Reverse Auctions

A supplier's survival guide.

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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."

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