Maximizing Potential Benefits in Reverse Auction

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Maximizing Potential Benefits in Reverse Auction:
A Framework




Contents

Abstract

It is a well known fact, that Consumer packaged goods (CPG) companies are aggressively pursuing cost efficiencies in their sourcing programs. In line with this, over the last few years, there has been widespread implementation of Reverse Auction (RA) and other forms of auctions such as Dutch auction as strategic sourcing tools. However realizing maximum potential of these mechanisms still eludes the majority in the industry. This paper presents a framework to structure the RA process and gain maximum mileage out of the initiative.

Introduction

Imagine this – a consumer product & goods major 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 done at the best possible price and 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” engines, the job has become much less complex. While, RA has been active in the sourcing landscape since the 1990’s, 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. In 2003, only 15%1 of buyers reported using e-auctions while the 2004 numbers show 27% of buyers using RA and another 21% say they will use e-auctions in the near future. Forrester report also predicts a CAGR of 6%2 for e-Sourcing purchases through 2008.

Some of the key factors that are encouraging companies to implement Reverse Auction 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)/Revenue ratio.
  • Trend of high inflation in commodity markets world wide makes it imperative to adopt a sourcing system that can operate on a global scale and ensure accurate price determination.
  • Increased focus on standardizing sourcing function primarily to reduce cost, time and effort.
  • Need felt for better transparency in the sourcing cycle

Given the fact that RA, if implemented properly addresses the above factors, it is no surprise that CEO’S and CPO’s increasingly favor sourcing through auctions.

Reverse Auction Process

RA is an auction held online in which vendors, instead of negotiating with the buyer/ 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 like quantity on auction, designated date and time of auction , initial bid amount, bid decrement, payment terms , delivery terms are finalized and communicated to the participating vendors . More often than not, a pre auction quotation is also requested.

In Dutch auctions, although the underlying logic is the same, the auction mechanism is reversed. The auctioneer, (usually a CPG company) begins with a high asking price which is gradually lowered until; some participant (vendor) is willing to accept the auctioneer’s price. The winning participant accepts the contract on the last announced price. There is a prefixed base price, below which the auctioneer will not award contracts. Dutch auctions have been known to give extensive benefits when deployed in a sellers market .

Online Auction Benefits- Reverse auction and Dutch auction

Prima facie, these web enabled auction sourcing tools look no different from the legacy system of closed bids/tenders, but a closer analysis will reveal that they have certain unique advantages for both buyers and vendors. Some of the most important ones are listed below

Table 1 - Advantages of RA & DA for Buyers & Sellers (Infosys Industry Analysis)
Value Proposition of RA
Buyers Sellers
Dynamic Negotiations Increased reach- Access to New Customers on a global scale
Increased effectiveness in RFQ process Certainty of Volume and timing
Transparency of the procurement cycle Process transparency
Minimal Process cost Equal opportunity for all vendors regardless of distance
Greater Accuracy in price determination Vendors set their own supply price
From requisition to delivery- cycle time compressed

The above is only a snapshot of the benefits that can accrue to organizations evolving from personalized, buyer based sourcing to the automated negotiation space. What really clinches the argument is the fact that these auction mechanisms can be applied to all varieties of spends such as Direct & Indirect spends, Services & Maintenance spends etc. This holds special importance for CPG companies as, typically 30- 40% of their total spends fall under the indirect and services basket. (Infosys Industry Analysis)

Challenges in implementing online auctions- Reverse Auctions and Dutch Auctions

While it is true that both forms of online auctions are being increasingly 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 either RA or DA has landed companies in serious supply and price risk.

Quite recently, a large Asian FMCG major conducted a series of auctions for its raw materials. While the Pre-auction Request for Quotation (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 they 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 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 life time. This, more often than not results in disgruntled vendors, who are wary of participating the next time.

