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Online Auctions Are Here To Stay

Distributors must use counter tactics and focus on renewal strategies to avoid becoming undifferentiated suppliers.

By Adam J. Fein

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Online reverse auctions will be an increasingly important tool for customers trying to make more rational sourcing decisions. This article reviews reverse auctions, explains their appeal to customers, and suggests strategies for distributors.

Reverse auctions represent a sourcing strategy many distributors will be forced to cope with in the coming years — a situation likely to upset many wholesale distribution executives. This conclusion comes from the new Facing the Forces of Change: The Road to Opportunity report (available from the National Association of Wholesaler-Distributors here.

Strategic sourcing is a process by which customers gather and use information about their own spending patterns to reduce purchasing costs. Strategic sourcing initiatives aim to counter the field-level sales and marketing efforts of wholesale distribution sales reps trying to influence local buying decisions.

Understanding reverse auctions

Reverse auctions are real-time price competitions between pre-qualified suppliers to win a customer’s business. These auctions occur over the Internet using specialized software. Bidders, who could be either distributors or suppliers to distributors, submit progressively lower priced bids during the scheduled auction time. Unlike a traditional auction in which prices are bid higher, the winner of a reverse auction is the company that submits the lowest bid.

While this sourcing tool has been around for less than 10 years, it has already gained widespread acceptance. According to our Facing the Forces of Change: The Road to Opportunity study, almost half of large buyers were already using reverse auctions by mid-2003. (See Figure 1) Most buyers put less than 5% of their spending through online reverse auctions, although some buyers use reverse auctions for up to 25% of their spending.

While few distributors have experienced reverse auctions, wholesale distribution executives in Facing the Forces of Change forecast future dramatic growth among their own customers. For example, 43% of distributors selling to industrial MRO buyers forecast that a majority of their customers will be using reverse auctions by 2008.

Reverse auctions are not just limited to commodity products. Distribution executives should recognize the diversity of products currently being sourced successfully using reverse auctions.

Buyers are applying reverse auctions to MRO products, direct OEM materials, capital goods and services. Here are a few examples of products or services that have been successfully sourced using reverse auctions:

• Made-to-order printed circuit boards for an electronics manufacturer
• Construction materials for a cell-phone transmission tower by a construction engineering company
• Packaging materials for a specialty chemical manufacturer
• Cylinders and valves for an industrial gas manufacturer

• There is a large and easily identifiable base of qualified distributors who chase the same business.
• Products or services can be translated into clearly defined attributes and unambiguous specifications in terms of technical, logistical and commercial requirements.
• The buyer’s costs for switching suppliers are less than the expected savings from the reverse auction.

However, we should point out that not all products or services will be appropriate for reverse auctions. For example, reverse auctions have been unsuccessful when there are three or fewer qualified distributors or suppliers.

Implications for distributors

Reverse auctions magnify the fundamental tension within all buyer-supplier relationships. The distributor’s revenue is ultimately the customer’s cost. All else being equal, price reductions to the buyer translate into lower profit margins for a distributor. Unsurprisingly, our research interviews revealed intense disdain for reverse auctions by wholesale distribution executives.

Distributors should recognize why reverse auctions appeal to buyers:

• Buyers are realizing average price reductions of 15%. Reported price reductions range from 5% to 90%.
• Buyers perceive reverse auctions to be a much faster way to get to the final, best price from a group of suppliers. Price “negotiations” occur during a one-hour online event. Even though buyers spend more time qualifying suppliers for participation, the time savings for price negotiations shorten the overall process.
• The sourcing and vendor selection process becomes much more transparent, reducing the influence of personal relationships and salesforce efforts.
• Reverse auction software is inexpensive to install and easy to use. In addition, auction functionality is increasingly included with business software systems, making it available on the desktops of individual buyers.
• The Internet provides a low-cost, easily accessible way to connect a buyer with multiple sellers.
• Spending analysis programs aggregate purchasing volume into quantities that make participation attractive to many bidders.

These factors make reverse auctions an ideal tool for buyers to exploit the current environment facing distributors. Many distributors are locked in a market battle, seeking to steal share from their peers even as the overall market shrinks. If customers are asked to switch suppliers without a compelling reason, their motivation will often default to price.

Shifting the focus of negotiations primarily to piece price limits a distributor’s ability to market or communicate differentiated services or value. Current auction technology allows the inclusion of non-product price factors such as warranties, delivery time and switching costs. However, these factors remain difficult to quantify and can be perceived by buyers to take the focus away from cost reduction.

Anticipating reverse auctions

Many distributors do not become aware of changes in purchasing behavior until their customers have reached the sourcing and contracting stage. Anticipating strategic sourcing practices by your customers will be crucial early warnings of reverse auctions, vendor reductions or national account contract programs. This can also help with the development of strategies to counter these initiatives.

