Reverse Auctions: Guidelines for Federal Contractors

By Rob Handfield posted 12-23-2016 19:24

  

shutterstock_343293284.jpgAcquisition professionals and contract officers are besieged by a variety of different sourcing solutions designed to help them reduce their purchased cost of materials and services. For example, the FedBid reverse auction tool was widely recommended as a competitive tool available to contract officers within the VA, as a method for reducing costs to government internal customers. Many consultants have adopted reverse auctions as the next “best practice” in supply management, citing instances where supply managers have initially achieved significant cost savings for various purchased categories. The claim in such cases is that the reverse auction tool inexpensively connects buyers and sellers worldwide and supports competitive bidding while driving the price of the item or service to its ‘true market value’.

Increasingly, however, these reverse auctions have come under greater fire. An Industry Action Group representing suppliers to the VA gathered as part of a study I led, and representatives emphasized that reverse auctions failed to function properly for complex purchases such as medical equipment, as the specifications were not properly stabilized prior to use of a FedBid auction. Others have emphasized the increased potential risk of deteriorating supplier performance after a reverse auction, regardless of the prior supplier certification. In addition, some well-qualified suppliers (including MBWE businesses) may lack the technology needed to conduct or participate in reverse auctions or may be reluctant to engage in the process. Price transparency has been a cause of concern among suppliers because they are seeing market dynamics that they haven’t had to deal with before. Liability may be an additional concern for purchasers. Long-standing supplier relationships may be severed as a result of the reverse auctioning process.

An important input into category strategy development is an understanding of the current status of the relationship federal acquisition agencies have with its suppliers. This includes two major parameters: 1) the volume of business being conducted with suppliers, and 2) the relative value of the product or service provided by each supplier relative to other suppliers in that category. This information can be mapped onto a supplier segmentation tool, to provide an overall strategic view of the current status of the supply base capable of supplying the agency.

The first dimension, volume of business, can be measured using a Spend by Division tool. This tool answers the simple question – how much are we spending in each business, and who is spending the money? The first template shows a specific breakdown of total annual purchase volume (APV) for a specific category, across multiple divisions of a company. The second template provides some key points in terms of the trends, where the company is spending the majority of its spend, and the dynamics in the marketplace that are worth noting.

 The second dimension, supplier value, requires a more in-depth look at each supplier’s capabilities. Supplier research is required to identify the specific capabilities and financial health of key suppliers that are within the supply base, or who may not currently be in the supply base. Some of the key elements that should be documented and included in a comprehensive supplier analysis study include:

    • Cost structure
    • Financial status
    • Customer satisfaction levels
    • Support Capabilities
    • Relative strengths and weakness
    • How the buying company fits in their business
    • How the company is viewed
    • Core capabilities
    • Strategy/future direction
    • Culture

It may be difficult to build all of this information given time and resource constraints. However, understanding who are the major suppliers in a market is an important first step of any category analysis, especially when you are talking about global market share. This tells you who the world prefers: who the world is buying from! It is also critical to understand global capacity versus global demand and trends. When possible, the information should be documented in a set of templates that provides a) a high level overview of specific supplier categories, and recent developments of those suppliers , and b) more in-depth information on specific suppliers as they relate to the financial health, expansion, market status, technology developments, and other issues that can be gleaned from public sources.

Supplier segmentation

The two dimensions of spend value and market risk can be mapped onto a supplier segmentation matrix. This matrix is a useful way to structure the data prior to a category team meeting. Supplier segmentation (also called “portfolio analysis”) is a tool to structure and segment the supply base, and is used as a means of classifying suppliers into one of four types.   The objective is to categorize every purchase or family of purchases into one of four categories. The premise of portfolio analysis is that every purchase or family of purchases can be classified into one of four categories or quadrants: (1) Acquisition, (2) Critical, (3) Leverage, and (4) Strategic.[1] By effectively classifying the goods and services being purchased into one of these categories, those responsible for proposing a strategy are able to comprehend the strategic importance of the item to the business given The results of this analysis can then be compared to the current sourcing strategy for the category group, and tactics and actions defined for moving forward

When Should Reverse Auctions be Used?

Reverse auctions should be used primarily in the LEVERAGE quadrant in the portfolio analysis assessment. Used properly and ethically, reverse auctions are extremely valuable in arriving at true market pricing for commodities and services as they are specified. However, only select items that fall into the LEVERAGE quadrant lend themselves to auctioning. Reverse auctions can identify disparities in the market, in terms of suppliers with excess capacity that are willing to sell their product at a lower profit margin than their competitors – an effective market testing tool.

