Reverse auctions in
industrial marketing
and buying
Larry R. Smeltzer
Professor, Supply Chain Management, Arizona State
University, Tempe, Arizona
Amelia Carr
Professor of Operations Management, The Ohio State
University, Columbus, Ohio
Reverse auctions have been
a popular topic over the past
several years because they often
result in tremendous savings for
buyers and new markets for sellers.
But they also carry risks. Three primary
A
uctions may be one of the world’s oldest commercial tools. Their use has been reported as
early as 500 BC in Babylon, and several references are made in Roman history to auctioning everything from the spoils of war to royal furniture. Most historical references mention the English progressive auction
that is derived from the Latin root auctus, “an increase.”
But today the auction is different. E-commerce has
matured and reverse electronic auctions have received as
much as or more attention than any other electronic tool.
Why? Many companies, including Quaker Oats, United
Technologies, and SmithKlineBeecham, report millions of
dollars of savings with reverse auctions compared to traditional industrial buying methods. And many consulting
firms are hyping the advantages of reverse auctions for
both buyers and sellers.
As a result of all this attention, a survey conducted by Purchasing magazine (Porter 2000) found that 25 percent of
the respondents expected to use reverse auctions in 2000,
and that number is expected to rise during the next several
years. Various estimates indicate that billions of dollars of
industrial goods will be purchased in reverse auctions by
2004 as the tool becomes more commonly used. With this
level of estimated use, no doubt more and more managers
will be asking, “How and when should I be using reverse
auctions to reduce my material and operating costs?”
motivations, three potential disadvantages,
and four conditions and related guidelines for
success are reported here. If a reverse auction is
to succeed, the product or service specifications
must be clear and comprehensive, the purchase
must be large enough to provide an incentive
for the supplier to participate in the auction,
the appropriate supply market conditions must
exist, and the appropriate organizational
infrastructure must be in place.
What is a reverse auction?
A
ny auction, note McAfee and McMillan (1987), is
theoretically an attempt to create a pure market
with perfect information among both buyers and
sellers. The ideal is for everyone to understand the product being auctioned and to know the latest bid price. The
forward auction, in which the seller offers a product to
numerous buyers, is the most common type. The seller
“controls” the market because it is offering a product in
demand by a number of buyers. The price the buyers offer
47
continues to increase until a theoretical rational price is
met in the market. Supply and demand set the price.
In a reverse auction, the desired item is offered by a number of sellers, so the buyer controls the market. The price
the sellers offer continues to decrease until a theoretical
rational market price is achieved. An electronic auction
brings the buyers and sellers together via some type of
electronic media, usually the Internet. In fact, reverse auctions gained popularity with the advent of economical
and efficient electronic capabilities, and are often only
feasible when used electronically, via the Net. Here, however, the process will be referred to simply as a reverse
auction rather than an electronic reverse auction.
A reverse auction may result in “dynamic pricing,” which
means that the price for the item being auctioned changes
instantaneously because of the electronic format. As sellers
observe the price changing in real time, the assumption is
that it will continue to fall until a rational market price is
established. In economic terms, a balanced market for a particular item is established between buyer and sellers. Again,
the price is theoretically established by perfect information
about supply and demand. The basic premise is that supply
and the sellers’ profit margin are sufficient to offer lower
prices. The suppliers can instantaneously observe the prices
being offered by other sellers. And the seller can see the
price levels required to obtain the sale.
There are both advantages and disadvantages to using
reverse auctions, as well as a few conditions that lead to
their success. Our discussion of these factors is based not
only on the current literature but also on in-depth interviews with 41 managers who have used electronic reverse
auctions (see Figure 1).
Sellers’ and buyers’ reasons
for using reverse auctions
A
ny new management tool may face skepticism,
but both buyers and sellers have good reasons for
using reverse auctions. The primary reason for
sellers is the promise of increased business. In a traditional industrial market, a seller must often respond to a
Request for Quote (RFQ) knowing little about the market’s general pricing structure and the specific competition. Because the competition’s price level is unknown,
the seller may bid a price that could have been lower
while still maintaining a suitable profit. With reverse auction dynamic pricing, in contrast, the seller can immediately observe the competition’s price level. Hypothetically,
the seller should be able to bid a price that allows for an
acceptable profit but easily see when it is no longer feasible to remain in the competition for the sale.
