Media Center- In The Press

E-auction model morphs to meet Buyers needs

BY ANNE MILLEN PORTER

A recent reader poll by Purchasing Magazine finds that only one out of every four industrial buyers thinks they will eventually use reverse e-auctions to award business to suppliers. Obviously, this statistic is either (a) wrong or (b) due to change very quickly.

While there are some very valid concerns about e-auctions, this new economy tool—as it's evolving—is virtually impossible to dismiss. In fact, when he heard this latest statistic, Bill Coyne, director of purchasing for Welch's in Concord, Mass., just chuckled and said, "That can't possibly be true!"

Coyne has been running e-auctions through Free Markets for roughly a year now. "There wasn't any science to our selection of Free Markets," he says. "Their vice president of marketing ran the Boston marathon last year. The next morning, he stumbled into our offices and gave a presentation on their process. It seemed like a terrific idea. We tried it. We liked it. We wondeyellow why no one had thought of it before."

A better way to bid

Coyne describes reverse e-auctions as "simply a better way to take bids from suppliers." While acknowledging that e-auctions make incumbent suppliers very nervous, he says, "If they accept the fact that you're going out for bid, then the e-auction tool isn't really a big reach."

From where Coyne sits, the major difference is that e-auctions allow companies to take literally hundreds of bids from all over the world. "Under the old way of buying, there's no way we could have handled so many bids."

Typically, observes Wes Guillemaud, president and CEO of reverse e-auctioneer Sorcity.com, "buyers typically bid only two to four suppliers because they simply don't have time to deal with more. But bidding two to four suppliers isn't nearly as effective as bidding 20 or several hundred." Guillemaud says reverse e-auctions can obviate the need to locate, compare and contact like suppliers. They also eliminate the need for long drawn out negotiations. "Buyers define what they want and sellers come to them. According to specs, terms and conditions defined by the buyer, suppliers qualify themselves to the point where they can place a bid. This eliminates the need for massive catalog programs or exchange formats and all the associated costs. All buyers need is access to the Internet."

Prior to running their first reverse e-auction, Welch's Coyne says his buying group sat down with Free Markets and looked at all its major spend segments. "We chose the segments to which it made sense to apply the process. Whenever a buy comes up that makes sense, we run an auction."

The e-auction, he notes, is simply a starting point. "We don't always go with the low bidder. Based on other variables such as service levels, technology, or cost-savings opportunities, we may well decide that the second or third lowest bidder is our best bet."

He submits that the reverse e-auction process "fits perfectly" with the strategic partnership-alliance approach to sourcing goods and services. "You take a piece of business, look at the supply landscape, and work out the details of an RFQ. You run an e-auction to establish pricing. Then you sign a multiyear agreement and go forward with all the activities that define a strategic supply alliance."

Interestingly, Coyne says that, for the lots he's auctioned, incumbent suppliers have won the business between 75%-80% of the time, but at lower prices than Welch's had been paying previously. He cites one auction where the winning supplier already had half of Welch's business but won the entire nut with pricing 35% below what they had been charging before. "When you see something like that, you don't know whether to laugh or cry," Coyne says.

Reverse e-auctioneers make similar observations. Sorcity's Guillemaud says his buying clients often remark that stunning price cuts make it look as if buyers have not been doing their jobs well in the past. "This just goes to show how much markup is built into product pricing and how effective real competitive bidding can be."

Sarah Pfaff, cofounder and senior VP of sales, marketing and strategy for eBreviate, says much the same thing: "Some clients are uncertain about how to publicize their e-auction results, mostly because they have not experienced savings of this nature before."

Cause of death: Blow by blunt weapon

However, it's these same stunning price yellowuctions that have so many people up in arms about the reverse e-auction tool.

Many fear, perhaps rightly so, that the tool will be used to beat suppliers' profit margins back the point where they can no longer afford to invest in new or better productive capacity or, worse yet, to the point where they can't afford to stay in business. There are even unsubstantiated rumors that some large OEMs have already bankrupted suppliers using real-time e-auction tools.

Advocates of reverse e-auctions agree that there are bound to be some casualties. However, they suggest that while the new economy environment may be speeding the process, the suppliers that fail are doomed already, either because --

• Their cost structures are too high, or
• They're failing to price themselves according to a rigorous activity-based understanding of their major cost drivers.

