In a typical auction, the seller puts an item up for sale. Multiple buyers bid for the item, and one or more of the highest bidders buy the goods at a price determined at the conclusion of the bidding.
In a reverse auction, a buyer contracts with a market maker to help make the necessary preparations to conduct the reverse auction. This includes: finding new suppliers, training new and incumbent suppliers, organizing the auction, managing the auction event, and providing auction data to buyers to facilitate decision making.
The market maker, on behalf of the buyer, issues a request for quotation (RFQ) to purchase a particular item or group of items (called a "lot"). At the designated day and time, several suppliers, typically 5-20, log on to the auction site and will input several quotes over a 30-90 minute period. These quotes reflect the prices at which they are willing to supply the requested good or service.
Quoting performed in real-time via the Internet results in dynamic bidding. This helps achieve rapid downward price pressure that is not normally attainable using traditional static 3-quote paper-based bidding processes.
The prices that buyers obtain in the reverse auction reflect the narrow market which it created at the moment in time when the auction is held. Thus, it is possible that better value - i.e. lower prices, as well as better quality, delivery performance, technical capabilities, etc. - could be obtained from suppliers not engaged in the bidding or by other means such as collaborative cost management and joint process improvement.
The buyer may award contracts to the supplier who bid the lowest price. Or, a buyer could award contracts to suppliers who bid higher prices depending upon the buyer's specific needs with regards to quality, lead-time, capacity, or other value-adding capabilities. However, buyers frequently award contracts to incumbent (i.e. current) suppliers, even if prices are higher than the lowest bids, because the switching costs to move work to a new supplier are higher than the potential savings that can be realized. This outcome, while very attractive to buyers, is often strongly criticized by both new and incumbent suppliers.
The use of Optimization software has become popular since about 2002 to help buyers determine which supplier to source the work to. It includes relevant buyer and seller business data, including constraints.
Reverse auctions are used to fill both large and small value contracts for public and private commercial organizations. In addition to items traditionally thought of as commodities, reverse auctions are also used to source buyer-designed goods and services, and has even been used to source reverse auction providers. The first time this occurred was in August 2001, by America West Airlines (now US Airways) using FreeMarkets software and won by MaterialNet.
The majority of purchasing spend subject to reverse auctions over the years has been in the category of buyer-designed goods, followed by services, and then commodity items. Today, an average of 5% of total corporate spending is sourced using reverse auctions. This figure was higher in past years, indicating the goods and services to which reverse auctions can be successfully applied is limited.
The company's growth was aided greatly by the hype of the dot-com boom era. FreeMarkets customers included BP plc, United Technologies, Visteon, H.J. Heinz, Phelps Dodge, Exxon Mobil, and Royal Dutch Shell, to name a few. Dozens of competing start-up reverse auction service providers and established companies such as General Motors (an early FreeMarkets customer) and SAP, rushed to join the reverse auction marketspace.
Although FreeMarkets survived the winding down of the dot-com boom, by the early 2000s it was apparent that its business model was really like an old-economy consulting firm with some sophisticated proprietary software. Online reverse auctions started to become mainstream and the prices that FreeMarkets had commanded for its services dropped significantly. This led to a consolidation of the reverse auction service marketplace. In January 2004, Ariba announced that it purchased FreeMarkets for $493 million.
Fortune magazine published an article in March 2000 describing the early days of reverse auctions.
In the past few years mobile reverse auction have evolved. Unlike B2B reverse auctions, mobile reverse auction is B2C and allow consumers to bid on products for pennies. The lowest unique bid wins.
In Congressional testimony on the 2008 proposed legislative package to use federal funds to buy toxic assets from troubled financial firms, Federal Reserve chairman Ben Bernanke proposed that a reverse auction could be used to price the assets.
Buyers, sellers, and market makers should adhere to auction rules and industry codes of conduct for the use of reverse auctions, if they exist. Problems arise when one or more parties fail to conform to auction rules. This can range from simple cries of "foul" to litigation.
Buyers should not assume that reverse auctions will, in every case, deliver savings - either on a unit price or total cost basis. Reverse auction savings can range from negative (i.e. it costs the buyer money) to neutral (i.e. no savings) to positive savings (average gross of 10-20%, but net savings is typically half or less).
A true representation of savings can not be achieved if unit price-focused purchasing metrics such as "purchase price variance," "purchase order variance," or "material price variance" are used. Instead, total cost savings must be calculated, inclusive of direct and indirect losses associated with using reverse actions, implementing reverse auction results, subsequent procurement activity, and related activities such as customer returns, defective goods or services, warranty expense, litigation, etc.
Suppliers are advised to determine if a value proposition exists for them that would warrant their participation.
Some have characterized reverse auctions as a technologically-assisted form of zero-sum power-based bargaining, or as "going in reverse" with respect to developing buyer-seller relationships, collaboration, and purchasing process improvement. Reverse auctions have also been criticized as "bid shopping" - when a buyer uses a supplier's bid to obtain lower prices from other suppliers.
Suppliers seeking to avoid reverse auctions can create unique intellectual property, expand the value propositions for its customers by creating new products and services, or seek to extend or improve collaborative activities with their customers.
Reverse auctions used in industrial business-to-business procurement and spend management activities remain controversial, both within buying organizations, among suppliers, and among the academics who study them. As such, buyers considering the use of reverse auctions should carefully evaluate all available information, both favorable and unfavorable, to ensure that informed business decisions are made.
Reverse auctions (also becoming known as service auctions) are undergoing a resurgence at present (9/2008), as evidenced by a number of service auction sites for freelancers (e.g. eLance.com, guru.com) that are doing a significant volume of business both in number of projects and amount of money spent (20,000 projects in the last 30 days and over $100 million spent since 2006 according to eLance's website). There are narrow scope sites, such as those specializing in programming, technical writing and other professional, desk-based work (eLance.com, guru.com) or in home improvement and construction work, e.g. blauarbeit.de and eGenie.co.uk. A broad scope site, FlatDoor.com, covers all types of work in any part of the world, including volunteer projects for non-profit organizations.
One recent article in Inc. (May 2007; Reverse Auctions – A supplier's survival guide) by Mark Chafkin quotes Gartner Studios as having been successful with reverse auction bids. The same article quotes Sandy Jap, who studies reverse auctions at the Wharton School of Business as estimating that up to half of all corporate spending could some day be decided by reverse auction.
Gartner's keys to success as a supplier in reverse auctions are: (a) Thorough preparation – it's essential to know your costs, your suppliers, and your market to the greatest extent possible – tiny details can make the difference between winning and losing, and between being profitable or not; (b) Reverse auctions should be largely kept to the supply of commodity products rather than proprietary ones; and (c) Having a strong, competent bidder leading your effort at the time of the auction, with clear guidelines on when to bid and when to fold is essential. The results of these preparations and skills in the arena are that Gartner has been able to decrease their production and shipping costs by almost 30%; a little more than double their sales in 3 years (2003-2006); and increase their profits to an all-time high. "I know most people don't look at reverse auctions positively, but we see them as a process that makes you better," Gartner says. "If companies don't look at it that way, they'll lose to somebody who does."