at determining the ‘true’ market price

Disadvantages K K

K

Bidder collusion is possible Bidder concerned with revealing cost information to competitors Less familiar format

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A reverse auction involves upfront work for the buyer, preliminary communication between the buyer and seller, the auction process itself, and follow-up activities (including the delivery of goods). Figure 1 is a process diagram that breaks down the sequential steps typical of a reverse auction. Evolution of e-auction technology Market leaders in e-auction technology are continuing to address the realities and complexities involved with how companies buy goods and services. In the beginning, e-auction software started out as a simplistic ‘one itemprice only’ bidding for pure price comparisons. This first model has since grown into a toolset that allows multiple parameters to be considered in addition to price. Buyers can place

emphasis on other cost factors (besides price) as well as quality characteristics, both of which can be customised by the buyer. In order to evaluate complex bids, the auction platform relies on a mathematical, weighted formula (Teich et al., 2006). Formulas are applied in real time during the auction so that suppliers can receive immediate feedback and formulate their next bid strategy. It is also common for the software to account for the costs of switching from incumbents to new suppliers. Another technique that is employed to ensure a ‘true’ price is the idea of automatic time extensions that allows sellers to react to late bids. Although the current focus has been on optimising the buyer’s experience, there have been some technological advances to better serve the seller. For example, Sorcity’s system

PRE-AUCTION Determine product/service appropriateness for Reverse Auction

Perform spend analysis - what is being purchased, from who, and for how much

START

Yes

Develop unambiguous specifications

No Develop evaluation criteria, including any weighting

Invite suppliers and conduct prequalification

Enough competition?

No Yes AUCTION Notify suppliers and confirm reverse auction details

Conduct Reverse Auction

Train participants

POST-AUCTION END

Perform exchange

Accept wining bid and award contract

No

Yes

Evaluate bids

Requirements / Terms Met?

Figure 1: Reverse auction process flow (buyer’s perspective)

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can automatically submit bids based on the current price in order to help protect the seller from pricing lower than necessary to win the contract (Porter, 2000, p 34). Increasing numbers of companies have entered the scene providing internet services and auction tools with claims of vast dollar savings. A few of the well recognised web sites where buyers can hold reverse auctions include FreeMarkets.com, CommerceOne.com, Silver OakSolutions.com (now CGI), and eBreviate.com (now part of AT Kearney). Some of the industry-specific providers are Covisint.com for the auto industry, Exostar.com for the aerospace industry, e-Steel.com for the steel industry, and Chemconnect.com for the chemical industry. These companies are referred to as ‘market makers’ because they provide the buyer assistance in creating a comprehensive request for quote (RFQ). LITERATURE REVIEW The purpose of this section of the paper is to review existing reverse auction literature, and to consider the applicability of this literature to the implementation and specific use of reverse auctions by buying organisations. Opponents of reverse auctions In practice, reverse auctions are plagued with potential hazards for auction participants. Although reverse auctions have many benefits, implementing them incorrectly or at the wrong point can put relationships with buyers and suppliers at risk. Theoretical and experimental research on the use of reverse auctions point to minimal cost savings and significant deterioration in relations between trading partners. Two outspoken critics of reverse auctions are Bob Emiliani and David Stec of ‘The Center For Lean Business Management’ (http:// www.theclbm.com/). They have extensively analysed different aspects of reverse auctions. Their research continually questions the actual savings that reverse auction service providers advertise them to be. In general, they have found that savings from online auctions are difficult to measure and generally do not yield

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quick ROI or reduce sourcing time. ‘The data doesn’t support the market hype,’ says Emiliani, president of the Center for Lean Business Management at Rensselaer Polytechnic Institute. ‘If you critically analyze and meticulously pick apart details, you’ll find mostly unsubstantiated claims. The typical outcome is poor for both buyers and sellers’ (Dunn, 2003, p 1). Looking at the total costs associated with a reverse auction, the raw savings are significantly lowered by direct and indirect costs which are not clearly disclosed by market makers. The reverse auction companies’ measure savings at the time the auction closes if the buyer were to go with the lowest bidder, but there is a big difference with this measurement when compared to the savings measured at the very end of the transaction (Sawhney, 2003). Direct costs can include compensating for suppliers that are unable to deliver the product or service, delays in award decision, or supplemental negotiations. The lag in time between completion of the bid event and awarding the business can result in non-value added re-work. During this deliberation time, some suppliers end up deciding that they cannot or will not honour their bids, preferring instead to risk the loss of business, in order to develop relationships with other customers less focused on just price (Emiliani, 2000, p 180). It is not uncommon for them to go through several rounds of reevaluation to close the deal. On the indirect side, costs can include service fees or licensing of third-party reverse auction software, more supplier visits, increased costs associated with transporting the product, qualification and inspection efforts, longer lead-times, additional resources to manage new suppliers, or expenses in the extreme case when litigation is necessary to address supplier non-compliance. Savings from the first couple reverse auctions that a buyer conducts often overstates any future savings because the prices obtained through a pilot auction are most likely unsustainable as new suppliers may go under their cost structure to get the buyer’s business. Once they have won the business, suppliers will

