Reverse Auction: The Art of Online Negotiation

Mon, 24 Jan 2011 09:11:00 GMT

Reverse Auctions (RA) are fast gaining popularity as an online negotiation tool for sourcing and procurement. It saves time in negotiation while providing the best market price. Hence it helps in supplier and fair market price discovery. However, there are a few steps which need to be followed religiously for any commodity before conducting the online negotiation/ reverse auction in order to have a good negotiation. They are as below:

Once the buyer is clear about the above parameters, a Request For Quotation (RFQ) in line with the above parameters needs to be prepared. The supplier identification is to be done simultaneously. In case the commodity is strategic, a Request For Information (RFI) may be sent to a new supplier before on-boarding. The complete RFQ needs to be approved by the concerned authorities before floating it to the initially qualified suppliers.

The supplier responses should be in the same format as desired in the RFQ and according to the terms and conditions floated by the buyer. This is essential in order to have a fair comparison between all suppliers and to bring them at par in all parameters. The Technical and Commercial comparison sheet should be prepared separately and approved by the technical and commercial authorities respectively. In case a supplier does not qualify technically or commercially s/he is to be promptly informed and removed from the final list of qualified suppliers for Reverse Auction. In special cases a bid transformation/bid loading may be applied to a supplier who is technically qualified but does not adhere to commercial terms and be declared qualified for Reverse Auction if the supplier agrees for the bid transformation. This will be discussed later.

Assumptions before Reverse Auction:

1. RFQ had been drafted correctly with all the technical and commercial terms duly incorporated and other terms finalized which will aid in contract formation or release of purchase order.

2. The selected suppliers provide good quality material and each is at par with the others according to the selection criteria set by the buyer.

3. There is no hesitation in awarding the contract to any supplier who becomes L1. If there is even a very slight doubt, the supplier qualification process needs to be looked into.

Auction Strategy

Reverse Auctions strategies need to be planned very carefully in order to have the best market price. It is governed by the type of auction (e.g. Dutch auction, Material Index based auction, Discount percentage auction on list price, normal reverse auction etc.) and by the data that is visible to supplier during the auction as given below:

1. Minimum bid decrement in value only or in percentage and value both.

Minimum bid decrement is the minimum value or percentage (corresponding value is automatically calculated and shown on supplier’s screen) by which the supplier has to reduce his currently quoted price. The minimum bid decrement has to be a trade-off between a high value and very low value for that commodity. A high value may not be feasible for supplier in the final stages of RA when s/he wants to reduce his/her bid by small amounts. A small value may not be feasible when there is chance of only one bid from any supplier. The minimum bid decrement remains constant throughout the RA.

2. Supplier’s own rank

3. Supplier’s bid price

4. The lowest bid price.

5. The total number of suppliers participating in the reverse auction.

By judiciously choosing a combination of the above parameters visible to any supplier, the chances of getting a good price is significantly increased.

Best Practices

1. The reverse auctions should always be conducted on landed price of materials and services, taking into consideration all the applicable taxes, duties, levies, cess, tax credits and setoffs, insurance, freight, packing, forwarding, testing and any other applicable charges. This will automatically reflect in reduced prices in buying from local vendor since tax credit of CST (outstation vendor) is not available as against VAT (local vendor). Octroi, if applicable, entry tax etc. will also not be applicable for local vendor. It will bring all suppliers on par and there will be no hidden cost at the time of auction which may come up at the time of Contract formation/placing the Purchase Order.

2. If the buyer does not want to award contract to more than one supplier then s/he can disallow tie bids. In such cases the buyer can specify a certain percentage of the current L1 bid by which the L2 bid will be higher than the L1 bid. E.g. if lead bid is Rs 200000 and bid buffer is 0.01% which is equal to Rs 20. So the L2 supplier can quote upto Rs 200020 and if L2 supplier has to take lead then s/he has to quote Rs 1999980. The bid buffer percentage should be kept as low as possible to minimize the difference between L1 and L2 supplier and to have an aggressive bidding. Particularly in cases where the supplier is shown his/her rank only and not price, a high bid buffer may not allow them to come closer to the leading/lowest bid. Also, a high bid buffer percentage may restrict the L2 bidder from taking lead if L2 supplier does not have that much margin for reduction. The bid buffer percentage is set by the buyer depending upon the price of the commodity being sourced.

3. Before training the suppliers for the main event, the suppliers must be sent an Event information file containing the following details about the Reverse Auction event.

a. Event Name

b. Date and Time of the Event: Reverse Auction should be conducted as later in the day as possible ,in order for suppliers to reach their workplace and get things in order before the RA. If it is kept early morning at around 10am, a few suppliers may be on their way to office, leading to a delayed start and wait for some suppliers who have logged in on time. However, care should be taken that it is not kept in the evening as it is time for them to leave for home.

c. Type of Purchase: Spot purchase for immediate requirement or Rate Contract and the corresponding time period.

d. No. of Lots in the event and composition of each lot

The Lot structure should be made judiciously. E.g For Sourcing of a 5 Ton EOT Crane which constitutes Supply of Material and Supply of Service, if separate lot is made for Supply of Material and Supply of Service, it would lead to confusion. Each lot is equivalent to a separate event. Let us assume that Supplier X is L1 for Supply of Material. So the buyer cannot award Supply of Service to another Supplier Y. The buyer is bound to award the contract to Supplier X who may not be L1 in the Supply of Service. Supplier Z or Y may try to sabotage the auction by giving very low prices in Supply of Service portion. Therefore the Supply of Material and Supply of Service should be configured in the same LOT as two separate line items and the contract be awarded to the supplier who is L1 for the overall LOT.

e. Event Extension: In order to restrict any supplier from taking unfair advantage by quoting a low price at the very last second of the auction, buyer should configure “Event extension” so that the event gets extended if there is a change is Rank N or below for X minutes.

f. Bid price basis

Within any lot there may be line items e.g.