One of the most important challenges that arise out of the reverse auction mechanism is contract management. After the auction has been implemented, vendors frequently find ways and means to wriggle out of the contract, especially when the terms of the contract are unfavorable to the vendors. The marketable surplus quantity of the auctioned item may undergo a drastic change, which in turn forces a steep raise in the open market price. If the vendors have not hedged themselves by building up an inventory, they tend to either renege on the contract or at the very least delay it. If the contract is ambiguous as regards to quality, timing of supply, terms of supply, then it provides additional avenues to the vendor to renege on the contract. For a sourcing specialist, this is an extremely uncomfortable position to be in.

Quality of the auctioned material is another problematic issue. After the contracts have been awarded, the delivered input is different in quality from the earlier samples shown by the vendor before the auction was implemented. This happens often when reverse auction is implemented for sourcing of agricultural items. The reason is embedded in the nature of agricultural sourcing. Unlike sourcing of manufactured items, in agricultural sourcing, quality standards cannot be set to the minutest level, especially when the sourcing base is spread over a vast area. Consequently there are always areas of subjective judgment where quality of the input material is concerned.

Prima Facie analysis shows that typical implementation issues fall under three categories. This has been illustrated in Table 2 below.

Table 2: Typical issues in the implementation of RA (Infosys Industry Analysis)
Implementation Issue Category Description of issues in the category
Price Initial Bid prices are much less than what vendors quote in their RFQ
Volume Auctioned quantity is more than what is required
Vendor Supply not according to schedule and is deficient in quality
Time Timing & Frequency of the auction is not correct
Contract management Ambiguous contracts , giving vendors the opportunity to renege on the contract
Quality Quality of the input material vastly different from samples given

From the authors’ experience, it is clear that the problem here is not in the RA mechanism per se but in the rather haphazard way it 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 like Spend Analysis, commodity profiling, contract management, vendor-base analysis, which are absolutely crucial for the success of the auction process, are either being neglected or are being given a cursory overlook. The above mentioned analyses are crucially important as doing them not only gives the buyer crucial insight about when to administer the auction and how to structure the auction but also helps the buyer to manage post auction implementation issues. For Example: at present, contract management usually is limited to a purchase order, which just details the landed cost and the duration of the contract. Exceptional situations like supply risk due to an unnatural increase in the price of the auctioned item are handled on a “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 quality of the input material being supplied as well as meeting the delivery schedules. Again they are usually open ended and open to debate issues.

It can be deduced that the most probable reason for an organization sourcing through either RA or DA and yet not doing these vital preliminary activities is because , they are being implemented as a “quick fix solution” to get savings fast. The prevalent idea seems to be that RA process includes only setting up and administering the auction and awarding the contracts. Essential concomitant activities like fixing the appropriate time of the auction, gauging the supply market, analyzing the maturity level of the vendor base, 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

To recap, implementation of Reverse Auctions or Dutch Auctions without prior analysis of the demand & supply market will result in less than optimal benefits and in more severe cases expose the organization to supply and price risk These are Information Technology (IT) led process enhancement initiatives. Sustainable benefits, in the form of cost reduction and systems standardization will accrue only if the 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 over emphasized. Figure 1 below depicts the proposed framework and clearly highlights the additional functional elements over a typical RA process in order to enable a company to realize the full potential.

Fig 1: Proposed RA framework Infosys Research
IPP - Invoicing, processing and payments
Note: - Functional elements indicated in gray in the proposed framework are the additional activities recommended above a typical Reverse Auction Process.

The following table details the additional elements introduced in our framework and their benefits to business users.

Table 3:- Additional functional elements of the Proposed framework

Benefits of the new suggested framework

One of the most common issues that purchasers have is determining the quantity to be auctioned and 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 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 starting off with lost “savings”. Similarly in the case of Dutch Auctions, if the auction is starting off at too high a price, it stands a risk of being discredited as no vendor would bid. 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 a input to the vendor assessment exercise by validating the credibility level of the vendor. In the past, if a vendor has had persistent problems with product quality or meeting timelines, then the purchaser will factor this while awarding the final contracts.

