Reverse Auctions: Benefits, Challenges, and

Best Practices
Gus Manoochehri
California State University, Fullerton, CA
Christy Lindsy
Irvine Company, Newport Beach, CA

Taking advantage of new developments in technology, reverse auctions have significantly changed
the way many companies conduct their purchasing. For buyers, the primary benefits include reduced
purchase price, increased market efficiency, higher procurement process efficiency, and access to a
larger supplier base. However, application of reverse auctions can bring major risks and challenges.
It can lead to deterioration of strategic supplier relationships, loss of trust, erosion of supply chain,
and ultimately to higher total cost of purchased items. To effectively utilize reverse auctions,
management must consider the nature of product, nature of market, and the nature of buyer-supplier
relationship.

I. INTRODUCTION professionals, help to understand strengths and

weaknesses of reverse auction and provide
Recent advances in electronics and internet guidance for its effective applications. The
technologies have had major impacts on supply research methodology includes review of
chain management and, in particular, on literature on reverse auction models and
sourcing strategies and practices. One such frameworks, real world applications, and survey
development that has attracted the attention of results of companies that have participated in
many companies and gained popularity is the reverse auctions. The results of this research are
reverse auctions, also referred to as electronic or organized and presented in four parts. After a
online reverse auctions. Over the past few years, brief review of reverse auction process the
many companies in a variety of industries have benefits of reverse auctions are presented. That
started using reverse auctions. The list includes is followed by a discussion of the challenges in
GE, Boeing, Sun Microsystems, Hewlett- implementing reverse auctions. Finally, the last
Packard, Proctor & Gamble and Dow Chemical, section presents the best practices—effective
just to name a few. The 2006 Purchasing’s reverse auction implementation.
Annual Benchmark E-Sourcing Survey showed
that 31% of respondents saying they use reverse II. THE REVERSE AUCTION PROCESS
auctions. This is a dramatic increase compared
to 15% use in 2003 (Hannon, 2006). In the traditional auctions, also referred to as
The objective of this paper is to explore the forward auctions, a seller offers a product that is
developments and applications of reverse demanded by several buyers who compete and
auction in order to identify its benefits and bid up the price. The highest bidder wins and
challenges as well as the best practices for its buys the product. In a reverse auction, it is the
successful application. Findings of such research
can provide beneficial information to sourcing

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Reverse Auctions: Benefits, Challenges, and Best Practices

