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Maximizing Potential Benefits in Reverse Auctions

Written By: Noorani Subramanian Hariharan
Published On: August 31 2007

Imagine this: A consumer packaged goods (CPG) company has to source an intermediary product, the vendors for which are spread all over the world. This product has to be delivered to manufacturing locations across the globe and must conform to a specific level of quality. All this has to be done while ensuring that sourcing is performed at the best possible price and that input material is delivered to the processing units as per schedule.

For buyers, especially from the CPG industry, procurement cum logistical nightmares like these is fast becoming the norm. However, thanks to the advent of Web-based reverse-auction (RA) engines, the job has become much less complex. While RA has been active in the sourcing landscape since the 1990s, it is only now that CPG firms are aggressively targeting it as a strategic tool to capture inefficiencies in the sourcing cycle. This has resulted in RA continuing to gain greater acceptance. According to Purchasing.com, in 2003, only 15 percent of buyers reported using e-auctions, while the 2004 numbers show 27 percent of buyers using RA, and another 21 percent say they will use e-auctions in the near future. A 2007 Forrester report on the e-purchasing application market also predicts a compound annual growth rate (CAGR) of 6 percent for e-sourcing purchases through 2008.

Some of the key factors that are encouraging companies to implement RA as a sourcing tool are

  • ruthless competition and high pressure on margin, forcing companies to reduce their input costs in order to enhance cost of goods sold (COGS) and revenue ratio;
  • a trend of high inflation in commodity markets worldwide, making adoption of a sourcing system that can operate on a global scale and ensure accurate price determination imperative;
  • an increased focus on standardizing sourcing functions to reduce cost, time, and effort; and
  • a need for better transparency in the sourcing cycle.

If implemented properly, RA addresses the above factors, so it is no surprise that chief executive officers (CEOs) and chief procurement officers (CPOs) increasingly favor sourcing through auctions.

The RA Process

RA is an auction held online in which vendors, instead of negotiating with the buyer or strategic sourcing specialist, compete amongst themselves for supply of the auctioned input material. The logic is quite simple: Vendors start off with a preset initial bid price, and reduce their bids by multiples of the bid decrement value. The vendor with the lowest price at the closure of the auction is generally the order taker.

Prior to the auction "going live," necessary parameters, such as quantity on auction, designated date and time of auction, initial bid amount, bid decrement, payment terms, and delivery terms, are finalized and communicated to the participating vendors. More often than not, a pre-auction quotation is also requested.

RA Benefits

Prima facie (on first examination), the Web-enabled e-auction sourcing tool looks no different from the legacy system of closed bids and tenders, but a closer analysis will reveal that it has certain advantages for both buyers and vendors. Some of the most important ones are listed in Table 1.

Value Propositions of Reverse Auctions
For Buyers For Sellers
dynamic negotiations increased access to new customers on a global scale
increased effectiveness in request for quotation (RFQ) process certainty of volume and timing
transparency of the procurement cycle process transparency
minimal process cost equal opportunity for all sellers, regardless of distance
greater accuracy in price determination ability for sellers to set their own supply price
reduced cycle time from purchase requisition to processing unit or factory delivery  

Table 1. Advantages of RA for buyers and sellers (Infosys research, 2007)

The above is only a snapshot of the benefits that can accrue for organizations evolving from personalized, buyer-based sourcing to the automated negotiation space. The RA process can and is being applied to all varieties of spends, such as direct and indirect spends, services and maintenance spends, etc. This holds special importance for CPG companies, as typically 30 to 40 percent of their total spends fall under the indirect and services basket (Infosys research, 2007).

RA Challenges

While it is true that RA is increasingly being deployed across the CPG industry, it is also important to note that most companies are far from extracting the optimum potential benefit from the process. In some extreme cases, instead of improving the procurement process, deployment of RA has landed companies in serious supply and price risk.

Recently, a large Asian fast-moving consumer goods (FMCG) company conducted a series of auctions to sell its raw materials. While the pre-auction RFQ went off well, vendors refused to submit bids in the actual event. This was because the initial bid price was much lower than what the vendors had indicated in the RFQ. Eventually, the auction had to be cancelled and fresh quotations were invited which were, predictably, at much higher rates. Yet another Asian FMCG company found its cost savings quickly evaporate as the lead vendor (chosen on a least price basis) could not adhere to scheduled timelines.