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look for opportunities to raise prices or add hidden costs (Sawhney, 2003). Emiliani and Stec conducted a study within the Aerospace industry and confirmed at a vertical level what they had concluded at a horizontal level; namely, that reverse auctions ‘offer nothing for sellers, and the value proposition for buyers isn’t as strong for buyers as market-makers claim it to be.’ They believes that there is a big gap in apparent savings and realised savings — individually direct and indirect losses reduce gross savings by 50 per cent or more so in the worst case savings can be eliminated altogether or cost of goods sold may actually increase (Emiliani, 2004, p 16). At a superficial level, reverse auctions appear to be an effective way to reduce unit cost. This is usually enough to satisfy senior management who focus heavily on maximising shareholder value. From this perspective, reverse auctions are a ‘quick hit’ solution (Emiliani, 2002, p 15). Another concern with reverse auctions is that the buyer–supplier relationship will be negatively affected. Previous studies have shown that online reverse auctions damage supplier relationships and create distrust among incumbent suppliers. Referencing the same aerospace study from above, it found that suppliers view reverse auctions as opportunistic behaviour by buyers (Emiliani, 2004, p 68). Suppliers feel that buyers are abusing the process, by testing the market to determine just how low the price will go down, and then using this information to get their current supplier to match the price with no real intention of switching to another supplier (Dunn, 2003). In turn, suppliers retaliate by increasing prices on goods and services in future encounters. This is evident in the Aerospace case where at least 70 per cent of the incumbent suppliers indicated that they actively seek ‘opportunities to charge their customer higher prices as a direct result of their participation in online reverse auctions’ (Barlas, 2002). Online reverse auctions support the more traditional competitive buyer–supplier relationship instead of moving towards a collaborative partnership. This is problematic since successful

supplier strategic partnerships are characterised by high levels of trust, coordination, interdependence and information sharing to better facilitate conflict resolution (Hartley et al., 2004, p 155). Reverse auctions are viewed as a onetime event and do not foster longer term relationships. In order for the supplier to meet lower pricing, they will reduce quality, valueadded services, or overall responsiveness to the buyer (Barry, 2003). It is not to say that longterm relationships cannot grow from a reverse auction encounter but given the nature of a reverse auction where price is driving the relationship this usually does not happen. Another concern with the short-term agenda is that reverse auctions can result in relationships with smaller suppliers that have less capability to meet increasing demand over the long term. Exploratory research by Sandy Jap suggests that supplier cooperation is directly undermined by reverse auctions (Jap, 2000). Given that reverse auctions increase and leverage competition, incumbent suppliers may especially feel that they have been treated unfairly. Her study found that incumbent suppliers that believe they have worked hard to win and maintain a buyer’s business are especially troubled by the threat of losing the buyer’s business to a lower priced supplier through a reverse auction. With suppliers feeling mistrust and betrayal, they are more likely to require more explicit contractual assurances and demand more contingency agreements as a safeguard (Jap, 2001, p 33). There may also be long-term repercussions to reverse auction overuse. If prices of items continue to fall, suppliers may merge to achieve economies of scale, reducing the number of alternative suppliers shifting the power to the supply base (Jap, 2000). Another contributing factor to this power shift comes from increased demand for suppliers from China’s rising economy. Price spikes, as much as 30–45 per cent, are seen in the steel, plastics, and paper commodities. In facing the rising costs, Bill Michels, CEO of ADR North America, a supply chain consulting organisation based in

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Ann Arbor, MI, points his finger at reverse auctions. ‘In the good years, when people had leverage and were using auctions, they may have leveraged or auctioned their relationships away. But the relationships become very, very important in times of shortage, especially if things go on allocation in some categories’ (Reese, 2004). He recommends that sourcing organisations start rebuilding strategic relationships with their suppliers again. As a final comment on buyer–seller relationships, a supplier’s perspective is given from the printing industry. According to the Printing Industries of America’s (PIA), 2003 thirdquarter Print Market Survey, 50 per cent of all printers surveyed had been invited to participate in reverse auctions only half of those invited actually participating (Gabert, 2003). In a white paper directed to printing companies, different strategies are mapped out that includes specific instructions on when to accept an invitation to participate in a reverse auction (Stoddard, 2004). The general tone of this paper is cautionary and a survival mentality is apparent throughout the entire paper. Very strong negative words like ‘irrevocable damage’ are used to describe the buyer–seller relationship in the context of reverse auctions. Print suppliers are sensitive to buyers treating their product as a commodity. It can be inferred from the literature reviewed in the previous paragraphs, reverse auctions are on their way out. Much of the current material suggests that raw material trends and capacity shortages in the current economy have made this tool far less effective in the past year or two. In fact, buyers are working hard to get supply at any price (and may even wish they had nurtured less contentious relationships a few years ago when they had the upper hand) and used reverse auctions to great effect. Ethical considerations The rising use of reverse auction tools has also fostered some abuse of the reverse auction concept. As already mentioned researchers have

