Potential Pitfalls of E-Auctions

Fans of online reverse auctions, or e-auctions, can cite some big numbers —and some big names — to support their case. In 2001, for example, General Electric expected to generate more than $600 million in savings by putting $12 billion in contracts up for bid online. “The concept of reverse auctions was right in the GE sweet spot,” legendary CEO Jack Welch told shareholders in his April 2001 farewell address.

But those numbers don't tell the whole story, according to research by Sandy Jap, associate professor of marketing at Emory University's Goizueta Business School in Atlanta. As she reports in a July 2001 working paper titled “The Impact of Online Reverse Auctions on Buyer-Supplier Relationships,” online reverse auctions can potentially hurt a buyer's long-term performance by sowing distrust among its suppliers.

In a reverse auction, buyers and sellers swap their usual roles. The sellers compete for the opportunity to supply a product or service, and as bids come in, the price goes down. By putting these auctions online, buyers can streamline the process of collecting bids and deal with many sellers at once. That creates the potential for substantial savings by stimulating increased supplier competition.

In order to understand the impact of the process, Jap analyzed six reverse online auctions, collectively involving $100 million in purchase contracts, which took place between fall 1999 and spring 2000. All the auctions were conducted on behalf of a single manufacturer of automotive components and involved direct inputs to production, such as semiconductors, plastics and electrical parts. Three of the auctions involved a single round of sealed bids, whereas three used the open-bid format, in which suppliers see their competitors' bids (but typically not their identities) and respond in real time. In both cases, the buyer reserved the right to award its business to any auction participant, not just the lowest bidder.

Jap found that sealed-bid and open-bid auctions generated similar levels of potential savings, measured as the percentage difference between the lowest bid and the buyer's historical cost. However, the two formats provoked very different reactions among those taking part. Although sellers tended to see sealed-bid auctions as a more efficient way of doing business as usual, participating in an open-bid auction led them to regard the buyer with a more jaundiced eye. For example, suppliers in open-bid auctions were significantly more likely to agree with the statement, “This process will reduce my chances of earning a fair margin on the business.” Moreover, suppliers in open-bid auctions often suspected the buyer of manipulating the process — by bringing in unqualified sellers, for example, or by submitting its own bids in order to force prices down.

However unwarranted, such beliefs can do real damage to a buyer's relationship with suppliers. Suppliers who believe that a buyer is behaving opportunistically have fewer incentives to share information or engage in mutually beneficial cooperation. Even worse, suppliers who feel cheated “will look for an opportunity down the road to get even,” warns Bob Emiliani, director of the Center for Lean Business Management (CLBM) at Rensselaer Polytechnic Institute's Hartford campus. Emiliani and CLBM managing director David Stec played the lead role in launching online reverse auctions at a multinational durable-goods manufacturer in summer 1998.

What's more, the savings associated with online reverse auctions can be difficult to achieve, says Stec. In the short term, even if the auction process uncovers a new low-cost supplier, the process of learning to work with an untested partner can push up the buyer's total cost of goods. Over the longer term, if prices continue to fall, suppliers may merge to achieve economies of scale. That could “tip the balance of power to the supply base,” Jap explains.

Yet when used appropriately, online reverse auctions can still play a positive role, Jap believes. Her surveys revealed that after participating in an auction, suppliers were more willing to make investments in training, procedures, equipment and capacity that were tailored to the buyer's specific needs. That was true even of open-bid participants, despite their higher levels of distrust. Open-bid auctions also give sellers new information about their competitors' pricing, leading some companies to make investments to lower their costs. In addition, some sellers hope to avoid future auctions by creating a tighter relationship with the buyer.

As long as companies avoid overuse, Jap suggests, “Online reverse auctions can be a good wake-up call to your supply base.”