When Should Buyers Conduct Reverse Auctions?
What is a Reverse Auction?
A reverse auction is a strategy used in sourcing between buyers and suppliers in which sellers compete with one another to win the business of the buyer. It is called a reverse auction because prices trend down as the bidding goes on, rather than up, as they would in a typical auction. Suppliers are bidding at a lower and lower price to win the business.
Reverse auctions can be conducted live or electronically.
When Should Buyers Conduct Reverse Auctions?
Reverse auctions can be very effective to get the best price on parts when conducted in a manner that is not detrimental to relationships with current suppliers.
Buyers can utilize a reverse auction strategy during any of the following 4 circumstances:
1. The current supplier does not have the right equipment to produce the part. The supplier may be open to losing this part to gain trust and favor in supplying the buyer with other parts that better suit their capabilities.
For example, a buyer needs a high-volume, medium-sized sand casting that has a lot of machining. The current supplier only has a manual floor line and limited machining capabilities. Because of this, the supplier outsources the machining, reducing margin while consuming a lot of capacity.
Since this part would be better made by a supplier that has an automatic line with the proper machining capabilities, the current supplier would likely be willing to let it go. In this case, offering the part in a reverse auction would benefit the buyer, the current supplier, and the future supplier.
Using a cost estimating tool that indicates the most adequate equipment for this part, and provides the buyer with a new target price for auction, would be beneficial. With this information the buyer can invite better qualified suppliers to the reverse auction. Only suppliers that have the right equipment will be invited to this auction, resulting in an optimum price. For tips on what to look for in a manufacturing cost estimation tool, read our article here.
2. The buyer knows what it would cost to make the part but does not have the capacity to make it. This is a typical make vs buy situation; however, we are assuming the buyer has already decided to buy this part. This is a case in which no supplier currently has the buyer’s part (no one is losing an order), and the future supplier is gaining an order.
Because the buyer already knows what it would cost to make this part, they may not have much to gain from finding the market price. Ideally, the goal would be to beat their own internal cost. Suppliers that specialize in these parts may very well be able to beat that internal cost.
In this case, a reverse auction can become a competition, where the buyer sets a reserve/cap at their current cost. Inviting the right suppliers with the required capabilities is the best way to ensure they can successfully compete. Imagine the following scenario:
A supplier is repeatedly invited to a particular buyer’s reverse auctions, even though that supplier is never quite suited to economically make those parts. The supplier repeatedly loses the auctions. and decides to bow out of the next invitation (when in fact, this was the one part this supplier was suited for). From the buyer’s perspective, the buyer may inadvertently assume that the supplier keeps losing because they are too expensive. In reality, the supplier is bidding on parts that are not suited for their capabilities. This has massive ramifications on the buyer/supplier relationship.
3. The buyer makes a strategic decision to find a second source for particular parts. In this case, a supplier is making the buyer’s part. The buyer makes a business decision to identify a second source, so the current supplier is going to have to share the spend and the future supplier is gaining an order.
Ensuring that the invitees to the reverse auction have the right equipment and sufficient capacity to make the % of volume the buyers wants to “split” is important to get an optimum cost with a low delivery risk.
4. The buyer has a group of like parts to aggregate in an effort to get a volume discount. In this case there will be winners and losers, but all current suppliers have an equal chance of gaining more volume. The buyer compiles low-spend parts and aggregates them together in one bid package. While some suppliers may lose a little volume (these are, after all, low-spend parts), a couple of them will earn themselves a large chunk of spend. It is a bit of gambling for the suppliers, but it is a fair business practice.
Grouping Parts for Reverse Auctions: A Critical Component to Get the Right Price
There are times when it may be convenient and profitable for a buyer to purchase parts as a group. For example:
- A particular product has a dozen plastic parts and the rest are metal components, or vice versa. The team decides it would be beneficial to purchase all those plastic parts as a group. But does it make financial sense? Would it be better to split them? If so, how?
- The team believes that a group of parts are overpriced, but because they are purchased in such low quantities, it doesn’t seem worth the time to renegotiate them individually. How would the team go about grouping these parts in order to get the best price?
- The buyer decides to conduct a reverse auction which encompasses a collection of parts. What is the best way to define each lot in order to get the best price?
Examples of Reverse Auctions Between Buyers and Suppliers
The following two examples illustrate how a sophisticated cost estimating tool can help buyer’s make these decisions.
Example 1: RFQ For an Automotive Buyer with 15 Injection Molded Plastic Parts
An automotive buyer sends out a Request for Quote (RFQ) to 4 suppliers. The RFQ is for 15 injection molded parts that range in sizes from parts that fit in a 3”x2”x2” cube to parts that require a 24”x12”x10” cube to fit into. Most of the parts vary in thickness and may be made of different materials.
A cost estimating tool could help the buyer to determine whether the RFQs should be split or grouped together. The tool can identify the equipment necessary to make each part and help determine the approximate cooling time of each part. The 15 parts differ in size, thickness, and material, and therefore, the equipment necessary to make them can vary widely. The small parts may only require a 100-ton machine, while the larger parts may require a 400- or 600-ton machine.