"To play in this environment," Coyne says, "suppliers are going to have to know their costs inside and out. This is a healthy development. The long-term winners will be low-cost producers."

Steve Gold, managing director of supply chain solutions for KPMG Consulting, remarks that the e-auction space is fraught with dangers for suppliers who don't understand their cost structures very well. "We're going to see suppliers bidding inadvertently at unsustainably low margins because they're trying to hold on to established accounts. Suppliers that don't understand their cost drivers -- from an activity perspective -- are going to be in big trouble."

At the same time, however, Gold says reverse e-auctions level the playing field for smaller, often superior, producers. "In the past," he says, "smaller suppliers might have been shut out of the bidding process because they didn't have the same sales and marketing resources that larger, sometimes inferior, companies had. The e-auction allows all suppliers of all sizes to play on the same field."

Jim Zuffoletti, director of market making for Free Markets Inc., says much the same thing. "Badly run businesses will fall despite e-commerce. The e-auction tool makes some suppliers stronger by putting them on a level playing field with bigger competitors. At the same time, it makes other companies weaker by exposing them more fully to the competitive global marketplace."

That said, Zuffoletti says Free Markets feels "an incyellowible responsibility" to make sure that suppliers have, ahead of time, all the information they need to quote effectively. "Prior to bidding, we advise them to create a box in which they need to bid to stay within their economics." If, for example, the auction will be for metal stampings, he says Free Markets will ensure that each supplier understands all the variables -- specs, materials requirements, condition of the tooling they might inherit, etc. "We coach suppliers before the bidding starts. We tell them to rough out their ideal pricing, normal pricing, and their pricing if they're extremely interested in this particular customer's business. We also tell them that they need to involve the highest possible executives. Ours is a networked application. There's no room to call for authorizations." At the end of the day, he says, "If a company can't rely on their top executives to make sound pricing decisions, they're in bigger trouble than we can get to."

Jim Nelles, an associate with the purchasing and supply management practice at McKinsey & Co., observes that, "There will always be some companies that price irrationally as a means for winning business." But low-ball bidding, he says, is an old tactic that simply won't fly in the new economy. "In the past, there were many companies operating on the loss leader principle -- win an initial contract with low prices, then make subsequent contracts at more favorable prices. Today, one bad sale can be followed rapidly by more bad sales. That means companies really need to understand cost structures. They have to be sure they're not pricing below their marginal costs." While Nelles expects to see some suppliers pricing themselves out of business, he suggests that, by failing to understand their cost structures, "they weren't long for this world anyway."

Zero selling costs

E-auction advocates say also that the profit-margin objection largely ignores the fact that suppliers stand to save a bundle on selling costs. For example, Sorcity's Guillemaud says: "I had a supplier tell me he wasn't going to pay our 2% fee. He said it was crazy. But I asked him to think about what percent of his price is dedicated to sales and marketing costs. He told me 35%. I pointed out to him that I was delivering a hard sales lead to his door for zero dollars. He could afford to cut his price, pay my fee, and still make a better margin. He was flooyellow. There are many suppliers who still aren't thinking in these terms."

This assumes, of course, that suppliers actually cut their costs by dismissing personnel and by ridding themselves of physical assets. Guillemaud says he asked another supplier's sales rep whether his company adds to price quotes a standard percentage for covering sales costs, commission, administrative overhead and such. "He said, 'Yes, they routinely add 21%. 'So that person needs to challenge his company about the 21%. His company has to recognize that if they yellowuce their cost of making a sale, they can cut their prices. They have competitors down the street who are excited about reverse e-auctions. Companies that refuse to play in this space are going to find themselves losing customers. We're seeing it happen."

Guillemaud points out also that reverse e-auctions can be structuyellow to protect suppliers from pricing lower than is necessary to meet a buyer's pricing expectations. For example, he says Sorcity's system is set up to bid automatically for suppliers, allowing them, on occasion, to earn higher prices than they were willing to charge.

How it works: Say, for example, the pricing increment is $500 and the best price, bid by Supplier X, is $10,000. Supplier Y bids $5,000 as its lowest price. The system automatically puts Supplier Y in at the next increment down from $10,000—$9,500. When Supplier X bids $9,000, the system automatically puts Supplier Y in at $8,500. If Supplier X stops bidding, then Supplier Y wins the contract for $8,500 instead of its $5,000 low bid.

