Reverse Auctions: When the Price is too Low

EDITOR’S NOTE: This research post originally appeared here, on the Knowledge@Emory site. For more on Professor Jap’s research, click here.

Winning an auction can sometimes be a curse. Caught up in the competitive fray, buyers can overestimate the value of goods being sold and later find themselves remorseful over a Pyrrhic victory. The same holds true in reverse auctions, in which suppliers compete for contracts by placing lower and lower bids. Much like participants in the old “Name That Tune” television program from the 1970s—where contestants bid against one another to see who could name a song after hearing the fewest number of notes—suppliers competing in reverse auctions run the risk of winning a job by bidding too low. The chance of a supplier making money on such a deal is about as likely as naming a tune after hearing just one note.

Reverse auction strategy has become a big deal for many suppliers because events have become central to how most large firms purchase some goods and services, says Sandy Jap, a professor of marketing at Emory University’s Goizueta Business School. Most Fortune 500 companies have the capability to conduct such procurement events online through sourcing software they purchase from large vendors, Jap says. And as companies have conducted more reverse auctions, relationships between buyers and sellers have emerged as key factors in explaining how different suppliers bid during the events.

Jap’s research shows that “incumbent suppliers”—those with a history of doing business with the auction sponsor—often aren’t as aggressive in making low-price bids. That’s because incumbent suppliers often factor costs into their bids that new competitors fail to appreciate. The finding points to a caveat for firms hoping to win price savings by sponsoring reverse auctions: the events can introduce discord into otherwise harmonious relationships between buyers and sellers.

“Suppliers will trade off their relationship and the intangible value they bring to a buyer with the prices they bid in an auction,” Jap says. “The implication is that suppliers that bid high in an auction might be better qualified bidders than those who bid lower.”

Online reverse auctions emerged as a new procurement tool for companies in the late 1990s. Previously firms would spend six to eight weeks negotiating contracts with suppliers, but online reverse auctions compressed the timeline to just a few hours. By 2003, researchers estimated that companies using online reverse auctions were increasing the amount of business conducted through the events by about 10 to 15 percent per year. Companies using auctions spanned a broad range of industries from automotive, aviation, and electronics to chemicals, machinery, and pharmaceuticals.

Auctions have been popular not just because they are quick, but also because they wring out price savings. In late 2009, an executive with California-based Ariba Inc.—one of the leading vendors of software for online reverse auctions—estimated that auctions drive incremental savings of five to seven percent on average versus quotes received from suppliers in a non-interactive bidding environment. Reverse auctions also drive incremental savings of three to four percent on average from incumbent suppliers, according to an article published on the company’s website.

Many online procurement auctions begin with the buyer issuing a request for purchase that details the nature of the contract as well as specifications and expectations for the product, delivery, and handling. Buyers then go through a process to pre-qualify potential bidders, which can include everything from extensive surveys to site visits. Finally, a group of pre-qualified suppliers are invited to bid in an online auction for the chance to win a contract from the buyer. Many industrial auctions are “buyer determined,” Jap says, which means the buyer reserves the right to select the winner on any basis. The supplier that places the lowest bid in a buyer-determined reverse auction isn’t automatically the winner, although the supplier is legally bound to honor its lowest price bid. Suppliers don’t know who their competitors are in online reverse auctions or how many other firms are bidding. But as the auction takes place, suppliers can see one another’s bids and respond in real time.

Theories about how and why suppliers bid as they do during online reverse auctions are still emerging. But in a 2008 paper published in the Journal of Marketing Research, Jap and Ernan Haruvy from the University of Texas at Dallas explain how bidding patterns seem to be influenced by relationships between buyers and sellers…

Click here for the rest of the article.

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