Turned On To Reverse Auctions

Purchasing – and selling – may never be the same. Gone are the days of the three-martini lunch to decide what you’re going to buy. Gone, the tedious 90-day RFPs with ever-shifting statements of requirement. Welcome to the brave, and lucrative, new world of e-procurement, and the ultimate e-purchasing tool, the reverse auction.

Reverse auctions are hot right now, and for good reason. Here’s how they work. You tell suppliers what you want and invite them to a secure Web site where they can submit a price quote over the Internet. They can see on their screens what competitors are bidding and they can bid as many times as they want. The auction lasts a finite period – as little as an hour – and when it’s over, the lowest bid wins.

Hydro One Networks, one of several spin-offs from the old Ontario Hydro, the one that manages the province’s power grid, is at the leading edge of the e-procurement wave. But Hydro, which has a total annual spend of $500 million spread over 3,000 suppliers, is one of few Canadian companies so far to take the plunge. It ran its first auction earlier this year using software from Ariba Inc. of Sunnyvale CA. It was a resounding success. Now Hydro is implementing the reverse auction technology, and approach, throughout the company.

CIO Christopher Booth and Director of Supply Management Dan Olsen, the business sponsor for the project, admit they put their reputations on the line to get e-procurement and the reverse auction pilot on the table. “It was tough to convince senior management,” Booth says. “They really took a leap of faith in the end.” Luckily for Booth and Olsen, it appears to be paying off.

The company chose the subject of its first reverse auction carefully. It was a commodity item, rebar, or concrete reinforcing steel, to be used in building a new link between Ontario and Quebec power grids. The engineers involved were skeptical of the reverse auction, but went along. The rebar they needed had a street value of about $300,000, they estimated. So this was a significant contract, bound to make suppliers sit up and take notice – one reason it was chosen for the experiment.

Hydro invited a handful of suppliers to participate, some new, some old. The auction was to last just an hour. Bidding would begin at $300,000. It started slowly. In fact, most of the hour saw extremely conservative bidding. “But then in the last two or three minutes,” Booth relates, “it got very interesting. At the end of the day, we got the terms and conditions we wanted – and a 37-percent discount on the price. We expected maybe five or ten per cent.”

Why Isn’t Everybody

Doing It?

It sounds impressive; it’s the kind of result that makes true believers. And there is plenty more anecdotal evidence, mostly from the U.S., to suggest reverse auctions often do coax low, low prices out of suppliers. Which raises the question, why then isn’t everybody doing this?

They will, predicts Donna Kinoshita, senior vice president and chief operating officer of Toronto-based e-procurement consulting firm eComm Strategies Inc. “It’s not a question of if, it’s a question of when. This will eventually become the de facto way of doing business,” Kinoshita says.

But it’s early days yet. Most companies haven’t even implemented first-generation e-procurement systems that automate purchasing management, she says. And many need to go back to basics and revamp business processes before they attempt to automate the function. The reverse auction, Kinoshita says, is second- or third-generation e-procurement, the logical end point in an evolutionary process that in most companies has barely begun.

“I suspect that in the next 12 to 18 months we’ll see this coming to the fore,” she says. “There’s always the buzz vendors create, and then the real market buzz. The real market buzz for reverse auctions is just starting now.”

Canada, as in most things related to e-business, lags the U.S., Kinoshita adds. In the U.S., some large organizations have already made auctions their de facto way of purchasing. Commerce One Inc., a Pleasanton CA vendor of e-procurement infrastructure products, says Daimler Chrysler this year conducted more than $3 billion U.S. in auctions at Covisint, an automotive industry online marketplace that uses Commerce One technology. That was in one week.

Pantellos Group, operator of an online marketplace catering to the utilities in-dustry, recently hosted $100 million in auctions, yielding 20 percent cost savings for buyers. And Enporion Inc., another provider of online e-procurement services for the gas and electricity industry, recently conducted auctions for products such as natural gas and compressors which Commerce One says yielded average cost savings of 10 to 20 per cent for participating buyers.

Two Auction Approaches

Companies can implement reverse auctions in basically two ways. They can buy e-procurement software from vendors such as Ariba, Oracle and others and install it on their own networks, managing the whole process in house – which is what Hydro One is doing. Hydro is specifically implementing the Dynamic Trading product, which integrates with other Ariba e-procurement modules it already has. The other way is to outsource to one of a variety of different types of service providers, including online marketplaces such as Enporion and Covisint, and auction specialists like Sorcity.com (www.sorcity.com).

Market watcher International Data Corp. (IDC) of Framingham MA says e-procurement software and services markets are both growing like gangbusters. According to IDC, e-procurement applications sales jumped by 167 per cent in 2000, and will grow to $9.7 billion in 2004. By comparison, they were $47 million

in 1997. The market for e-procurement-related services – which includes everything from consulting on implementation of software to outsourcing auctions – will grow to almost $13 billion by 2004.