Here are five risk factors that indicate a customer is a likely to use a strategic sourcing tool such as a reverse auction:

1. Your customer is a large, multi-location company, but buys from its wholesaler-distributors as if it is a collection of smaller unrelated locations.
2. Your local branch or company is able to deal directly with the buying decision maker in the customer’s local market.
3. The customer’s local buyer is loyal to your company because of personal relationships and the challenges of identifying new local suppliers.
4. National contracts are rarely enforced, leading to maverick buying as individuals, departments or even entire locations purchase off-contract without taking advantage of negotiated company price discounts.
5. You, as a regional or national wholesaler-distributor, have had the opportunity to charge varying prices based upon the specific competitive conditions in each local market.

Customers meeting all or most of these criteria may be among your most profitable accounts. Nevertheless, these factors signal substantial potential gains for the customer who turns to strategic sourcing. Forewarned is forearmed.

Countering reverse auctions

Reverse auctions put large volumes up for grabs, making it tempting to offer major price concessions without truly thinking through the implications for the customer. Accurate knowledge can give distributors the power to predict when a reverse auction will be unsuccessful.

Keep in mind that customers conduct extensive analyses of their own spending and product costs, but often neglect to focus on the costs of providing the services required by their individual locations. This knowledge gap creates an opportunity for distributors to counter auction sourcing initiatives with an independent understanding of their customers and their company’s economics.

In a case study from the new Facing the Forces of Change report, we talked to executives at a regional steel service center. These executives analyzed the causes of low profitability at a large customer, discovering excessive rush orders. When this customer decided to use a reverse auction, the executives at this service center chose not to pursue the account. They reasoned that the winner would be unable to provide the high service levels they usually offered. As the executives predicted, the customer selected a supplier offering a lower price but unacceptable service levels. In the end, the customer fired the auction winner and set up a new relationship with the original distributor.

The lesson here is that understanding your internal cost structure and the customer’s true service needs will be vital to properly responding to competitive sourcing environments. Activity-based costing (ABC) provides a fact-based look at how much it costs to sell, fulfill and provide service to your customers. ABC allows you to track internal costs and determine the breakeven price for your services.

ABC software programs can extract data from existing corporate systems to provide real-time analysis of costs and profits. Few distributors use these packages today, although we forecast that nearly two-thirds of distributors with revenues above $20 million will employ this technology by 2008.

The future of reverse auctions

Despite the growing momentum behind the reverse auction trend, there are three significant uncertainties that may limit the growth of this sourcing strategy:

• Reverse auctions undermine relationships with distribution suppliers. Research has shown that distributors who participate in a reverse auction feel exploited by the process and trust the buyer much less after the process is complete.
• Suppliers perceive reverse auctions to be a tool used solely to pressure incumbent suppliers to lower price. One study found that incumbent suppliers kept the business following a reverse auction, but at a lower price.
• Price reductions may not be sustainable over time because suppliers may underbid to keep or get the business. A distributor who wins a reverse auction may be unable to support the business profitably without reducing service levels, as was the case for the service center mentioned above.

While the economic recovery will somewhat lessen price pressures, wholesale distribution executives should not expect the reverse auction trend to slow down substantially. Looking forward, expect buyers to become increasingly sophisticated and constantly questioning the value of wholesale distribution.

Facing the Forces of Change: The Road to Opportunity highlights two approaches to strategic renewal for distributors:

• As customers shop for the lowest price and highest-value provider, products will become increasingly commoditized while customer service will become the true differentiator. But not all customers will want the same level of service with the same price sensitivity. Distributors have an opportunity to become suppliers of customized and differentiated relationships that provide products with related services instead of merely delivering acceptable goods.
• As traditional product margins shrink, many wholesaler-distributors plan to offer new services for a fee separate from product costs. Distributors will succeed by offering new services that directly improve the customer’s profitability and operations. Distributors can leverage existing relationships, build on traditional competencies, offer new value and get compensated appropriately for the value provided.
• Distributors must act now to reinvent their supplier relationships. Online auctions will force distributors to cut back on sales people and request more drop shipments to customers, undercutting the fundamental distribution role desired by manufacturers. If distributors do not take the lead, manufacturers will simply take more and more business direct.

By adopting these strategies, your company can successfully counter the impact of reverse auctions and seek out the new paths to profitability outlined in Facing the Forces of Change: The Road to Opportunity. Failing to strategically address reverse auctions will cause your company to struggle under ever tightening margins as an undifferentiated supplier of undervalued services.

© 2004 Pembroke Consulting, Inc. Adam J. Fein, Ph.D. is the founder and president of Pembroke Consulting, a firm that helps senior executives of wholesale distribution, manufacturing and B2B technology companies build and sustain market leadership. He can be reached at 215-523-5700 or on the web at PembrokeConsulting.com. This article is adapted from Facing the Forces of Change: The Road to Opportunity, available for purchase online here.