Fair Play

Online reverse auctions are helping buyers procure at the best total cost without favoring one supplier over another.

There is a dirty little secret in purchasing that suppliers frequently accompany a request for quote (RFQ) with a verbal nudge to the buyer to "let me know what I need to do to win the business." Naturally, any company wants to win orders at the highest margin possible, so they seek with great vigor to discover the magical price that will capture the order while leaving them whole.

Part of the reason suppliers use this tactic is that some buyers routinely bid out their business, but only award orders to their preferred suppliers. What the buyer does is ask their favorite supplier, after the bidding is complete, to "meet comp." In plain terms this means that the buyer takes the dollar amount of the lowest bid received in the RFQ and tells the favorite supplier, "If you can meet (or slightly beat) XYZ's bid of ABC, then I'll give you the order." If the buyer doesn't prompt a supplier with a chance to meet their competition, quite often the supplier hopes for the best, takes the initiative and asks for the favor.

The logic behind this insidious (and as far as I'm concerned, unethical) process is that it enables the buyer to use competitive bidding to get pricing down, while still permitting them to issue the order to their supplier of choice. If the preferred supplier can meet virtually any competitive bid, and in my experience, they almost always do, the buyer is clearly leaving money on the table when the deal is done.

Even buyers that shun the "meet comp" practice have to deal with this issue on a regular basis. There are always suppliers that need a particular order to make their quarterly numbers, or a new supplier that desperately needs a good reference account. The larger and more visible your employer is, as a buyer, the worse this situation is. And as a buyer, it's hard to ignore. You have a duty to your employer to procure at the best possible total cost. So when a supplier calls you a couple of days after the bids are in, and says, "please let me know what I can do to win the business," the buyer is in a really tough spot.

Some buyers claim to get around this issue by asking suppliers to submit a "best and final bid" the first time around. The idea is to encourage suppliers to go ahead and submit the very lowest price right off the bat. Frankly, I'm unconvinced that this works. The desire of a supplier to maintain a high level of profitability cannot be underestimated, and I believe that this approach leaves money on the table. I know if I am given one chance to bid, now that I am in business for myself, I don't immediately drop to the lowest acceptable price.

At one point in my purchasing career, I worked for a really hot networking company that was growing more than 300 percent per year for several years in a row. My business was a target account for every supplier in the territory, so I frequently found myself in the position of having suppliers offer to lower their bid if I gave them a second chance. My standard response to this was to allow it, as long as I had the time and everybody was given the opportunity to requote. In other words, if supplier "a" came in the lowest, and supplier "b" called up and said "I'll lower my price if that will get me the order," then I would approve a rebid, but also give supplier "a" the chance to rebid. This way, my company was able to take advantage of lower prices, but I was not favoring one supplier over another.

The obvious problem with my solution to this dilemma was that it was time consuming and cumbersome, particularly if more than a few suppliers were quoting. In addition, allowing multiple rounds of bidding extended the amount of time it took to select a supplier. Here is where online reverse auctions come in.

The Solution Enabled
In a reverse auction, one buyer invites multiple suppliers to bid on an RFQ. It is very much like a traditional RFQ, where the buyer sends out a document specifying their needs to pre-selected suppliers. The catch, however, is that all the suppliers can see the bids for the job, as they come in. Today the medium is the Internet, and a finite period of time is set for the bidding, say two hours. Each time a new bid is submitted, the buyer and all the suppliers can see that bid. So, until the time that the bid is slated to close, suppliers have the opportunity to submit new, lower bids.

The beauty of the reverse auction is the ability to completely circumvent the "meet comp," "best and final price" and the time-consuming multi-round approaches to supplier selection. Now, within two hours buyers can effectively let all bidding suppliers know what they need to do to win the business, so no money is left on the table. As a manager, this is especially important because you can know with much more confidence that the bidding process used by your buyers was both effective and fair.

I have heard some complaints recently that reverse auctions are a problem because suppliers that do not have appropriate capabilities end up undercutting incumbents but not delivering on the contracts they win. Just because buyers have a new arrow in their quiver doesn¹t mean they should discard important steps in the sourcing process - like pre-qualifying suppliers for strategic purchases. If buyers do get into trouble, they will learn from their mistakes. Buyers that source from suppliers who can't deliver don¹t last very long.

Preventing a Serious Problem
A more serious concern is that suppliers will use the reverse auction process to collude. It is quite possible as a supplier, when you know your opponent's pricing, to "signal" each other and work together to keep prices high. Take for example oil prices and OPEC. When all the players in OPEC decide to keep their prices steady, there is very little the buyer can do about it, since OPEC controls most of the supply. The key to this system is that the sellers are able to communicate with each other. If Saudi Arabia knows that Venezuela will not quote below $35 per barrel of light sweet crude, then they can also safely keep their price at $35 and not lose any business.

In fact, in two separate instances, I actually studied how to systematically collude with competition. At the Harvard University course on negotiating, we did exercises simulating multiple bidding rounds with other suppliers, and studied how to maximize profits under such situations. Then, in my MBA program, we learned a quantitative method for maximizing margins when you have to bid regularly for your work. So, don¹t think that suppliers won't try to do it. In fact, I'm certain that during my tenure as a purchasing manager, it happened right under my nose at least once, but I couldn't prove it.

Preventing collusion, however, is fortunately, relatively simple. All the systems I studied required a limited number of suppliers that continually and regularly bid against each other. The way they established communication was by monitoring the different responses to each other¹s bids. The way, to avoid problems is to regularly introduce new suppliers into your bidding, so there is always a new player to interfere. And of course, you should be willing to award business to that new player if they fairly win the auction.

I read recently that reverse auctions are bringing in such high levels of savings that senior managers are questioning whether purchasing has been doing its job. Just remember, buyers struggle every day with inefficient systems that don¹t help them get the lowest possible prices. So smile, help your procurement professionals learn about reverse auctions, and congratulate them (and yourself!) when the tool is effective.