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found that in some cases, buyers set out to drive down the price of their current supplier by using a reverse auction setting to get other suppliers to bid down the price. The buyer never actually had the intention to switch to another supplier. Along these lines, buyers could include suppliers who are not viable to help drive the price lower (Beall, 2003, p 12). Another debate surrounding reverse auction ethics is around the do-it-yourself versus thirdparty auction software. Market makers argue that a neutral party is the only way to guarantee integrity of bids. If the buyer is controlling the software, how does the seller know if the bidders and bids are legitimate or phantom? Suppliers are less hesitant to participate if a third-party vendor is hosting the reverse auction (Porter, 2000). Sellers also have to be mindful because there are potential ethical issues from their end as well. A seller could enter a reverse auction with no intentions of actually bidding to win but instead has the goal of gathering market intelligence. Some suppliers could end up cutting corners, particularly in area of safety, to meet the low price. It is important to understand that reverse auctions bring with it a new set of ethical considerations that should be well understood by both parties (Emiliani, 2005). Appropriate conditions for reverse auctions The pitfalls of reverse auctions are numerous but limiting its use to the appropriate circumstances can be worthwhile. Lessons learned from industry have shown that reverse auctions are an advantageous tool when used to procure indirect materials that can be classified as commodities. By a commodity, it is meant that the only differentiating characteristic that the product exhibits is its price. It is in the situation where reverse auctions are extended to pseudo commodities or service-oriented products that problems arise with nominal cost savings and buyer–supplier relationships. Relational consequences do not matter for indirect purchasing activities — those products that are not used for

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production purchases, such as office equipment, maintenance, repair and operating supplies, etc. Tremendous savings have already been demonstrated in this area (Jap, 2001, p 5; Hur et al., 2006). An example of one company that has found a happy medium in the area of online reverse auctions is Phoenix-based America West Airlines. According to Michael Inman, director of general purchasing, buyers are educated and given the freedom to decide when a reverse auction is to be used over traditional methods. ‘We use a matrix tool that tells us when to hold an auction based on how many suppliers there are, and how strategic and tactical the buy is,’ says Inman. ‘The buyers have taken to it well. It wasn’t forced on them and we have supported the buyers’ decisions, both when they do auctions and when they say we shouldn’t do it’ (Staff, 2002). America West’s success is largely in part of its selective usage of reverse auctions on indirect and general materials. To date, America West has purchased fasteners and filters through online reverse auctions. Two fundamental conditions to follow in determining the usage of reverse auctions is represented by Figure 2. Condition 1 cifications.

Clearly stated product spe-

This guideline requires a thorough specification including all related conditions for purchase. This includes information about quality, certification requirements, lead times, precise order sizes, or geographic/transportation requirements. This step is critical whether a reverse auction is used or not. A key difference for a reverse auction is that the more standardised the product is the better fit for a reverse auction. Customised products can have compatibility problems even though the product was specified clearly. Condition 2 Highly competitive supply market. A sufficient number of competitive suppliers must exist and excess supply capacity must also be present. Also, the product’s market price has to be somewhat elastic (Smeltzer and Carr, 2003, 486). This means that the price needs to be reasonably sensitive to demand conditions. Based on reviewing the existing literature and looking at industry outcomes, a list of lessons learned for reverse auctions is compiled:  Have full understanding of your spend profile — know exactly what is being purchased, from who, and for how much before implementing reverse auctions.  Develop large purchase lots through pooling families of parts across the organisation to

Q1 - Q4 starting in the upper left hand corner going clockwise High

Limited

High

Q1 : High competition/low specifiability = limited use Rivairy among suppliers

Q2 : High competition/high specifiability = high use Q3 : Low competition/low specifiability = low use

Low

Low

Limited

Q4 : Low competition/high specifiability = limited use Low

High

specifiability of good or service

Figure 2: Reverse auction applicability (Beall, 2003, p 15)

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leverage volume in driving down the unit cost. The correct organisational infrastructure must exist for the buying organisation — make sure employees are educated about reverse auction process and strategies. Use a third-party auction service for first attempts at reverse auctions but for long-run success build capabilities internally. Think beyond price and account for hidden costs. Raise the level of awareness. Keep in mind that reverse auctions help ‘discover’ a true market price but once the correct price is found, savings are incremental at best. Use reverse auctions as an initial step in the development of a long-term strategic partnership.