48
This is highly related to another seller benefit: penetrating
new markets. Market penetration may be easier when a
seller can readily observe the pricing required for a sale
within the new market. A seller willing to sacrifice profits
initially in order to penetrate a market can determine the
exact required price. This is not possible with the traditional paper bid process.
In addition to understanding the competition’s pricing,
the seller has less paperwork and and a low corresponding cycle time between bidding and awarding business.
Simple electronic entries may be the only requirement
once the seller has been qualified. Consequently, the
seller should be better able to plan production scheduling
and reduce excess inventory levels because less time is lost
between the bid and the actual sale.
Reduced purchase prices, administrative costs, and inventory levels are the main promises that entice buyers to use
reverse auctions. The incentive of low prices was what initially caught most buyers’ attention. With claims of as
much as 20 percent price cuts and an average between 5
and 12 percent, it is not surprising that buyers would be
interested.
Another compelling incentive for buyers is similar to that
for suppliers: the ability to cut administrative costs. The
typical RFQ scenario follows these eight basic steps: (1)
write specifications, (2) identify suppliers, (3) qualify suppliers, (4) mail RFQs, (5) wait for responses, (6) evaluate
responses, (7) notify selected supplier, and (8) negotiate
final terms and conditions. For reverse auctions, the first
three steps require about the same amount of time; however, Steps 4 through 7 are dramatically faster. As much as
50 percent of the purchasing cycle time may be eliminated,
with an average range of 25 to 35 percent.
Reduced inventory level is the third incentive for buyers
to use reverse auctions. Inventories can be replenished
quickly and less buffer stock is needed. This is especially
important for companies that manage irregular demands.
Potential disadvantages
of reverse auctions
A
lthough reverse auctions hold many promises,
several potential shortcomings exist for both sellers and buyers. The strongest disadvantage for
sellers may be that the purchase decision is based entirely
on the lowest price. When this is the case, the buyer develops no loyalty to the seller, and no future business may be
anticipated. Any investment made to obtain the order,
such as revised work processes, employee training, or capital expenditures, will not be recovered from the buyer.
Business Horizons / March-April 2002
Second, the possibility exists that the buyer is only using
the reverse auction as a negotiation ploy. The buyer may
have identified a preferred supplier before the auction and
has no intention of awarding business to the lowest bidder. Because the bids are public knowledge, the buyer
only intends to use them as a comparison standard in
subsequent negotiations with the current seller. In other
words, the buyer may only be trying to determine the
nature of the market and gain a power position in negotiating. Serving as merely a puppet for the buyer, the seller
loses time and effort in the process.
The question may be asked whether this open competition is different with an electronic reverse auction than
with a traditional paper bid. Sellers may observe the electronic competing bids in real time and feel greater pressure to conform in subsequent face-to-face negotiations.
In many instances, suppliers believe that buyers are only
using the bids as a pressure to conform—and in certain
situations, buyers will admit that this is the case.
A third disadvantage is that the seller may get caught up in
the “dog race.” Just as greyhounds chase a mechanical rabbit around a race track but never quite catch it, a seller
may begin chasing an elusive price figure. Bidders may get
so caught up in the emotion of the race or competition
that they offer unreasonably low prices. Cases have been
reported of sellers unwittingly offering bids below their
cost. Sellers have also been known to present bids for
greater quantities than they could possibly deliver. In these
situations, the sellers later tried to release themselves from
the commitment, which contaminated the marketing
process and dramatically hindered the possibility of future
transactions with the buyer. Unfortunately, competitive
emotion overshadowed good business judgment.
Three primary disadvantages also exist for buyers. The first
and by far the strongest possibility is that buyers may
destroy sellers’ trust. The danger is worse when buyers and
sellers have long working histories together. When announcing a reverse auction, a buyer is essentially indicating
that the seller is no longer meeting expectations, so the purchase will be “shopped around.” The buyer may be “throwing aside” the past relationship even if the previous supplier is the low bidder in the forthcoming reverse auction.
Jap (2000) reports that in many instances the reverse auction definitely altered the relationship. In one case of copper wiring, the supplier was so upset that it refused to bid
with its customer of over seven years.
Figure 1
Research questions and methodology
Because reverse auctions have received so much attention yet so little is known
about the process, three general questions were posed in this study:
1. What is the primary reason for using reverse auctions?
2. What are the primary risks that have been experienced with reverse auctions?
3. What are the conditions for success, according to users?
Non-directive field interviews addressed these questions, using extensive
probes and summary questions to develop trends and themes from the interviewees. When using such an approach, it is important that the researcher have
as little a priori bias as possible. The primary interviewers in this project had
extensive training in qualitative research interviews and had conducted numerous such studies. The average interview lasted about an hour.