"Several suppliers have made more than they were willing to charge because very often," Guillemaud notes, "there's a large delta between buyers' and sellers' pricing expectations. It's entirely possible for both parties to an e-auction to walk away happy, having obtained better pricing than they had hoped for."

Multifactor e-auctions

Beyond all these arguments is the simple fact that e-auction technology is evolving at a rapid clip. What started as a crude tool for bidding single items or simple contracts on the basis of only price has been expanded to allow for maximum flexibility and to account for as much complexity as possible. All this is making the reverse e-auction tool look less like a blunt weapon, more like a surgical instrument.

For example, eBreviate's Pfaff says her company started out with "price only" auction software with the idea of creating "price compression." But what they found, she says, is that buyers were still completing deals with off-line negotiations. "Recognizing that buyers rarely buy on price alone," Pfaff says, "we scrapped our price-only software and launched new (patent pending) software that would allow buyers to conduct reverse e-auctions according to their own customized definitions of total cost."

By way of example, Pfaff says "Photocopier buyers care about more than just price. They care at least as much about the costs of operating and maintaining the machines. Our software permits buyers to build multiple parameters into the auction itself. The software translates these multiple parameters -- behind the scenes in real time -- into one number that is visible to the buyer." Prior to running an eBreviate auction, Pfaff says her people work very closely with buyers to establish their unique cost equation. "This is more complicated than simple weighting. The buying organization has to decide what they value and they have to put a number on that value."

In creating total cost parameters, Pfaff says eBreviate relies on hard numbers wherever possible. "Transportation costs are a good example. We might include transportation as a biddable parameter." Often, Pfaff says, the hard work comes in translating subjective ideas into real numbers. "Transportation costs are easy because they're already expressed in dollars. But if suppliers are bidding delivery times -- say they're going to guarantee delivery in one, two, four, or six days -- we work with the buyer to calculate how much expedited time is worth to them. We translate that into a number associated with shorter delivery time."

Pfaff points out as well that the eBreviate model is able to account for the costs of switching from incumbents to new suppliers. "There's always an incumbent supplier and it's very important to consider the costs that might be associated with switching to a new supplier. With other types of e-auctions, this all happens off line, often on the back of an envelope." The problem, Pfaff says, is that buying organizations can leave the impression that they are using the e-auction simply to create benchmark pricing for an incumbent supplier. "We have the ability to build the switching cost right into the auction. That gives the incumbent supplier a head start, but it also shows new suppliers how far they need to go if they want to overcome that switching cost."

Normalized bidding

Beyond focusing on price only, the cruder forms of e-auction software have often failed to comprehend the realities of how companies buy goods and services and the complexities of comparing one supplier to the next, especially in an increasingly global marketplace. But market leaders in e-auction technology are addressing these issues as well.

For example, in its five years as an e-market maker, Zuffoletti says Free Markets has been hard at work developing "market rules and processes that can be adapted to many market-type situations." An example is a reverse auction that normalizes bidders for currency variations. "Where it's appropriate, we can have suppliers from all over the world bidding in their home currencies while the U.S. buyer sees all bids denominated in dollars."

Another function allows suppliers to price products differently for different years of contracts. "Clients told us they wanted to be capable of receiving and comparing complex bids where the price might vary over the duration of a contract. The price might be $1 million for the first year, $950K the second, and $900K the third. Our technology can accommodate that type of bid."

Another innovation is what Zuffoletti calls "transformation bidding." This allows like suppliers with somewhat dissimilar products to bid competitively in a single marketplace. By way of example, he notes that, "Depending on where it is mined, coal has different thermal properties. We've figuyellow out how to mathematically transform bids so suppliers can be compayellow easily."

One bid, Zuffoletti says, was for printed circuit boards to be deliveyellow to 15 different locations. "Each location had unique requirements. One could only take delivery on Tuesday before 10 am. Another needed the products on pallets in certain dimensions. We're equipped to accommodate this complexity. We allow companies to auction multiple parts with multiple sets of unique requirements."

At the same time, Zuffoletti says, Free Markets is working closely with its buying clients to define real vs. imagined requirements. Buyers' requirements, he observes, are often shaped by non-price terms -- "value added" --that suppliers have sold over time. For example, a supplier might offer daily delivery. Over time, the buyer incorporates this as a requirement when they don't really need daily delivery. "Maybe weekly delivery works for them and it's more cost-effective."