The tantalizing prospect of getting rock-bottom prices may be the drivers for these hot markets now, but lower prices are by no means the only benefit – or even in some cases the most important, Olsen suggests – and the big savings may, in any case, not be sustainable.

“It’s certainly true that lots of companies have seen savings they could never have gotten without the reverse auction,” says Bob Barr, client services principle with IBM Canada Global Services. “It’s a new technique that will drive out a bunch of these examples in the short term. But over the long haul will it continue? I don’t think so.”

It’s Not All About Price

Barr led the multi-vendor team that implemented the basic Ariba e-procurement software at Hydro One and then set up the reverse auction pilot. Barr believes savings in the long term will be more modest. As he points out, the bottom line is that suppliers won’t sell below cost. Sometimes there may be situations –

a supplier is overstocked, for example – in which deep discounts are more likely with a reverse auction than otherwise. But it won’t happen every time.

Olsen agrees. In fact, he won’t even hazaard a guess at the average cost savings Hydro One might expect using reverse auctions. He’s wary of the whole emphasis on price reductions because it implies the only or main reason Hydro decided to use reverse auctions was to “grind” suppliers’ prices down. It’s a perception he has worked hard to change. “There is no value to us in squeezing suppliers to the point that they would not participate,” Olsen argues. “If we drive prices down to the point where there’s a single source or a couple, that’s not a competitive environment anymore.”

He admits that when Hydro first broached the idea of a reverse auction with the rebar suppliers, many resisted. “The first sessions we held with them tended to be very confrontational,” Olsen admits. “They said, ‘You’re really just

trying to squeeze us some more.'” But as he took them through the process and pointed out that there were some benefits to them as well – they would have more than one chance to bid (“more than one kick at the cat,” as Booth puts it), they would still have complete control over their prices and they wouldn’t have to guess whether they’d left too much on the table – suppliers began to come around.

“The more they thought about it,” Olsen says, “the more they warmed up to the idea. In the end, all of them indicated they would participate again, which surprised me a little. I thought the unsuccessful bidders wouldn’t be interested.”

A Word From The Winner

The company that won the rebar auction, Omer Steel Ltd. of Bolton, just north

of Toronto, was one that initially had reservations about the auction process,

although general manager and principal Pat Kilkenny claims they were more concerned about security and getting technical support if anything broke down in the midst of the auction. “Anything that’s new, people have a hard time

accepting at first,” Kilkenny says, treading warily. “But we could certainly see

it would be very beneficial for them to proceed with it.”

The fact is suppliers like Omer don’t have much choice but to accept reverse auctions as a way of life. Omer had even less choice on this one. A relatively small company, it had never supplied Hydro One before. To decline to participate when invited would likely have closed the door. Kilkenny implies that part of the reason the company bid as low as it did was to ensure it got a foot in that door.

Was that part of Hydro’s calculation? Probably, but Olsen points to other factors that weigh in the auction approach. “What we’re attempting to do with reverse auctions,” he says, “is move beyond the traditional closed-bid process that has predominated at Hydro to one that is esentially leveraging the technology more effectively so we can ensure we’re truly reducing the total cost of ownership of goods and services.”

This may sound like corporate-speak, but Olsen is simply pointing out that there are factors other than price that determine the cost of acquiring and using goods – quality, delivery time, lead time, payment terms, and so on. Reverse auctions let buyers elicit commitments on these other “attributes” as well as on price.

The software lets them establish several quantifiable attributes on which

suppliers bid. They don’t just bid a price. Each attribute is weighted to calculate

the final value of the bid. Suppliers understand the weighting going in. So even if price is not an issue at all – if suppliers have virtually no room to move on price and all come in about the same – reverse auctions will still pay dividends.

And some attributes – a shorter lead time to delivery that would reduce the buyer’s inventory costs – might turn out to be more important to the total cost than price. “It might sound heretical,” Olsen says. “But we may be willing to pay a higher unit cost in some cases – for example, because the supplier offered a better warranty. A lot of suppliers have difficulty accepting that this is really what we’re doing today.”

As much as there are other factors besides price, clearly price is still important, though. “I’d be lying if I said it wasn’t,” Olsen concedes. Booth says the company expects direct savings of 5 to 10 percent across the board from reverse auctions. And certainly the object of the exercise is to reduce costs one way or another. In fact, Booth estimates that eventually the whole e-procurement project, of which reverse auctions are only the most visible and dramatic part, will save the company $11 million a year.

Nor does Olsen pretend reverse auctions aren’t a tough pill for suppliers to swallow. He admits their acquiescence may be forced. And for many long-term Hydro suppliers, it’s even tougher, he notes. They have really not had to contend with competition at all. Now for the first time they will have to butt heads in reverse auctions with other suppliers, some of them newcomers.

