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Forward Thinking about Reverse Auctions

Forward Thinking about Reverse Auctions

It’s easy to overestimate the value of this online procurement tool

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 per cent, 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 $US600 million by using reverse auctions in 2001, which was a net savings of 8 per cent.

In the public sector, the US General Services Administration reported that a pilot program in which the Defence Finance and Accounting Service, Air Force and Coast Guard used reverse auctions resulted in savings of 12 per cent to 48 per cent. And in its 2001 annual report, the leading auction software and services company FreeMarkets reported that it had saved its customers an estimated 20 per cent on a total of $US30 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 ML (Bob) Emiliani from the Centre 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 per cent of the savings from using reverse auctions disappear because of factors such as errors in supplier data, post-auction 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 non-performance. 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 per cent 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 per cent of the suppliers reported recapturing 20 per cent 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.

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