8/7/02

Perils of Reverse Auctions Compiled by: Asmita Barve, SCRC

The reverse auction -- where interested parties bid a price down from an amount set by the buyers -- is increasingly drawing attention as a tool to drive down procurement costs. Because reverse auctions use the market mechanism to drive the price of an item to its "true market value," the potential for cost savings from the process seems obvious. And there is evidence in the form of big name companies who acknowledge realizing big savings that the process can work.

But there are hazards associated with reverse auctions...
Bob Emiliani and David Stec are outspoken reverse auction critics (more...). They believe that while reverse auctions may drive down unit cost, real savings may be hard to achieve since indirect losses (switching costs, customer dissatisfaction, logistics costs, etc.) may actually increase. Sandy Jan, associate professor of marketing at Emory University's Goizueta business school believes that there may be long term repercussions to reverse auction overuse. If prices of items continue to fall, suppliers may merge to achieve economies of scale, which could tip the balance of power to the supply base (1).

Reverse auctions can also damage buyer-supplier relationships. In a study conducted by supply management graduate students at NC State University and sponsored by the ISM pharmaceutical forum, an overwhelming majority of suppliers indicated that reverse auctions had a negative impact on their relationships with their buyers. Despite their negative feelings about the process however, suppliers felt forced to participate in reverse auctions in order to retain their customers and remain competitive.

Furthermore, the survey revealed a lack of trust among suppliers about the buyers in a reverse auction situation. Sellers felt vulnerable to their competitors and customers by being forced to reveal confidential cost related information. They also believed that the process may not be fair. Some of the probable causes for losing contracts in reverse auctions suggested by suppliers in the survey included: I) the process may be biased towards incumbent suppliers, II) the process may be influenced by third party recommendations, and III) the exercise may be aimed at forcing price reduction on the existing supplier.

Given these high levels of distrust, suppliers are unlikely to be willing to divulge their real cost information and engage in collaborative behavior. Also, small suppliers that have been driven to bid low in an attempt to retain their big customers cannot sustain sharp price reductions. So although the buyer may enjoy savings for a while, he may risk supply security and huge losses in the long-term.

Still, if used appropriately, reverse auctions can provide great benefits. For example, the NC State student survey showed that reverse auctions can be used by suppliers to obtain market information and data on their competitiveness. Sandy Jan's study revealed that buyers can use reverse auctions to reach a wide range of suppliers, get a sense of market pricing and encourage incumbent suppliers to remain competitive (2). According to Jan, reverse auctions can also play a role in cementing supplier-buyer relationships. Suppliers are more likely to make investments in training, technology and equipment customized to the buyer's needs in an attempt to develop a closer relationship with the buyer and move away from endless bidding.

So how do you avoid the pitfalls and use reverse auctions to your advantage?