An important step in using reverse auctions is to carefully define the specification for the requirement. Buyers who are not careful to do so may wind up experiencing a lot of trouble. For example, in 2001, a packaging supplier bid on a stretch film product used in packaging, with delivery to multiple locations. The purchasing company failed to provide detailed specifications – and although this supplier met the reserve price and beat out seven other manufacturers, one company came in lower than it did: the supplier’s vendor! This vendor was a manufacturer of film, but did not understand how the original buyer was using its product. Thus, although its price beat out their bid, the buying company is now using 300% more product because it is not running correctly in its machines and is creating more waste! In effect, the supplier with which we spoke who lost its business with the buyer in the auction was not only providing the film but was helping the buyer use it properly in its machines – so instead of using 250,000 pounds of film per year, the buyer was now using 1 million pounds of film per year at a substantially higher total cost. A similar situation occurred when the same supplier bid on a paper product used in multi-locations. Again, the buyer provided incomplete specifications. It met the reserved price, but was not awarded the business and was not told why. When it asked to receive the cost breakdowns provided by other suppliers, it was told this would be forthcoming. Although the auction took place in May, it was not until September that the cost breakdowns were finally sent.

Reverse auctions can be either for one specific product/service in a spot buy or for contracts to provide the products or services over the course of a year.

Reverse auctions have a number of important advantages, but pitfalls as well. First, they can reduce the lead time associated with the Strategic Sourcing Process. In addition, auctions establish real-time competition to achieve significant cost savings. They also provide real-time market pricing data, which is especially useful in volatile markets. Auctions can also provide automated data on pricing, products, and sellers, and can also help reduce the possibility of “back-door selling” and sales calls from unqualified vendors. The downside of reverse auctions is that they often do not address issues such as the total cost of ownership, and can be particularly risky when involving precise specifications, tight tolerances on engineered custom parts, or other situations. They are also less useful in situations where demand exceeds supply, commodities are in an up-cycle, there is reduced capacity in the industry, or suppliers are not openly competing or acting in a “cartel-like” manner.

One instance when a reverse auction worked very effectively was a pharmaceutical company that decided to run its hotel suppliers through a reverse auction. The company’s executives traveled extensively, but analysis revealed that the majority of that travel occurred in 30 large cities. The sourcing analyst then identified the major hotels located in these cities, with a final list of 500 hotels. All of the hotels were contacted electronically, and asked to submit an RFI, and provided with details regarding the request for quote. The RFQ stipulated that each hotel should be willing to provide its best nightly stay rates, which would include a free breakfast and no local phone charges. (The RFIs were sent to each of the individual hotel location offices, not the central hotel offices.) The auction was then conducted, with over 400 hotels participating. Reductions of around 15-20% were achieved through this auction, not including the other costs. These hotels then became the preferred provider for executives traveling through this city.

Working with the supplier IAG group, we developed a tool to assist contractors understand when and how a reverse auction was appropriate in a given situation.  We tested the tool on a number of product categories where reverse auctions had been applied.  Several insights emerged:

  • Reverse auctions can general potentially high returns for items that have a higher price and low complexity. Items that are already priced very low and which are overly complex are not suitable, and as such, are not likely to generate significant cost savings. On the other hand, running complex items through auctions can result in poor sourcing decisions, which can lead to disgruntled and unhappy internal customers.
  • Reverse auctions have a fee associated with them, and also require an investment in time. It is important to spend a good amount of time with internal stakeholders to fully understand the specifications and application of a product or service prior to rendering this decision.
  • The tool can provide a good checklist of items that can be used for a conversation between the CO and the internal customer during the initial stages of requisitioning, that can lead to a more informed decision about whether reverse auctions are a good idea or not. The questions in the tool can be used as a baseline for also conducting additional market research if the CO is not familiar with the supplier market environment or the product/service technology.
  • Construction and architectural design is generally a very poor fit for reverse auctions. These are highly complex and customized services.

The application of the tool will not require a major set of changes to current contractor policies, but can simply augment current practices in conjunction with training on strategic sourcing and category management. As noted, the tool can be integrated into current discussions that take place with stakeholders, as well as using the questions in Request for Information documents. The tool could also potentially be web-enabled, and track how different categories are being sourced based on best practices across the acquisition community. The IAG strongly supports the use of this tool to avoid future issues that are occurring with the inappropriate use of reverse auctions.

[1] Monczka, R., Trent, R., and Handfield, R., Purchasing and Supply Chain Management, 6th edition, Southwestern College Publishing, 2016.

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