buyer who is in control of the process. The buyer claimed that there are some distinct benefits for
is interested in an item offered by a number of the suppliers, case studies and surveys of
sellers who compete and lower their price in suppliers do not support these claims
order to get the deal. Unlike traditional auctions (Giampietro and Emiliani, 2007; Jap, 2003). Key
that occur at physical locations, reverse auctions benefits of reverse auctions include reduction of
are accessed online, through web browsers, via purchasing costs, increased efficiency in the
private software companies known as “market market, enhancement of the procurement
makers.” The market makers facilitate the process, and access to a global supplier base.
auction process and provide support, training
and all necessary software to suppliers Purchasing Cost Reduction
participating in the bidding process. The reverse The most obvious benefit from reverse auctions
auctions process starts with the buyer preparing is in purchasing cost savings to the buyer. As
and posting an electronic request for quote any dollar saved in purchasing cost adds a dollar
(RFQ) to a web site. Through the use of RFQs, to the bottom line, reduction of procurement
the company electronically communicates its costs has always been a high priority for top
expectations to prospective suppliers. Once the management. Reverse auctions can have
RFQ is prepared and posted, selected suppliers significant impact on reducing purchasing cost.
are invited to bid. These suppliers have been One beneficiary is Rio Grande Regional
screened and pre-qualified based on established Hospital, which was able to reduce its cost for
standards. contract nurses from $850,000 a quarter down to
Reverse auctions can be either open- or $300,000. To fill the gaps in its nursing schedule
sealed-bid. In a sealed-bid auction, after the the hospital traditionally used contract nurses
buyer posts the RFQ, suppliers have a few days hired through agencies that charge as much as
or weeks to submit a bid. Only the supplier and $75 per hour, while staff nurse average charge is
the buyer are aware of the details of the bid. The around $25 per hour. By using reverse auctions,
buyer reviews all the bids and either makes a the hospital goes directly to the qualified nurses
decision or, if not satisfied, proceeds with and allows them to bid for available shifts, with
another round of bidding. Most reverse auctions the lowest bidder winning the shift (Martin,
are of open-bid format. In an open-bid auction, 2006).
once the RFQ is posted, suppliers start posting Because many companies that use reverse
their bids on a site bulletin board at a designated auctions buy in volume, they are able to take
day and time. The bidding process generally even greater advantage of cost savings. The
takes three to eight hours. In this format the significant savings has allowed companies to
buyer and all suppliers can view bids as they are enjoy short-term profit increases and steep
posted. The suppliers’ ability to view other bids returns on investments. Also, because the
creates a more competitive environment that reverse auctions are conducted at a much faster
encourages suppliers to outbid their competition, pace than traditional auctions, savings are
if financially feasible. Of course, one supplier’s realized much more quickly.
attempt to outbid a competitor, can lead to a
response from that competitor, or another, with Increased Market Efficiency
yet a lower price. The ability of the market to bring buyers and
sellers together in an open environment is
III. BENEFITS OF REVERSE AUCTIONS critical in indicating the true value of a product
or service. Online reverse auctions do that very
Reverse auctions offer some significant benefits. effectively. Reverse auctions effectiveness can
The buyer is the primary beneficiary. While it is be attributed to the following factors:
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• Suppliers are able to see the bids of others and IV. CHALLENGES IN IMPLEMENTING
thus buyers benefit from vendors “fighting the REVERSE AUCTIONS
price out.”
• Bidding is not limited to those physically There are several challenges associated with
present. It removes geographical limitations implementing successful online reverse auction
and leads to global searches for the best price. projects. While suppliers face most of the
• The reverse auction’s ability to include a larger challenges, buyers can face serious obstacles as
number of suppliers and keep the bidding well.
process transparent, makes it possible for a
supplier’s excess capacity to be effectively 4.1 Challenges Facing Buyers
utilized to meet the buyer’s demand. Jeopardizing Strategic Relationships. Reverse
auctions seem to contradict the recent trend
Procurement Process Efficiency focusing on strategic relationships and
Another significant factor for both buyers and partnership with suppliers which is needed in
sellers is the improved smoothness and speed of order to maximize efficiency and effectiveness
the procurement process. The reverse auctions in the supply chain. By focusing excessively on
are much faster than traditional auctions. price, the online reverse auction has caused a
Traditional auctions average about six weeks in move away from the close partnerships that were
duration, while online auctions are typically once successfully working for both buyers and
completed in 3 to 8 hours (Jap, 2003). All the sellers. A recent empirical study concluded that
paperwork and communications through mail, high emphasis on two main benefits of reverse
fax, phone calls and negotiations through auctions, purchase price reduction and time
multiple rounds of bidding are eliminated. savings (procurement process efficiency),
Decisions are made with a click of the mouse, negatively impact the buyer-supplier cooperation
and negotiations are concluded within one and suppliers’ strategic relationships (Pearcy et
business day. In a sense, negotiation is relegated al., 2007)
to a system that allows suppliers to negotiate
among themselves. Higher Ultimate Purchase Cost.
While focusing on finding the supplier with the
Access to a Larger Supplier Base lowest price, the reverse auction process may
With traditional bidding, companies were ultimately lead to higher actual costs as other
limited to selecting only suppliers in their non-price factors are not considered in the
geographic regions with whom they were process. Competitive priorities such as quality,
familiar. The technological capabilities of delivery reliability and timing, flexibility, and
reverse auctions can spread a much wider net, technological capabilities can be traded off for
around the globe, and allow companies lower unit price. Although the RFQ can define
thousands of miles away to compete. It can also the requirements for non-price factors, the
increase the supplier base by providing the winning factor is the unit price. In order to win
opportunity for smaller companies to compete. the bid, a supplier has to lower its margin to a
The reverse auction is a more open and bare minimum. With such a low margin, there is
transparent process and gives newer companies a no room for any adjusting and adapting to
chance to compete as long as they meet the unforeseen situations. Further, the process of
buyer’s qualification standards. learning to work with a new low-cost supplier
can push up the buyer’s total cost of goods
(Nair, 2005).

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Erosion of Supply Chain. The initial