Another vexing issue is the quantity to be auctioned. Based on the premise that higher volume results in lower bid prices and hence better savings, companies often put on the block more than what can be consumed in the auction lifetime. This, more often than not, results in disgruntled vendors that become wary of participating the next time. A preliminary analysis shows that typical implementation issues fall under four categories, as illustrated in Table 2.

Implementation Issue Category Description of Issues
price Initial bid prices are much less than what vendors quote in their RFQs.
volume Auctioned quantity is more than what is required.
vendor Supply is not delivered according to schedule and is deficient in quality.
time Timing and frequency of the auction are suboptimal.

Table 2. Typical issues in the implementation of RA (Infosys research, 2007)

From the authors' experience, it is clear that the problem here is not in the RA mechanism per se, but rather in the haphazard way RA is currently being deployed. In their haste to squeeze savings out of this new mechanism, organizations are implementing RA without doing prior homework. Important activities such as spend analysis, commodity profiling, contract management, and vendor-based analysis—all of which are crucial for the success of the auction process—are either being neglected or are being given a cursory once-over.

The above-mentioned analyses are essential, as performing them not only gives the buyer critical insight about when to administer and how to structure the auction, but such analyses also help the buyer to manage post-auction implementation issues. For example, contract management is usually limited to a purchase order, which just details the landed cost and the duration of the contract. "Exception" situations, such as supply risk due to an unnatural increase in the price of the auctioned item, are handled on an "as it happens" basis. There is no well laid out procedure for this. As a result, compliance becomes suspect whenever such unnatural price rises occur. Carrying this argument further, such deviations can occur in the quality of the input material being supplied as well as in meeting the delivery schedules. Again, these issues are usually open-ended and open to debate.

The most likely reason for not carrying out these vital preliminary activities when sourcing organizations through RA is that RA is being implemented as a quick fix to save money. The prevalent misconception seems to be that the RA process only entails setting up and administering the auction, and then awarding the contracts. Essential concomitant activities, such as fixing the appropriate time of the auction, gauging the supply market, analyzing the maturity level of the vendor base, and establishing a robust contract system, are being regarded as outside the ambit of the RA mechanism. The idée fixe is "Just administer the auction, and the savings will automatically flow."

A Framework for RA

RA is an information technology (IT)–led process enhancement initiative. Sustainable benefits, in the form of cost reduction and systems standardization, will accrue only if deployment of the initiative is in concordance with the broad sourcing landscape. RA, like any other system improvement initiative, requires a framework to yield optimum results. Thus, the need for a generic blueprint of "do's" can hardly be overemphasized. Figure 1 depicts a proposed framework and clearly highlights the additional functional elements over a typical RA process in order to enable a company to realize RA's full potential.

Figure 1. Current and proposed RA frameworks (Infosys Research, 2007)

Benefits of the Proposed Framework

Some of the common issues that purchasers have are in determining the quantity to be auctioned and in validating the accuracy of the initial price offered in the RFQ by vendors. Since savings depends heavily on the initial bid price and the decrements, more often than not, there is a persisting doubt about whether the auction is starting off at the correct price. If the vendors offer a greatly enhanced price at the RFQ stage only, then the auction is beginning with lost savings. The buyers therefore need a check against this. Spend visibility offers this check. As the buyer examines the historical consumption pattern of the item, the historical purchase price, trends of volume consumption, and price pattern become apparent to the buyer. This knowledge proves invaluable while setting up the auction quantity and deciding on the opening bid of the auction. Spend visibility also acts as an input to the vendor assessment exercise by validating the credibility level of the vendor. If, in the past, a vendor has had persistent problems with product quality or with meeting timelines, then the purchaser will consider this when awarding the final contracts.

Commodity profiling empowers the buyer with relevant information about the commodity, such as the scale and nature of the commodity landscape, for example. The buyer analyzes factors affecting the demand and supply of the commodity, and examines such issues as the effect on price if the demand and supply factors change. The benefits of commodity profiling are best illustrated in the timing and frequency of the auction. If the commodity to be auctioned is seasonal in supply, it would be better to administer the auction just when the fresh supply hits the market. At that point in time, one can logically assume that supply will be at its highest, and prices will be tapering off (that is, a buyers market).