Commodity profiling empowers the buyer with relevant information about the commodity like the scale and nature of the commodity landscape etc. The buyer analyses factors affecting the demand and supply of the commodity and examines issues like 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 of time, it is to be logically assumed that supply will be at the highest and prices will tend to taper off i.e. 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 in which 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, auction can be timed appropriately.

Vendor Assessment and Selection: While the basic premise of an auction is to get 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. To go for the next best vendor would entail restructuring of the entire contracts involving time , cost and effort. Also vendors in their eagerness to capture as much as possible of the supply market, reduce bids indiscriminately. After the awards are contracted, it then becomes an issue of manipulation of quality parameters. This is especially prevalent in the case of 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 should assume the shape of a “Vendor credibility matrix , in which vendors would be ranked not only on cost but also on period of association & business stake in the organization, increase in supply value & volume over time , ratings for quality of supply etc. Vendors could then be awarded contracts on the basis of total cumulative score and not on just the price offered in the auction. This concept should obviously be explained to the vendors before they participate in the auction. Two direct and important benefits will ensue from this. The first is obviously greatly reduced risk of supply disruption. Secondly, vendors will also bid responsibly knowing that price is not the only criterion. This would in many cases mean lesser savings but a more robust system, one which the buyer can depend on. Again, the point being reiterated that RA is not just about reducing costs but also structuring the procurement process.

Post Auction, Contract management should become the focus of buyers. This should be done as fast as possible after the auction, thus closing the cycle. The important issue is the detailing of the contracts. Not only should it be specific regarding quality and delivery schedule, but more importantly it should also detail out all possible “exception” situations, be they price, quality or delivery oriented. For example:, penalty clauses for the suppliers, if supply is falling in quality, or delivery consistently. Similar, clauses for the company if invoice processing and payments are not being done on time, Provisions for discussion 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 knows the situation clearly, his trust on 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 occurs often for long winded contracts. This is purely because the purchase orders do not did not have the provision for such a eventuality. A well laid contract clears the ambiguity by detailing any such eventuality and provides a way out.

Conclusion

As companies scale up globally, managers are increasingly looking towards their procurement division to fund their grandiose plans for expansion. In light of this, CPOs will need sophisticated, easy to implement IT sourcing solutions which not only give cost benefits on a sustainable basis but 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 Reverse Action is one of them and therefore here to stay. The only crux of the argument being that RA like any other system improvement measure is only as good as the results it delivers. Proper implementation like in the model suggested above will ensure the delivery of optimum results on a sustainable basis.

References

  1. Online Buying gathers steam; one Buyer at a time - http://www.Purchasing.com, Oct 2004
  2. E purchasing software market – Forrester, Feb 2007
  3. Role of Reverse Auction in Strategic Sourcing - Caps Research Paper, 2003

About the Authors

Amitava is a consultant in the Retail & CPG practice in Infosys Technologies Ltd. He has over 6 years of procurement and sourcing experience in the CPG industry. His expertise lies in the spheres of Strategic sourcing, Procurement planning, Vendor and Inventory management. He has a management degree from the Institute of Rural management, Anand. He can be reached at amitava@infosys.com.

Hariharan is a Consultant in the Retail & CPG Practice in Infosys Technologies Ltd. He has over 6 years of experience in CPG industry. His expertise is in the areas of product development, brand strategy, sales and distribution functions. He has a management degree from the Indian Institute of Management. He can be reached at Hariharan_noorani@infosys.com.

Infosys Technologies Ltd. (NASDAQ: INFY) provides consulting and IT services to clients globally as partners to conceptualize and realize technology driven business transformation initiatives. With over 72,000 employees worldwide, we use a low-risk Global Delivery Model (GDM) to accelerate schedules with a high degree of time and cost predictability. http://www.infosys.com.

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