purchase cost savings brought about by reverse Risk of New Entrants
auctions cannot be maintained over a long time The risk associated with new entrants into a
period. Purchase cost reductions will not particular market is another cause of supplier
continue at the same rate. After an initial period, pessimism concerning reverse auctions. The
market inefficiencies will be eliminated and reverse auctions process opens the door for new
prices will become stable. As a result non- entrants and gives them a chance to compete
competitive suppliers will be eliminated. with the incumbent and other known suppliers.
However, if the price drops further, some viable Given that a new entrant is highly motivated to
suppliers will not be able to survive. Gradually, gain a new customer, it is willing to cut its profit
some will be pushed out of the market or have to margin to a bare minimum. In this process, the
consolidate to increase the economies of scale to new entrant, not fully understanding the
support lower prices. Either way, over time, this customer’s requirements, may unrealistically
erosion of the supply base will result in less outbid other suppliers in order to win the
competition and, ultimately, higher bargaining business.
power for suppliers.
Reducing Their Products to a Commodity
4.2 Challenges Facing Suppliers By focusing on price as the determining factor
Suppliers do not feel that they can gain much and almost ignoring all other factors, suppliers
from the reverse auction, but rather have much contend that the reverse auction process reduces
to lose. There are widespread complaints and their product to a commodity. Most companies
concerns among incumbent suppliers about the use a “satisfying” strategy for non-price issues
negative impacts of reverse auctions on their by specifying minimum performance levels
margin erosion and loss of sales volume required in categories such as quality, service,
(Emiliani, 2005). and delivery. Such specifications will be used in
evaluating and pre-qualifying suppliers for
Buyers Acting Opportunistically participating in the auction (Kaufmann and
The most important challenge encountered in Carter, 2004). While this approach considers the
reverse auctions is the suppliers’ impression that minimum level of performance for non-price
buyers are acting opportunistically and taking issues, it cannot consider comparative levels of
advantage of suppliers. A survey of suppliers performance for different suppliers; and once
after an open-bid auction indicated that the they are pre-qualified, their performances on
suppliers’ suspicion of buyers acting non-price issues are considered equal. More than
opportunistically had increased (Jap, 2003). 50% of suppliers surveyed after a reverse
They felt that the process was exploitative and auction considered their inability to express their
unfair; and indicated that they would avoid such full capabilities a disadvantage of the electronic
events and condemned the process. Such a bidding mechanism (Jap, 2003).
negative impression is the major contributing
factor to loss of trust in the buyer, which can The Winner’s Curse Risk
jeopardize the long term relationship. In an In its enthusiasm for getting a contract, a
empirical study, Carter and Kaufmann (2007) supplier may suffer the winner’s curse. During
concluded that higher suppliers’ perceptions of the reverse auction process, which takes only a
opportunism reduce relationship trust and few hours, a supplier may get so caught up in the
increases buyer-supplier dysfunctional conflict competition that it offers unrealistically low
which subsequently reduces suppliers’ non-price prices. Cases were reported in which some
performance. suppliers actually presented bids below their
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costs (Smeltzer et al., 2003). The risk of the unambiguous specifications (Kaufmann and
winner’s curse increases in situations where it is Carter, 2004).
hard to estimate costs accurately. Given the The best and safest applications of reverse
uncertainties, the supplier who makes the most auction are for purchase of commodities. Such
optimistic estimate gets the contract, and items meet the above two requirements. In
possibly the winner’s curse. addition, typically they are mature, standard
products that are produced by many suppliers.
V. BEST PRACTICES—EFFECTIVE
REVERSE AUCTION IMPLEMENTATION 5.2 Market Characteristics
A high degree of competition among suppliers is
Considering these benefits and challenges, it is a key market factor impacting the success of
critical to understand when the use of reverse reverse auctions. The higher the number of
auctions is beneficial, and recognize important competitive suppliers and the more rivalry
requirements for successful reverse auction among them, the more effective the reverse
implementation. Feedback from companies with auction process will be in lowering the price.
experience in reverse auctions has provided While the required minimum number of
some guidance. These requirements can be suppliers depends on the specific product and
classified into three groups: product market, studies have provided a ballpark figure
characteristics, market characteristics, and of four or five (Carter et al., 2004; Smeltzer et
buyer-supplier relationships. al., 2003). Empirical evidence indicates that
auctions with higher numbers of suppliers are
5.1 Product Characteristics more successful (Kaufmann and Carter, 2004;
A product is a better candidate for reverse Jap, 2007).
auction if it is price-based; i.e., the purchase Another contributing market factor is the
price constitutes the largest component of its volume of the purchase contract. The purchase
value (Jap, 2002). When the purchase price is volume should be large enough to be attractive
the dominant portion of the product value, then to potential suppliers. Larger volume can attract
the value of the product can be easily expressed a larger number of suppliers, which in turn will
quantitatively; and therefore, reverse auction can lead to higher competition and lower prices. A
be used to efficiently evaluate the suppliers’ bids survey of purchasing professionals with reverse
and set the purchase price. Typically, non-price- auctions experience reports that a million dollars
based items, where the non-price attributes are in sales was frequently used as a minimum
important, should be considered in a contract, guideline for a reverse auction, given that this
requiring face-to-face negotiation and discussion figure depends on the specific product and
to determine the market pricing. market (Smeltzer et al., 2003).
If you can spec it, you can bid it. Reverse The third market factor influencing the
auction can be used more effectively if the applicability of reverse auction is availability of
purchase item has clearly defined attributes that excess supply capacity. If excess capacity exists
can be expressed by the buyer and interpreted by in the supply base, there is incentive for the
suppliers the same way. The item’s attributes suppliers to bid in order to get more business.
should be translated into unambiguous Then, the reverse auction can provide an
specifications that cannot be misinterpreted by effective means for suppliers and buyers to
suppliers. Contrary to common belief, a efficiently allocate the spare capacity. The
complex item or service can be auctioned, as reverse auction is particularly well suited to
long as its attributes can be translated into service industries, such as transportation, whose

