Reverse auction: Friend or foe?

In the world of B2B auctions, the reverse auction is king. But is that just the buyer talking? Adrian Mello investigates the benefits or otherwise for all sides

Reverse auctions are so named because, as the auction progresses, prices are bid down rather than up as they are with ordinary forward auctions. And unlike forward auctions, buyers, not sellers, initiate the trading activity.

In general, reverse auctions usually work better for buyers than sellers.
"Buyers love reverse auctions but if suppliers have to use them, they will fight, kick, and scream before they participate," says AMR Research vice president Pierre Mitchell.

But in some instances, such as huge liquidations, suppliers favour reverse auctions.

Suppliers that are low-cost producers also welcome reverse auctions because they play to their competitive strengths and they may not have the margin for marketing or sales staff.

In an ideal scenario, the benefit of a reverse auction is that it lowers the cost of goods for the buyers, because the bidding process creates downward pressure on prices.

"Many companies save 10 to 30 per cent on their purchasing in situations that lend themselves to reverse auctions," says Giga Information Group research director Tom Harwick. He also points out that "in other situations, there are no real savings".

Despite significant potential savings, reverse auctions can be the wrong tool for a sourcing job. Buyers should be aware of several conditions when reverse auctions are a bust. Reverse auctions don't work when:
- Purchases are too small because it can cost more to run the auction than the potential price savings.
- Buyers have no time to detail their specifications and run the auction. Buyers won't attract very useful bids unless they prepare their request for quotations (RFQs) carefully. The RFQ should provide the necessary details such as desired products or services, quality levels, product quantities, service levels, payment terms, method of delivery, and scheduling requirements.
"While this may seem trivial, creating a detailed, total cost RFQ is actually the most important step in the development of a successful auction," advises John Maholtz, director of sourcing operations at FreeMarkets, an online sourcing vendor.
- The cost of switching suppliers is too high. It usually costs time and money to align purchasing and manufacturing systems between a buyer and a supplier and to work the bugs between their systems.
- There is insufficient competition among suppliers. Reverse auctions only work in highly fragmented markets and in markets where capacity outstrips demand.
- It's too difficult to quantify the value of what suppliers offer. Harwick points out that this is often the case when services, such as software consulting, are on the auction block.
"You want to meet the people to see how smart they are and to see whether you have a rapport," Harwick says.

When reverse auctions aren't appropriate, they're worse than ineffectual. They can have an adverse effect on a business.

They can alienate incumbent suppliers because throwing the business up for grabs devalues the investment that suppliers make in providing service and modifications to their production process to meet individual buyer's needs.

Reverse auctions can also undermine the trust needed to manage complex intertwining business processes, such as demand forecasting or design collaboration. Driving down prices can also reduce the number of surviving suppliers, especially those who are not low-cost producers but who nonetheless provide buyers with special services and value.

Before employing reverse auctions, enterprises should carefully understand the role sourcing plays in their overall business. Used properly reverse auctions can save money. But used improperly, reverse auctions can backfire badly.

Adrian Mello writes for ZDNet.com.au