Three consulting firms that provide reverse auction technology and services
offered the names of companies that had used auctions. In each instance, the
consulting firm provided the manager’s name who championed the process or
who seemed to take the greatest sense of ownership. If these people did not
have the time to participate, they were asked to designate a colleague. Only
one person from each company was interviewed.
In total, 41 individuals participated in the interviews. The 41
organizations consisted of 23 manufacturing companies (or
distinctly different divisions of the same company), 12 service
firms, 5 retailers, and 1 governmental agency. Each of the
interviewees had been involved in more than two auctions,
including a wide variety of products from office supplies and
services to direct production materials and resale items.
Reverse auctions in industrial marketing and buying
Related to trust is the disadvantage
that holds for both seller and buyer:
the fear of committing any resources
to the order. When using the auction,
buyers are implicitly saying, “We will
stay with you as long as your price is
the lowest. But beware! Another auction will be conducted as soon as the
contract needs to be renewed.” In this
case, the seller would be reluctant to
commit any tooling, capital acquisition, or employee training to the customer’s order, so any special adjustments cannot be expected.
The third potential disadvantage for
buyers is that too few suppliers will
respond to the reverse auction announcement and a competitive environment will not develop. In theory,
only two competing firms (a duopoly)
are required to conduct an auction.
But economic game theory indicates
that when only two competitors exist,
they are inclined not to participate in
either a reverse or forward auction.
Even though only two parties may
well be involved in the final stages of
bidding, maintains Cassady (1967),
at least four or five viable, competitive
bidders are generally required to begin
an auction.
49
Appropriate conditions
for reverse auctions
T
o maximize the potential of reverse auctions and
avoid the disadvantages, consideration must be
given to the specifications for the product or service being auctioned, the purchase size, the industrial markets, and the company’s infrastructure. Four conditions or
guidelines govern each of these general factors.
Condition 1: Clearly state the commodity
specifications.
Confusion will reign if commodity specifications—including quality and ISO 9000 certification, lead times, precise
order sizes, geographic requirements, and transportation
conditions or any related service factors—cannot be stated
clearly and precisely. Suppliers should be reluctant to respond to a solicitation when they cannot be clear on all
conditions. And buyers may find themselves buying
oranges when they were trying to purchase apples.
Many examples can be cited in which purchasers tried to
“force” the reverse auction of a product or service that
could not be clearly specified. In one case, a team considered auctioning the installation of telecommunication
equipment. This was not feasible because each contract
had to be adapted to individual conditions. In one installation a flat fee contract was appropriate, while in another
situation cost-plus-materials was much better. Too many
differences existed among the sites to use an auction.
This guideline requires a thorough review and writing of
specifications and related expectations—a first step in any
good strategic sourcing effort. Accordingly, reverse auctions are best used within the framework of strategic
sourcing.
Condition 2: Purchase lots must be large
enough to justify the seller’s involvement.
A division of a large corporation attempted to purchase
resins. Unfortunately, few suppliers expressed any interest
in getting involved. They knew that the real purpose of the
auction was to lower the purchase price, which meant a
lower profit margin for them. Even further, they knew that
the purchase lot was not large enough for them to develop
any volume efficiencies. As one potential supplier succinctly put it, “Why would we want to get involved in a
process that showed us more business and less profit?”
Volume efficiencies generally increase as a result of lot
sizes for two reasons. First, transaction costs are reduced;
it is easier and more efficient to process one order of the
same goods than three or four different orders. Second,
production economies of scale are obtained. Knowledge
of the supply market’s general transaction costs and its
50
production efficiencies is helpful in understanding appropriate lot sizes. A frequent problem is that too often buyers do not understand the supplier’s cost structure so it is
not possible to thoroughly plan the lot size. The $1 million figure is often heard as a minimum guideline for a
reverse auction, but this would, of course, depend on the
product or service.
Three approaches are generally used to increase lot sizes
for a reverse auction. Again, an interesting note is that each
of these techniques follows good procurement practices, so
reverse auctions must be completed within the framework
of the strategic sourcing process. Before becoming involved
with reverse auctions, the marketing department may want
to determine whether the buyer has implemented one of
the following techniques. If not, the seller may encourage
the buyer to do so in order to increase purchase volume.