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output can’t be stored and its excess capacity suppliers can increase auction costs for the
would otherwise be lost (Nair, 2005). buyer. Furthermore, their presence reduces the
credibility of the auction for other suppliers who
5.3 Buyer-Supplier Relationships might opt out or not pursue the bidding process
The effectiveness of reverse auction is highly sincerely.
impacted by the nature of buyer-supplier
relationships. These relationships can be 5.4 Not Just Price—Consider Non-Price
classified along a continuum (Daly and Nath, Issues
2005). At one end of the continuum is a The primary criticism of reverse auctions is that
transactional exchange which is conducted at it grants contracts based solely on price, and
arms-length, is focused on the current does not consider non-price issues. While this
transaction, has short term contracts, and often approach makes the process very efficient, it is
selects the supplier solely based on comparative not adequate for products for which non-price
price. At the other end is the relational exchange issues are critical. Certain variations of reverse
where the relationship is much closer and auctions can overcome this limitation. Some
strategic, and other non-price attributes--such as companies use a “satisfying” strategy as
quality, reliability, technological capability, discussed earlier. Another approach is that the
organizational culture and goals--are critical in buyer does not commit to the lowest bidder, but
selecting a supplier. The buyer makes a long uses reverse auction as a “screening” tool to
term commitment to the supplier, and the identify a few low price suppliers and
supplier makes substantial investments to satisfy subsequently considers their performance on
the buyer requirements. It is evident that reverse non-price issues to select one to grant the
auctions are more appropriate for transactional contract. Most auctions conducted by GE use
supplier relationships. Organizations using a this method (Nair, 2005). To make the final
transactional exchange relationship realize decision, a face-to-face negotiation with the top
greater cost and time saving from reverse bidders selected through the screening process
auctions application (Pearcy et al., 2007). It is can follow. This approach is more supplier
recommended that the nature of each supplier friendly, as it allows the buyer to consider other
relationship should be evaluated before deciding issues where a supplier might have superiority.
on reverse auctions applicability. More recently, multiple issue auction
Daly and Nath (2005) contend that it is software and algorithms have been developed
possible to design reverse auctions more that allow consideration of a variety of issues.
conducive to relational suppliers by subsidizing Several companies such as Frictionless, Ariba,
relational partners for their long-term Emptoris, Perfect and ComerceOne, among
investments, making payments to cover costs of others, have developed systems addressing
losing bidders, and even renegotiate final contact multiple issue auctions. These systems use a
bid prices and specifications. Pearcy et al (2007) variety of approaches in combining the buyer’s
maintains that organizations focusing on preference for different issues. A typical
relational exchange can use reverse auctions; but approach is based on eliciting the buyer’s
they should not overemphasize the price. preference for these issues and programming it
Another critical factor for the success of reverse into a value function. Once the bids are placed,
auction is the selection of suppliers to participate which requires suppliers’ input on all issues to
in the auction. A supplier should be pre-qualified be considered, the value function calculates the
before being invited to an auction. The relative desirability of suppliers. While some of
suppliers’ capability of fulfilling the purchase these systems are pure reverse auctions, some
contract should be verified. Nonqualified others combine auctions and negotiations. These
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systems are most comprehensive; however, they flexibility of the buyers to better consider the
are much more complex and their applications non-price issues. Such developments can reduce
have been limited. Sandholm (2006) discusses of some of the suppliers’ resistance and improve
one such approach called expressive commerce the effectiveness of this tool.
that combines advantages of highly expressive The reverse auction is here to stay.
human negotiation with the advantages of Technology has made it possible; competition is
electronic reverse auction. using it and benefiting from it. In order to stay
competitive and continue to strengthen their
VI. CONCLUSIONS businesses, it is imperative that companies learn
how to use it effectively and keep up with its
Application of reverse auctions can result in new developments.
considerable savings in purchase cost. Higher
market efficiency, procurement process VII. REFERENCES
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