More importantly, if the source material for the item to be auctioned is strained in supply, commodity profiling is essential. It allows the buyer to fix the auctions at those times when supply is relatively stable. The same logic also works for the demand side. If, on the basis of commodity profiling, the procurement specialist knows that there is a surge in demand of the base raw material, the auction can be timed appropriately.

Vendor base and selection of suppliers should be done while keeping in mind that although supply cost reduction is important, it is not the only parameter. While the basic premise of an auction is to obtain the maximum savings, it is not always prudent to award contracts just on the basis of least cost. For one, if the least cost supplier is unable to deliver, the buyer is in a fix (difficult situation). To select the next best vendor would entail restructuring the entire contract, which involves time, cost, and effort. Also, vendors, in their eagerness to capture as much of the supply market as possible, reduce bids indiscriminately. After the contracts are awarded, it then becomes an issue of manipulation of quality parameters.

This situation is especially prevalent with agricultural commodities, whose source base is small in geography and limited in time. It would be infinitely better for the procurement specialists to undertake a comprehensive vendor credibility exercise before awarding the contract. This could assume the shape of a vendor credibility matrix, in which vendors would be ranked not only on cost, but also on period of association and business stake in the organization, increase in supply value and volume over time, ratings for quality of supply, etc. Vendors could then be awarded contracts on the basis of a total cumulative score, and not just on the price offered in the auction.

This concept should be explained to the vendors before they participate in the auction, resulting in two direct and important benefits. The first is reduced risk of supply disruption. The second is that vendors will also bid responsibly, knowing that price is not the only criterion. In many cases this could mean lesser savings, but a more robust system—one that the buyer can depend on. Again, RA is not just about reducing costs; it is also about structuring the procurement process.

In the post auction phase, buyers should focus on implementing and managing the contract. This should be done as soon as possible after the auction, thus closing the cycle. What is most important is the details stipulated in the contracts. Not only should contracts be specific regarding quality and delivery schedule, but they should also detail all possible exception situations with respect to price, quality, or delivery schedules. An effective way of handling exception situations could be to introduce vendor penalty clauses into the contract to protect the buyer if supply is consistently failing quality parameters or delivery deadlines.

Similar clauses for the organization can also be incorporated if invoice processing and payments are not being made on time. Most importantly, provisions for discussion should be included if there is a sudden and unnatural increase in the price of the item in the open source market. Contract management, if applied correctly, clears the ambiguity between the two parties. Since the vendor clearly understands the situation, its trust in the buyer and the system increases. It has also been observed that if the price of the item increases sharply while the contract is in force, then a deadlock ensues between the vendor and the buyer regarding supply. This often occurs with long-winded contracts because purchase orders may not have the provisions for such an eventuality. A well laid out contract clears the ambiguity by detailing any such eventuality as well as provides a way out.

Conclusion

As companies scale up globally, managers are increasingly looking to their procurement divisions to fund their plans for expansion. In light of this, CPOs will need sophisticated, easy-to-implement IT sourcing solutions that not only give cost benefits on a sustainable basis, but that also impart structure and transparency to the purchase function. Given its basic business logic and sense, it would not be an exaggeration to state that RA is one of these sourcing solutions, and is therefore here to stay. RA is like any other system improvement measure; it is only as good as the results it delivers. Proper implementation, such as in the model suggested above, will ensure the delivery of optimum results on a sustainable basis.

About the Authors

Amitava is a consultant in the retail and CPG practice of the domain competency group, a consultancy division of Infosys Technologies Ltd. in Bangalore, India. He has over six years of procurement and sourcing experience in the CPG industry. Amitava's expertise lies in the spheres of strategic sourcing, procurement planning, and vendor and inventory management. He has a management degree from the Institute of Rural Management Anand (India). Amitava can be reached at amitava@infosys.com.

Noorani Subramanian Hariharan is a consultant in the retail and CPG practice of Infosys Technologies Ltd. in Bangalore, India. He has over four years of experience in brand and customer management with Titan Industries Ltd. Hariharan has a degree in management from the Indian Institute of Management. He can be reached at Hariharan_noorani@infosys.com

 

 

 

 

 

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