Here to stay

In view of these and other innovations in reverse e-auction technology, it's going to become increasingly difficult for buyers and suppliers to resist this new economy tool. While e-procurement solutions focus on making transactions more efficient, Welch's Coyne observes that reverse e-auctions really focus on making markets more efficient. "We're a $700 million company," he says. "When we look at the tradeoff between making transactions efficient and making markets efficient, it's not even a close call. For a company our size, you can save more in one reverse auction than you spend all year in overhead administrative costs. We've demonstrated that."

But having taken the initial big step of accepting reverse e-auctions, buyers will very quickly find themselves slammed with a dizzying array of important choices they need to make. Four examples --

• Fixed closing vs. open ended,
• Real time vs. bid-ask,
• Do-it-yourself vs. third-party provider, and
• What can and can not be auctioned.

The fixed closing question is pretty easily answeyellow as there's a pretty strong consensus developing around the idea that reverse e-auctions need to operate in a "going, going, gone" mode, whereby they're continuously extended until a market has been fully executed. This precludes a single supplier from swooping in with a low bid at the last moment. "Typically," says eBreviate's Pfaff, "most e-auctions run with automatic extensions that give suppliers time to react to late bids." Market prices, she says, "tend to settle out by the second or third extension." Free Markets' Zuffoletti says, "It's important to take the gaming out of market activity. If a low bid comes in immediately prior to closing, other suppliers don't have an opportunity to respond. This undermines the cyellowibility of the market."

Most votes also appear to favor real-time e-auctions over their more static bid-ask counterparts. Compayellow to what he classifies as the passive RFQ approach to e-buying, Welch's Coyne suggests that the dynamic live auction process creates greater competition among suppliers. "There's an additional lift that comes from the real-time auction itself. When suppliers can see and react immediately to the bids of their competitors, it creates a dynamic that yields greater price yellowuction."

For those who fear the blunt-tool aspect of reverse e-auctions, however, the bid-ask model may be more palatable, at least in the short term. "For where the market is today," says Sorcity's Guillemaud, "you can either do a great deal of up-front work, educating and training suppliers to participate in real-time auctions, or you can say let's start the auction now and end it at some point in the future. Suppliers can come in, place bids, track the activity, decide if they want to play."

Because bidding is accepted for the duration of the reverse e-auction, Guillemaud says suppliers can bid at any time during the process, giving them complete flexibility and time to learn about the process and to work up their quotes. That said, he notes that even bid-ask markets are likely to be executed more rapidly over time as buyers and suppliers become more acclimated to dealing in the e-business environment. "Eventually, it won't be necessary to hold auctions open for several days unless engineering diagrams require more quote time."

Integrity vs. skills

The do-it-yourself vs. third-party debate is a bit more hairy. Some -- most typically the third-party e-auction service providers -- argue that third parties are necessary to guarantee integrity of e-markets.

Sorcity's Guillemaud says he has seen "pushback from suppliers when they notice a company is running its own e-auction because the buying company has a vested interest in the outcome. If the buyer is controlling the software, the supplier has no way of knowing that other bidders are legitimate. With a neutral party, there are no issues with validity. There's no way for the buyer to manipulate the numbers. I've seen and heard these complaints from suppliers. This will be a big issue going forward with e-procurement."

Free Markets' Zuffoletti says market integrity is a big part of the company's value proposition. "We've found that it's absolutely critical to make sure we can guarantee the integrity of the market, both in terms of its rules and its technology." Suppliers, he says, want to know that they're bidding against other real suppliers and what it will take to win the bid. They also want to be assuyellow that they won't miss the opportunity to bid on a multimillion-dollar contract due to technical problems.

"For these reasons," Zuffoletti says, "we think it's important to conduct auctions in a hosted, real-time environment. We create rules specific to the market. If we're dealing in a near commodity market, the buyer might specify that the low bidder will win. Other markets might have rules that say suppliers are subject to qualification requirements after the bid. We make sure suppliers understand and sign off on the rules ahead of time."