The first technique is that a family of goods may be pooled
together and bid during the same auction. In one example,
a home appliance manufacturer pooled the rubber parts
Not every firm is ready to get
involved with reverse auctions. To
wield this strategic sourcing and
marketing tool, a firm must have
professionals who understand it
and can implement the process
correctly.
that included gaskets, belts, bushings, and moldings into
one purchase lot. Rather than having four different classes
of goods, a family of parts was purchased in a lot that was
70 percent larger than any one class of the group.
The second tactic is to standardize parts. Rather than having numerous specifications, a seller can use fewer custom
parts so that the volume of standardized parts may be
increased. When a lawn mower manufacturer analyzed its
pull-starting mechanisms, it found that 14 different mechanisms were used for 20 different styles of lawn mowers.
A simple analysis indicated that these 14 mechanisms
could be effectively reduced to three. This made it much
easier to develop specifications and create a lot large
enough for the buyer to bid for the business.
The third tactic for increasing lot sizes is to leverage the
purchase across the company’s business units. Often, divisions operate autonomously and do not take advantage of
Business Horizons / March-April 2002
leveraging corporate efforts. An extreme example occurred
with a $40 billion manufacturing company that had five
major business sectors. Each sector purchased laptop computers with similar specifications, resulting in the corporation having six different contracts with the same laptop
supplier for almost the same machine. Moreover, numerous spot buys and purchases through distributors were
identified for these machines.
This story does have a positive ending, however. After
identifying and consolidating computer purchases
throughout the corporation, purchasing power was leveraged. Reverse auctions then developed the best contract
for the company’s computer users throughout the world.
The supplier that obtained the business also derived an
advantage—all computers had to be purchased from one
point, so administrative costs were reduced as well as spot
buys from other suppliers.
Condition 3: The appropriate supply
market conditions must exist.
What does it mean to say that an appropriate market
must exist? Three conditions make for a successful reverse
auction. The first and most important is that there must
be a sufficient number of competitive suppliers to develop
a competitive market, which means that the supply market should be somewhat fragmented. Such fragmentation
fosters buyer power in any negotiation, but it may be even
more critical in a reverse auction. A review of the research
literature was somewhat inconclusive about the number
of competitive suppliers required for a robust auction.
However, it seems that a minimum of five viable bidders
is needed. Most likely, only two or three will be involved
toward the end of the auction, but for competitive reasons
it is important to have more at the beginning.
Second, excess supply capacity, a cost incentive, or some
economy of scale must exist if a supplier is to be motivated enough to pursue additional business. If there is no
incentive for a supplier to bid, the auction obviously will
not succeed. A chicken auction provides an example. A
large processor of meat and poultry for sandwich meats
and sausages announced it was buying a one-year supply
of chicken. However, at the time of the announcement,
chicken production was at nearly 97 percent of capacity in
the United States. Little incentive existed for the producers
to bid for additional business in a reverse auction. As a
result, only a few suppliers expressed any interest in the
sale. In this case, a reverse auction was clearly inappropriate. As an alternative, a creative long-term development
alliance was established with a primary supplier.
The third condition in the supply market, highly related to
the previous two, is that the product’s market prices must
be somewhat elastic. This simply means that the supply
prices must be capable of being driven downward by low-
Reverse auctions in industrial marketing and buying
ered demand. In an ideal situation, the buyer is trying to
take advantage of demand and a high level of supply—a
market force that should create downward price pressure.
However, for some goods, prices are inelastic and do not
readily adapt to market supply and demand forces. An
example is high-end liquors; this product does not adapt
readily to market forces, so prices will remain stable even
when supply is high and demand is low. The same is true
for goods in some electronic and other select markets.
Markets can be difficult to understand because the supply
and demand equilibrium, price elasticity, and a firm’s output or consumption will affect the market equilibrium. If
doubts exist about the market, it may be helpful to consult with an experienced industrial market analyst.
Condition 4: The organizational
infrastructure must be appropriate.
Not every company is ready to get involved with reverse
auctions. To wield this strategic sourcing and marketing
tool, a company must have professionals who understand
it and can implement the process correctly.
Each step in the strategic sourcing and marketing process
related to reverse auctions requires a sophisticated set of
skills and knowledge. Product knowledge is needed to create accurate specifications. Research skills are needed to
develop comprehensive market knowledge and understanding of the supply base. Cost analysis tools are needed
to develop total cost models and accurately understand
profit margins with different lot sizes. Reverse auctions will
not be effective without such skills and knowledge.