LOT = 5 ton EOT crane

Item names:

1. Supply of Material

2. Supply of Service

Here it is Aggregate price basis where the supplier will quote for the whole material supply and service supply. The per unit price is not applicable here.

However, if it is purchase of cables, the details will be as below

LOT = Control Cables

Item Names:

1. 2.5 mm², 3 core cable Qty = 4 km

2. 1.5 mm², 4 core cable Qty = 3 km

Here the bidding may be on per km basis for each line item and the system will calculate the total cost or for total 4 km and 3 km wherein the supplier will provide a total value and the break-up for individual line items can be provided later.

g. The starting price for the auction. It will be the initial landed price submitted by the supplier in response to RFQ or a ceiling price set by the buyer for an exorbitantly high price quoted by the supplier. This ceiling price is based on market conditions, price submitted by other suppliers. Ceiling price is basically a cap on the quoted price of supplier. It is generally set when the quotes of L2, L3, L4..Ln suppliers are more than say 10% of the L1 supplier. The choice of setting the ceiling price other than the supplier’s initially quoted landed price solely rests on the buyer. It may be the same for all suppliers or different for each supplier and communication should be sent accordingly. It gives an indication whether a supplier is ready to accept the reasonable price set by the buyer. If the supplier refuses to accept the ceiling price, it means that the buyer cannot expect savings to that extent from this supplier. The setting of ceiling prices and its acceptance by the suppliers leads to competitive initial bids by the suppliers and paves the way for an aggressive reverse auction. Also, the starting price prevents the supplier from entering any random higher price at the start of auction.

h. Reserve price for the auction. This is the benchmark for savings set by the buyer, again based on the market conditions, price submitted by suppliers and the buyer’s estimate of the fair price for the commodity. If the suppliers reduce their prices to the reserve price, they are able to see the reserve price. However, the contract is awarded to L1 supplier who may go much below the reserve price due to competitive bidding. If no supplier reaches the reserve price, the buyer is not legally bound to award the contract to any supplier.

i. Award Criteria: Award criteria should be clearly mentioned in the Event Information file if the buyer wants to consider some other factors beside L1 criterion. Also, it should be clearly mentioned whether the contract will be awarded to one supplier or more than supplier and the percentage distribution of contract value if awarded to more than one supplier.

j. Price Variation: Sometimes the commodity being sourced is such that the raw materials for the same experience significant price variation due to which firm prices are not possible for the commodity for the contract period. In such cases it is best to fix the index or data source for the raw material price and if possible, the formula which will be used to calculate the price variation. This should be communicated to the supplier during RFQ and at the time of circulating the Event Information File. Since formulating the Price Variation Clause(PVC) is a tedious process and will require significant time and effort to fix with each supplier, it is best to discuss it only with the L1 supplier post auction. However, if the buyer has significan bargaining power, s/he can declare his/her own PVC at the time of floating RFQ.

k. Post Award Clauses: The buyer should mention if there are any post award clauses which need to be adhered to by the supplier. In case of commodities having price variation the buyer may ask for the delivery of first consignment at the auction prices with no variation. However, the delivery should be within a month of the auction so that the supplier may not immediately ask for price variation.

4. It is a good practice to confirm during the training or before the auction on mail that the supplier is agreeing to the commercial terms and conditions especially the payment and delivery terms so that there is no chance of any confusion and there is confirmation that all suppliers are at par with each other.

5. Bid Transformation: If suppliers are not on par for commercial terms and conditions, the buyer can bring them on par by loading their bids with a value. This is termed as bid transformation. This loading may be done if the supplier is not agreeing to the buyer’s payment terms or not complying with delivery terms. It may also be applicable if there are A class and B class suppliers participating in the auction. The buyer should judiciously quantify the loading value.

6. Surrogate Bidding: It is not advisable to have surrogate bidders or dummy vendors because if the information spreads in the market that the buyer resorts to unethical practices, no supplier will give their best price and reverse auctions will not lead to desired results. It may also happen that to get very low prices, dummy vendors may be used. However, if the dummy vendor is L1 then the buyer will approach L2 supplier. If this happens for a few times, the buyer’s reputation will deteriorate in the market.

Summarizing the above, it can be said that Reverse Auction is an online negotiation tool which helps to negotiate with any number of suppliers within the specified time frame resulting in reduced time spent on negotiations. Since all suppliers are competing with one another for the business, it is extremely helpful to the buyer in getting highly competitive price from the market. If the buyer has done due diligence in selecting and qualifying the willing suppliers for reverse auction, s/he can expect significant savings from this tool.

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Reverse Auction: The Art of Online Negotiation