“The new kids on the block are really causing some angst among long-standing suppliers,” Olsen concedes. “But that’s not entirely a bad thing – not from my point of view.”

The Time-savings Factor

There is another huge benefit to reverse auctions. They save time and also compress the whole procurement process – cutting elapsed time in half, Olsen estimates. He manages a group of purchasing professionals whose job is to work with business managers to ensure the best

possible total cost of ownership on every purchase. This requires analysis and

intelligence. In a typical year, his people find the time to focus on perhaps $170 million of the total annual spend.

“If we could more efficiently work through the entire $500-million spend, leveraging all the opportunities to save, clearly we’d be further ahead,” Olsen says. “Using reverse auctions will free up time and allow us to constantly look for situations where market conditions are such that supply is greater than demand. So it’s like the old adage says, time is money.

And the more time it takes us to work through a deal, do the analysis, perform the search to find the right suppliers, etc., the longer it takes us to get the benefits.”

While there is a huge time saving, reverse auctions don’t – or certainly shouldn’t – happen overnight. They demand a different approach. There is more work at the front end now to ensure there is no ambiguity about what suppliers are bidding on. “We’re really changing the focus of what contract engineers work on,” Olsen says. Which is perhaps as it should be. Reverse auctions definitely force discipline, Booth and Olsen both say.

But can reverse auctions work for any product or service? Not any, Olsen concedes, but “at least half” of what Hydro buys. Engineered-to-order parts may be tough to auction, he says, but then adds, “Even there, if everyone were bidding against that same spec, you might still be able to create an auction environment that would be successful.

Consulting Services Auction

Booth is gung-ho to try reverse auctioning management consulting services. Consulting services can be reduced to quantifiable terms – hourly rates for a given class of professional. And many consulting firms have employees “on the bench”, Booth points out. So they may be willing to reduce rates in an auction environment to get the business. Not that price is everything, of course.

Olsen says auctioning consulting services is probably pushing the envelope,

but concedes it might work. Whether or not it tries this technique on consulting services, Hydro will be in experimental mode at first, Booth says. “Sure, a reverse auction works easier for a commodity item. But that doesn’t mean we can’t test the bounds for this. And we may have some wins and we may have some

failures.”

He’s also keen to try auctioning cellular phone minutes. While he is looking forward to sourcing some IT-related items via reverse auction, including hardware, using it for seemingly obvious items such as laptop computers may be more complicated than it appears because of the long-term support contracts that are part of purchase agreements. “That kind of auction is something we might do once every two or three years when we make a strategic decision to change vendors,” Booth says.

Hydro One Powers Up

Auction Capability

The first rebar auction was conducted using Ariba and IBM facilities. Now Hydro One has installed Dynamic Trading on its own systems. It was a rush project

that saw the vendor partners do the implementation in just 67 days. Hydro One was expecting to begin widespread use of reverse auctioning in June, starting with large concrete and structural steel orders.

The entire e-procurement project, which began early last year, is costing the company between $5 and $6 million, Booth says. The additional cost of implementing the reverse auction software had not been finalized at the time of writing, but would be less than $500,000.

Hydro One rejected the notion of using outsourcers to run auctions for it for a couple of reasons, Olsen says. Transaction fees charged by some were pro-hibitive, especially in situations where margins are tight. Also, having the facility in-house means everybody in the organization can use it at any time. Olsen believes purchasers will be more likely to use the tool creatively if they have it in-house.

Hydro chose Ariba and IBM for several reasons, one of them being price. “They were hungry,” Booth says. “But they also took the time to understand our needs

and then they put a package together that fulfilled them. And at the end of the day they delivered on time and on budget.”

The fact that Ariba and IBM also had what Hydro considered the right philo-sophy about reverse auctions made it easier. The right philosophy is basically that suppliers’ interests must be taken into consideration for reverse auctioning to be successful in the long term. It’s an overriding concern for Olsen and Booth both. Ask them what the potential pitfalls are in implementing a reverse auction system and strategy and they repeat the same mantras.

“It’s very easy to get almost mesmerized by the types of price reductions you might see, and end up focusing exclusively on price,” Olsen says. And, “You have to include suppliers in the process” to be successful.

Is reverse auctioning the holy grail of purchasing? Maybe. But probably not for the reasons that most prospective users are thinking today – that is, price, price, price. And speaking of price, the price of software systems will have to come way down before any but the biggest spenders are likely to take the plunge.

Here’s a thought. Maybe somebody should try running a reverse auction to acquire reverse auction software.

Gerry Blackwell is a freelance writer specializing in information technology

and IT management. He is based in London, Ont.