A growing number of large companies are forcing suppliers to bid through reverse auctions. Here's how to survive one with your margins intact.
On days when Gartner Studios is trying to lock down a major sale, Greg Gartner turns his employee lounge into a war room. An arsenal of laptops and phones and reams of data are brought in for employees to use. Shouting matches among workers are common. So is heavy perspiration. If Gartner's team wins the deal, there's a lot of whooping and the boss hands out tequila shots. These back-breaking dealmaking sessions can last for eight hours or more.
For Gartner, a company that supplies stationery and related products to mass market retailers and office superstores, selling paper ain't what it used to be. Deals that 10 years ago would have started with a cold call and ended months later with a handshake are now governed by a process that was virtually unheard of when the Stillwater, Minnesota, company was founded in 1998: the online reverse auction.
During a reverse auction, a customer allows suppliers only a short window of time to bid down the price on their products or services. The practice was pioneered by automotive and aerospace buyers, which used reverse auctions to procure commodity parts. Today, many large companies use them to buy everything from paper clips to their employee health care plans. Reverse auctions are loved by corporate purchasing managers, loathed by suppliers, and rarely discussed publicly by anyone involved.
Typically, a buyer announces an auction months in advance. After a qualifying process that may include interviews, presentations, and a preliminary bid, a group of suppliers--usually between three and 12--is selected to participate. At a set date and time (often between 6 and 8 in the morning to accommodate Asian bidders), companies log on to a secure Web-based program and bid against one another anonymously. Most auctions are limited to an hour or two, but they can drag on as long as the bids roll in.
Easy enough, right? It depends on whom you ask. Among procurement professionals, reverse auctions are considered a best practice, a tool that can reduce costs by as much as 20 percent. Target (NYSE:TGT), Dell (NASDAQ:DELL), and General Electric (NYSE:GE) are said to use them liberally. Sandy Jap, a professor at Emory University who studies reverse auctions, says it's possible that half of all corporate spending could someday be decided by reverse auction.
For small suppliers, however, reverse auctions are incredibly stressful--win or lose. "The prices can fall quickly, and it's a frightening situation," says Michael Roberts, who runs Kid-riffic, a St. Louis-based toy distributor. Roberts first faced reverse auctions five years ago when his former company, a private label manufacturer and distributor of items such as drum sets and toy walkie-talkies, lost $3 million in sales through reverse auctions in a matter of months--in spite of having long-term customer relationships. "They had us competing directly against factories," says Roberts, who sold that company to a Chinese rival shortly after the debacle. "Reverse auctions are great for buyers, but I'd have to use my imagination to see how they're good for suppliers," he says.
Squaring off against a low-cost competitor is only part of the problem. Despite the fact that bids are generally ranked by price, reverse auctions are not binding for the buyer. Companies will sometimes go with the second- or third-lowest bid based on qualitative factors such as reliability, customer service, and the cost of switching away from an incumbent supplier. "In some cases, buyers provide incorrect or incomplete information about what they want," says Robert Handfield, a professor at North Carolina State University who studies supply-chain management. "What they're asking for becomes a moving target."
Because bidders don't always understand what they need to do to win a piece of business, and they're prohibited from asking the buyer all but basic technical questions during the actual auction, companies can find themselves making a lot of snap decisions about contract terms, pricing, and packaging. When a salesperson is trying to meet a quota or a business owner is trying to hit a sales target set by investors, a company can make an impulsive bid it later regrets. "People get emotional," says Handfield. "You see somebody else bidding over and you lose your sense of perspective."
Some businesses, like Gartner Studios, have responded to the rise of reverse auctions by completely rethinking the way they operate. "We didn't like it at first," says Gartner, "but these were our customers and this was the trend: Either you figure it out or you go out of business."
For Gartner, winning reverse auctions has meant focusing less on good product design, which he previously considered his company's greatest strength, and more on production. Because he assumed that sharp price cuts would be inevitable, he started looking for factories in Asia to replace the American manufacturers that he had worked with in the past. He sent his No. 2 to Hong Kong to open an office. That office, which manages sourcing, has grown to 30 employees, a quarter of Gartner's work force. Today the company imports 90 percent of its products, up from 25 percent before it started to bid in reverse auctions.
It's crucial, says Gartner, to figure out how any single adjustment to the supply chain can improve profitability. To prepare for an auction, he starts by asking his factories how much they pay for raw materials such as wood pulp and ink in order to determine if they might be able to shave their costs--and, consequently, to lower the price he pays. (During a live auction, he talks frequently by phone with the factory owners in case the bidding gets close. Gartner is sometimes able to exact a last-second concession, lowering production costs by, say, a quarter of a percentage point.)
Gartner also makes sure that he knows, well ahead of time, the answer to a range of thorny what-ifs: How much does it cost to deliver a pallet of paper to a logistics center in Asia versus delivering to a facility in the United States? Can you cut costs by selling paper in units of four cases versus two? If you switch to packs of four, will the new dimensions affect your ability to fit the same amount of paper per shipping container? By poring over these variables, Gartner better understands the financial implications of even the tiniest change in contract terms that he may feel compelled to offer during a reverse auction. "As easy as these things sound, the more you dig into them, the more difficult they become," he says.
Because reverse auctions are typically won or lost during the preparation that precedes them, actual tactics (see "Game-Day Strategies" ) are less important than keeping calm and playing by the numbers. Knowing the competition is also helpful. Mark Lilien, a consultant who advises retailers and their suppliers on procurement strategy, says companies should do some detective work to find out who is bidding, what their cost structure is, and how far they are likely to go.
If, for instance, you know you're bidding against a low-margin supplier with a history of quality problems, you may chose to aim for second place because the purchaser is apt to shy away from your opponent. If you're bidding against a supplier that already has the account, assume that you'll have to beat the supplier substantially on price to offset the cost to the customer of switching vendors.
Make sure you appoint a good chief bidder to lead your team. Because reverse auctions typically involve big pieces of business with large clients, the boss should always be kept in the loop. But a CEO who tends to be cautious or overly competitive--or who isn't intimate with the numbers--may do well to ask a sales manager to run the auction, based on a set of guidelines approved beforehand.
Of all the numbers Gartner and his team track during a reverse auction, the most important one tells them when to walk away. "It's like gambling," he says. "If you can't afford to be at the table, you shouldn't be there." Prior to an auction, he and his managers agree on what they call their walk-away price. If a bid drops below that price, the company does just that.
Many companies go one step further, steering clear of the table entirely. At Kid-riffic, for example, Roberts has been able to avoid reverse auctions by selling only products for which he possesses a proprietary design or an exclusive license. Today the company enjoys sales of nearly $20 million and counts Wal-Mart (NYSE:WMT), Target, and Toys "R" Us among its customers. "If I were in my customer's position, I'd be using them to buy commodity products too," he says. "But if you're the one selling commodity goods, it's tough to build a business." (See "The Case Against Reverse Auctions".)
Gartner doesn't dispute that the process is painful. "Would we prefer to not have them?" he asks. "Yeah, but we don't shy away from them." And Gartner would say that the rigors of the process have helped his company become much better at understanding its cost structure. It's smarter about sourcing products. And because the business possesses expertise in working with low margins, it has been able to expand its product mix to include items such as notebooks and paper cups.
All told, since Gartner Studios began competing in reverse auctions, production and shipping costs have fallen by more than 30 percent per truckload. Sales have increased to $60 million in 2006, up from $26 million in 2003. And profits are at 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."