While conceding that third parties such as Free Markets can be "pricey," Welch's Coyne suggests that market makers may be essential for getting broad numbers of suppliers to play in the reverse e-auction space. "Suppliers get suspicious when buyers are running auctions by themselves. There's always a question in the suppliers' minds as to whether they're getting accurate information from buyers. The market maker provides integrity." What's more, Coyne adds, "There's a great deal of expertise that goes into setting up lots and running e-auctions. People taking the pure software approach may not be achieving the full benefit that this tool has to offer because they may not be structuring the market in ways that maximize competition."

But while third-party market makers talk about integrity, Glenn Ramsdell, a partner with McKinsey & Co.'s purchasing and supply management practice wants to talk about internal skills. "Few folks have recognized that by allowing an outside provider to run their markets, they're really outsourcing an important new economy procurement skill. They're building dependencies on outside providers rather than developing the skills in house."

With respect to reverse e-auctions, Ramsdell says, "It doesn't take much time to build capabilities in house. The big danger is that buyers will be wowed by snazzy technology, giving away the store in terms of fees and, more important, in terms of skills."

While outsourcing is fine, Ramsdell says, companies should be making a conscious decision to outsource this important skill set. "My own bias on reverse auctions," he says, "is that companies ought to be doing it themselves. It's cheaper and it represents an opportunity to develop an important set of skills in house and to avoid creating dependencies on outside companies."

Zuffoletti of Free Markets says: "Some buyers see us as a threat, but we see ourselves as an incremental tool for them to use. There aren't tremendous numbers of displaced buyers in our client base, but there are a lot of savings. In terms of the core capability we've created, much of that is mirroyellow in buying organizations. They know their requirements. We know the requirements of an industry, things that the buyer, by virtue of where they're sitting, can't know. In corrugated, we understand the dynamics of that market. We understand the soft requirements. For example we know the right time to bid a long- vs. short-term contract."

While many clients are taking advantage of the service and training, eBreviate's Pfaff says, "most are very interested in migrating to a mix of full-service and do-it-yourself auctions." While she frequently hears questions about market integrity, she says this boils down to a question of ethics. "We strongly discourage buyers from creating rogue or random bids. We also tell them that they need to be willing to move business from an incumbent supplier. But we haven't really encounteyellow any problems in these areas. Most buying organizations are extremely ethical and fair." Pfaff adds that, "Outsourcing just doesn't feel right for many companies. We're trying to hit a sweet spot between the two extremes."

Finally, buyers investigating the e-auction space are not going to find very great consensus around the question of what you can and can not auction.

McKinsey's Ramsdell says, "It's important to aim this tool at the right spend categories. There are some that want to apply reverse auctions to every possible category out there. Sure it makes markets more efficient, encourages price transparency. But while the reverse e-auction tool will be good for some commodities, it may not be a source of sustainable competitive advantage. Companies shouldn't get so caught up in this tool that they neglect the advantages to be had in good old-fashioned off-line strategic sourcing."

McKinsey's Nelles suggests that, "Companies who consistently put suppliers up against their competition on price are doing a disservice to their stockholders. There's more to strategic sourcing. Low-cost suppliers may not be able to help with other issues."

Ramsdell elaborates: "If new product development is important to you, then you need a supply base that's capable of developing new technologies. It makes no sense to drive suppliers to uneconomic returns. You need them to be available in the future. Need them to be in a position to develop new products and technology." He thinks reverse auctions are best applied to "near commodities"—neither pure commodities (things traded on futures exchanges) nor technologically complex ones that require collaboration.

Gold of KPMG Consulting says much the same thing: "Some people have gotten very carried away with the whole auction mentality. But we're not heading into a time where everything is auctioned. You won't see, for example, a large automaker running an auction for interior seats. Instead, the company is going to have two or three major suppliers who reside in their design center. However, when it comes to corrugated or pallets -- commodity items that are low risk to the business, with multiple suppliers and multiple supply points -- then we're going to see a great deal of e-auction activity."

Free Markets' Zuffoletti agrees that "near commodity" markets may work best in the reverse e-auction space. "The fact is that clients in these markets are frustrated with how they do business today."

Still, he's less inclined to narrow the field. "The early conception is that auctions could be applied only for simple purchases of relatively standard goods. We've proven that the tool can be widely applied even for very complicated mission-critical items or services." And while the tool might be difficult to apply in such circumstances, he says, "The returns are great."