CONCLUSIONS Online reverse actions can be a valuable tool in reducing procurement costs if they are approached in a deliberate manner. Knowledge of the different factors, both positive and negative, and how they influence the final cost savings can lead to the successful implementation of reverse auctions. As with any new tool, there is room for improvement. Specifically, suppliers need to start benefiting more from this technology in order for it to create a win-win situation. Some of this can be addressed by introducing new forms of automation through learning what the pain points are for suppliers and buyers. It is no doubt that reverse auctions will go through more changes as more is learned through users of reverse auctions. REFERENCES Barlas, D. (2002) ‘Reverse auctions overhyped’, E-Business Executive Daily, November. Available from: http://www.line56.com/articles/default. asp?articleID=4164&TopicID=1. Barry, A. (2003) ‘Reverse auctions destroy relationships’, Manufacturing Engineering, June. Available

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from: http://www.looksmartauto.com/p/articles/ mi_qa3618/is_200306/ai_n9245054. Beall, S. (2003) ‘The role of reverse auctions in strategic sourcing’, Focus Studies, CAPS Research, Arizona. Dunn, D. (2003) ‘Reverse auctions fail to deliver on their promise’, Information Week, September, 8. Available from: http://www.informationweek. com/. Emiliani, M. L. (2000) ‘Business-to-business online auctions: key issues for purchasing process improvement’, Supply Chain Management: An International Journal, 5, 4, 176–186. Emiliani, M. L. (2002) ‘Realizing savings from online reverse auctions’, Supply Chain Management: An International Journal, 7, 1, 12–23. Emiliani, M. L. (2004) ‘Sourcing in the global aerospace supply chain using online reverse auctions’, Industrial Marketing Management, 33, 65–72. Emiliani, M. L. (2005) ‘Regulating B2B online reverse auctions through voluntary codes of conduct’, Industrial Marketing Management, 34, 5, 526–534. Emiliani, M. L. (2006) ‘Executive decision-making traps and B2B online reverse auctions’, Supply Chain Management: an International Journal, 11, 1, 6–9. FreeMarkets, Inc. (1999) Annual Report. Available from: http://www.freemarkets.com. FreeMarkets, Inc. (2004) Annual Report. Available from: http://www.freemarkets.com. Gabert, S. (2003) ‘Are reverse auctions friend or foe?’ Printing News, April. Available from: http://www. printingnews.com/pages/issues/2003/040703/ lead2.shtml. Hartley, J. L., Lane, M. D. and Hong, Y. (2004) ‘An exploration of the adoption of e-auctions in supply management’, IEEE Transactions of Engineering Management, 51, 2, 153–161. Hur, D., Hartley, J. L. and Mabert, V. A. (2006) ‘Implementing reverse e-auctions: a learning process’, Business Horizons, 49, 1, 21–29. Jap, S. D. (2000) ‘Going, going, gone’, Harvard Business Review, 78, 60, 77–84. Jap, S. D. (2001) ‘The Impact of Online, Reverse Auctions on Buyer–Supplier Relationships’, Working Paper: GBS-MKT-2001-001, July. Jap, S. D. (2002) ‘Online, reverse auctions: issues, themes, and prospects for the future’, Journal of the Academy of Marketing Science, 30, 4, 506–525.

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Porter, A. M. (2000) ‘E-auction model morphs to meet buyers’ needs’, Purchasing Magazine Online, June. Available from: http://www.purchasing. com/article/CA138880.html. Reese, A. (2004) ‘Final thoughts: the blowback of reverse auctions’, Supply and Demand Chain Executive, November. Available from: http:// sdcexec.com/article.asp?article_id=6260. Sawhney, M. (2003) ‘Forward thinking about reverse auctions’, CIO Magazine, June. Available from: http://www.cio.com/archive/060103/gains.html. Smeltzer, L. R. and Carr, A. S. (2003) ‘Electronic reverse auctions promises, risks, and conditions

for success’, Industrial Marketing Management, 32, 481–488. Staff. (2002) ‘Online reverse auctions create two procurement camps’, Purchasing Magazine Online, March. Available from: http://www.purchasing. com/article/CA200244.html. Stoddard, J. K. (2004) ‘Strategies for reverse auction survival’, Printing Industries of America, Inc White Paper. Available from: http://www.gain.net/ PIA_GATF/PDF/ebcreverseauctionfinal.pdf. Teich, J. E., Wallenius, H., Wallenius, J. and Zaitsev, A. (2006) ‘A multi-attribute e-auction mechanism for procurement: theoretical foundations’, European Journal of Operational Research, 175, 1, 90–100.

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