But in this example, the buyer sent this RFQ to 4 suppliers without using a cost estimating tool and without the knowledge gained regarding the equipment by using one. Details regarding the 4 suppliers are:
- Supplier A has a wide variety of equipment from 100-ton to 800-ton machines
- Suppliers B and C have only small equipment (200-ton machines and smaller)
- Supplier D has only large equipment (400 tons and higher)
In this case, Suppliers B and C will have to outsource the larger parts and increase their cost as they are subbed. Similarly, Supplier D will have to outsource the small parts, or worse, make them in a larger machine than necessary increasing their cost dramatically. The only supplier in this group that can provide a competitive quote is Supplier A; therefore, there is only one viable quote.
A Successful Reverse Auction Would Have Looked Like This:
Utilize the cost estimating tool which provides the machine size requirements. Then:
- Group the parts by similar machine sizes e.g. < 200 – 400 tons; > 400 tons
- Send the RFQ packages to suppliers with the right machine sizes and have sufficient capacity to make each group of parts.
- Receive multiple truly competitive quotes for each grouping
Bonus: By cost estimating each group ahead of time, there is a target cost to which to compare the RFQ responses.
Example 2 – RFQ for an Aero Engine Buyer with 25 Sheet Metal Parts
An aero engine buyer has 25 miscellaneous sheet metal parts (brackets and frames). Each part represents a small amount of spend, roughly $20,000 per year, but in aggregate these parts represent $500,000 in annual spend. An average 20% cost reduction between these parts would yield a $100,000 annual savings. In this example, selecting the right groupings is again important to optimize cost.
One of the brackets (Image 1) has a complex perimeter with four round holes and one bend. That bracket can best be made by a laser and a simple bend break. If a supplier with mostly turret presses and fancy robotic bend breaks quotes on that bracket, then the cost may be unnecessarily high. However, if that bracket was more complex, with multiple internal cut-outs and several bends like the one below, it may indeed be better suited to a supplier that has a fast turret press and robotic bend breaks.
A cost estimating tool that indicates the best routing for each part helps the buyer to group the 25 sheet metal parts into 2 or 3 groups. These groups can be sent to the suppliers with the correct capabilities so that each RFQ is optimal from the start. This enables the buyer to achieve maximum savings from as little negotiations as possible without overtaxing the suppliers.
Without the knowledge from the cost estimating tool, the buyer sends all 25 parts out for quote on one RFQ package. The lowest total quote contains a mix of individual parts that are individually quoted lower by other suppliers. In this case, the buyer is not getting the lowest total quote by group. Selecting and grouping the right parts together in one reverse auction package is critical to getting the best price for the lot. Buyers cannot cherry pick which parts they buy from one supplier or another. The winner of the lot gets all the parts and the discount is based on aggregated spend.
Best Practices for Conducting Successful Reverse Auctions
- Parts may be bid individually
- Parts can be placed for auction in a group (several parts in an unbreakable set in which the supplier must bid on all the parts in the set). If the supplier wins, it wins all the parts in that lot. This is done to accumulate buying power by aggregating spend to command a higher discount.
- If this is the case, segregate parts properly in lots that have similar manufacturing requirements.
- Choose an achievable price to start the bidding – it would be embarrassing to start too high and not have any bids.
- Or, set a reserved price: let the suppliers bid, but make it clear that if a particular cost is not achieved, there is no winner.
- Have all required information available and sent ahead of time
- Do not promise 100% of the EAU to the winner
- Promise up to 80%
- Reserve 20%
- Keep 2 suppliers for each part
- There may be reasons other than money to keep a second source. For example, the buyer may need a supplier that is close to the plant to fill emergency requirements.
- Set a requirement that the winning supplier must be a qualified supplier, OR cost gains must be a certain amount more than the cost of qualification.
- Set up a pre-auction conference call to answer questions about parts in the lot.
- Keep a running list (easily accessible to all suppliers) of FAQs for each bid package
- List the capabilities believed to be required to make the part
- State that not all of them need to be in-house
- If possible, state estimated capacity requirements (yearly or by order qty.) for each critical piece of equipment in an effort to avoid delivery risk later.
- If there are any expected difficulties with your part, let the bidders know ahead of time to avoid scrap and rework later.
- For example, if a hole in a low volume sheet metal part is too close to a bend, then it may deform when making the bend. Depending on the proximity, material thickness, and other factors, the supplier may have to machine or punch the hole after the bend is made (extra process). If the supplier misses this, the buyer will get quality issues from the start, and the supplier may want to increase the price after the issue is resolved.
- If hosting an electronic reverse auction, set up a flexible time limit. This is to prevent bidders from waiting until the last minute to bid.
- For example, if a buyer is set to conduct an auction for Lot A or part 123C234 from 10:00 to 10:10, the buyer should create a rule that states that if a bid comes in in the last minute, the time will automatically extend one minute, and so on, until there are no last minute bids.
- Conducting live reverse auctions – This is a great way to find and meet new suppliers. A live event also allows the supplier to physically see the parts, ask questions live, and even provide valuable DFM feedback to your buyers.
The popularity of reverse auctions has diminished over the last 10 or 15 years. Previously, the practice was often used to squeeze suppliers to reduce prices to razor thin margins, and ultimately, valuable relationships were broken. However, if the buyer implements a reverse auction strategy, conducting reverse auctions at the right time and inviting suppliers that are best suited to make the parts at lower costs can be very fruitful, especially when the right tools and practices are set in place beforehand.
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