In addition to being qualified, employees must not be
threatened by reverse auctions. As one interviewee stated,
“Think about those sourcing employees that believe they
have been doing a good job in negotiations and cost savings but then are told that a reverse auction could reduce
prices by 10 percent. It is easily understood if the employees feel threatened or disenfranchised.” Or to quote a
sales manager, “After years of taking pride in our sales
abilities, the Internet is taking it away from us! Yes, it is
demoralizing and affecting our personal pride.”
The first condition for the infrastructure is that employees
must be qualified and receptive to a new tool. The second
is that tools must be available for the buyer to forecast an
accurate demand for the goods or services being auctioned.
Moreover, the seller must have information and accounting systems to accurately measure profit contributions. If
the reverse auction announcement indicates a purchase
lot size that is subsequently inaccurate, the entire process
may be voided. One company completed a reverse auction for somewhat specialized fasteners, then found that it
required only about 60 percent of the number indicated
in the auction. Both buyer and supplier mutually agreed
51
to void the final price, but the relationship was severely
damaged.
It is often necessary to pool or consolidate a purchase
across organizational divisions or across companies in
order to increase the purchase volume. As a result, the
third condition of the buyer’s infrastructure is that appropriate technology must be in place to consolidate purchase volume and buying off a master contract. As one
interviewee stated, “We can’t even communicate between
buildings.…We have enough problems without trying
something like a reverse auction for multiple divisions.”
But in another company, major savings were recognized
for shrink wrap because the company was able to consolidate its purchase and use a reverse auction.
R
everse auctions can indeed increase the effectiveness and efficiency of industrial markets. With
more sophisticated technology making their
implementation economical, they can represent a formidable tool. However, the fact remains that a reverse auction is a tool. And just as with any tool, it must be used
within the correct context.
The appropriate use of reverse auctions is simply as a
managerial tool. It will be successful only when used correctly within the strategic sourcing and marketing processes. The primary steps to be followed are:
• clearly and comprehensively develop and understand
specifications for the goods or services to be auctioned
• develop large purchase lots by pooling families of
parts, standardizing, and leveraging across the firm
• understand the profit contributions resulting from
changing lot sizes
• analyze the supply market to ensure that the appropriate conditions exist
When these basic steps are followed, the promise of lower
purchase prices, lower administrative costs, improved
inventory turns, and greater markets can be achieved.
It is not known how reverse auctions will ultimately affect
buyer-supplier trust. The effect probably depends on the
previous relationship and the manner in which the auction is communicated to suppliers. Efforts must be made
not to ruin trust that has been developed.
An auction is a complex economic process for which it is
difficult to develop concrete parameters. However, managers may be confident in the success of reverse auctions
if they meet the four conditions stated here and avoid the
potential disadvantages. ❍
References and selected bibliography
Brunelli, Mark. 2000. E-auctions online save millions for Quaker
Oats and SmithKlineBeecham. Purchasing (23 March): S22.
Bulow, Jeremy, and Paul Klemperer. 1996. Auctions vs. negotiations. American Economic Review 86/1 (March): 180-194.
Case, Karl E., and Ray C. Fair. 1999. Principles of microeconomics.
New York: Prentice-Hall.
Cassady, Ralph. 1967. Auctions and auctioneering. Berkeley, CA:
University of California Press.
Croom, Simon R. 2000. The impact of Web-based procurement
on the management of operating resources supply. Journal of
Supply Chain Management 36/1 (Winter): 4-13.
Jap, Sandy. 2000. Going, going, gone. Harvard Business Review
78/6 (November-December): 30.
Lancioni, Richard A., Michael F. Smith, and T.A. Oliva. 2000.
The role of the Internet in supply chain management. Industrial Marketing Management 29/1 (January): 45-56.
McAfee, R. Preston, and John McMillan. 1987. Auctions and bidding. Journal of Economic Literature 25 (June): 699-738.
Porter, Anne Millen. 2000. Buyers turn wary eyes on electronic
auctions. Purchasing (24 August): 109-112.
Vanscoy, Kayte. 2001. B2B bust. Ziff Davis Smart Business for the
New Economy (March): 100-108.
• develop the appropriate organizational infrastructure
52
Business Horizons / March-April 2002