The curse of reverse auctions

by Rich Vurva

Participating in online auctions doesn’t have to be a nightmare experience. Preparation and knowledge are paramount.

Online reverse auctions aren’t generating headlines like they were a few years ago. Don’t be fooled, however, because they haven’t gone away. Some distributors who have participated in online bidding activities say the experience left a bad taste in their mouth. Yet they learned valuable lessons that will be useful when the next reverse auction opportunity rolls around.

Reverse auctions gained popularity in the late 1990s after companies such as General Electric touted phenomenal savings achieved through Internet auctions. A reverse auction is a type of auction where buyers and sellers flop roles. Unlike an ordinary auction, where buyers compete for the right to purchase the item being auctioned, in a reverse auction, sellers compete for the right to provide a product or service.

In a typical auction, a customer invites a group of pre-qualified suppliers to compete for its business. The company establishes a list of items to include in the market basket and a ceiling price based on historic usage patterns. Often, the price is determined by the actual price paid for those items in the previous year from multiple suppliers. On a given day, suppliers use specialized computer software to submit progressively lower priced bids during an established timeframe. The actual bidding process generally lasts from 30 minutes to an hour-and-a-half.

Recent experiences of two industrial distributors point out some of the inherent difficulties with reverse auctions. Problems typically arise when customers fail to consider their service needs, and when distributors make imprudent bids based on inadequate knowledge of their own service costs.

Understanding service needs
One of the biggest problems with reverse auctions is that the process makes it difficult — if not impossible — for suppliers to differentiate their service offerings.

“The biggest mistake I see customers making is they do not understand the different service levels required by different locations,” says Adam Fein, president of Pembroke Consulting in Philadelphia. “If the customer doesn’t understand what their local service needs are, they’re not going to understand that they have to pay for those different service levels.”

Drago Supply Company of Port Arthur, Texas, participated in a reverse auction with a company where Drago was the incumbent supplier. The company’s goal was to set up a national contract for a single supplier to serve multiple plant locations.

The customer established the ceiling price for the items in the auction, but did not consider the differing service requirements at individual plant locations. For example, some plants required suppliers to provide onsite vendor-managed inventory while other plants had their own employees manage inventory. Even though Drago won the bidding war, executive vice president Sam Drago says his company may be forced to reduce its service levels.

“The auction was pretty bloody and we lost several points of margin in the process but we retained our position with the customer. As a result, we may have to stop providing some of the value-added services and activities we provided before,” he says.

Drago based its bid on the cost to provide dock-to-dock delivery, since the process didn’t consider services such as inventory management or other onsite activities. If the customer decides it will require those services at individual locations, Drago will unbundle the service and negotiate a separate price.

Drago believes the customer-supplier relationship would be better served if customers sat down with trusted suppliers to discuss ways to take cost out of the supply chain. Together, customer and supplier could look for areas where they duplicate activities or processes and eliminate the duplication.

“Reverse auctions create cost reductions by simply taking money out of the pocket of the supplier. We give up margin and the customer loses many of the value-added services we provided earlier because we no longer have the margin to provide them,” he says.

Understanding cost-to-serve
A second problem that arises in reverse auctions is when distributors involved in the process don’t have an adequate understanding of their own cost structures. In their zeal to win the auction, they may bid so low that it becomes impossible for them to service the account after winning a contract.

Kathryn Robart Bowdish, president of Safety Services of Kalamazoo, Mich., says when her management team decides to participate in a reverse auction, they carefully study the items in the market basket.

“Our preparation is intense. We review all pricing from our manufacturer suppliers and alternative manufacturers. It takes a lot of preparation by a number of our product, marketing, purchasing and financial managers,” she says.

Past auctions proved to Safety Services how price-driven some auctions can become. This expectation changed with a more recent auction experience. On the day the bidding process began, her team assembled in a conference room as the auction unfolded. They entered their opening bid, and then watched as other participants pushed the price down lower. Safety Services entered a few more bids, but stopped when the price dipped below their predetermined stopping point.

Bowdish later learned the customer decided to expand its search criteria to consider factors other than price, and Safety Services ultimately won the contract. Bowdish says the experience taught her that auction results are not always the sole factor for selecting suppliers.

“I don’t think reverse auctions alone are a viable means of establishing a supply line, particularly in the safety products area,” says Bowdish. “The economic indicators in the country right now are obviously showing that distribution is suffering from the downturn in manufacturing. Reverse auctions can drive desperation. The reverse auction is not an arena that any business can survive in and maintain service levels.”

She says informed customers evaluate potential suppliers on many levels to make sure they can meet their expectations beyond just the price.

Lessons learned
Despite having negative experiences with reverse auctions, Drago and Bowdish both realize they may have to participate in them again in the future. When they do participate, they can benefit by keeping the following advice in mind:

Learn from past experiences. “All distributors should have a single person inside their company responsible for identifying how their company is going to respond to a reverse auction. That way you can at least carry that learning across opportunities that arise,” says Fein.

Know when to participate. Make a decision on the corporate level about what products or types of services to include in an online bidding process. “Many distributors refuse to participate in reverse auctions because they believe there’s a high value-added engineering or sales component to what they’re selling. And they simply choose not to participate,” says Fein.

Know your cost structure. Make sure you understand your internal cost structure and the customer’s service needs so you can properly respond in a competitive sourcing environment. “Accurate knowledge gives the distributor the power to predict when the reverse auction will become unsuccessful and when they should walk away from the deal,” says Fein.

Know when to walk away. “Don’t get emotional when it comes to the actual bidding process. Know what your costs are. Always make sure the customer is identifying what your services are, because that’s where markup is really determined. Don’t be afraid to walk away from a deal,” says Drago.

Do your homework. Is the customer using the reverse auction to solicit the best bid, or simply to beat up its incumbent supplier for a lower price? “Understand whether the customer is selectively using a reverse auction, giving you an opportunity to service the account, or whether the customer is parceling out the reverse auction activities, in which case a loss leader will turn into a loss,” says Fein.

Where the action is
A benchmark study recently found that across eight major industry groups, only about 3 percent of all purchasing was conducted via online auctions. The greatest concentration is among metals and mining companies, computer hardware manufacturers and electronic and semiconductor manufacturers.

Adam Fein of Pembroke Consulting says there are a few key tests that distributors can look for to determine if their customers are likely to use reverse auctions. No. 1, if the customer is part of a large, multi-location company, but buys from multiple local distributors. No. 2, if distributors can charge the same customer different prices at different locations. No. 3, when a national contract exists, but local plants continue to make maverick buying decisions.

“The thing to remember is that reverse auctions are just a tool. They’re one of many tools that a customer can use to achieve their purchasing objective. But it’s a very blunt tool, and it’s not appropriate for many product categories. For many core industrial supply categories, the reverse auction is not appropriate,” says Fein.

Sources: CAPS Center for Strategic Supply Research; Pembroke Consulting

This article originally appeared in the May/June 2006 issue of Progressive Distributor. Copyright 2006.

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