Reverse Auctions: The High Cost of Low Prices

By Randall Weis

Let’s get the facts about reverse auctions on the table. Is there a bargain in this bidding method?

In an ordinary auction, buyers compete for a good or service. In a reverse auction, sellers compete to obtain business. The goal is to drive down prices—low prices are always good, right?

Not so fast. Consider this scenario: you’re an experienced, successful facility manager and it’s time for your annual salary review. Your boss has the company in cost containment mode and decides to save money in your area by running a reverse auction on your job.  You’re now a commodity going on the block just like paper towels or floor care. Rather than compliment you and renew your position for a year, the company has invited in four other candidates for a reverse auction bid for your job.  Oh, and you?  Of course, you can also bid, with the starting bid at your current salary.

Of course there are people who want a facilities management job and would do it for much less than what you’re being paid. But why are they so cheap? Well, it might be their inexperience or desperation or a misunderstanding of what the job entails.  The new applicants might not know what things cost or the hard work it takes to do things right.  They may lack the reliability that comes with experience and the skills to perform the work in the quality way your company demands.  They may also think: “Once inside, after I figure it all out, I can get my price up!”

Any bidder who understands the absolute requirements for quality, assurance and integrity demanded in your work knows that it doesn’t come cheaply. And Buyers often find that the lowest of the low comes at a high price, without quality, value-added (but expected) services, and with little accountability. And this kind of performance, in turn, chews up time and reputation, affecting the buyer’s business.

In an influential study, two researchers from Rensselaer Polytechnic Institute, David Stec and M.L. Emiliani from the Center for Lean Business Management, discovered exactly how the low prices of online reverse auctions come with unexpected high hidden costs.

In their groundbreaking work, Emiliani and Stec found that in reverse auctions, the buyer’s focus on lowest price actually forces skill loss on the supplier. The low price is the important thing, not meeting the full demands of the job. Low price leads to a race to the bottom, abandoning the necessary elements of quality, innovation, and reliability. Over time, the “successful” reverse auction buyers end of suffering skill and development losses as well, hurting their subsequent competitiveness.

So, when we think about forming a relationship with a vendor, we need to consider price, but focus on value. At a PRSM meeting in Las Vegas two years ago, I attended a session on reverse auctions. The panel had people who were both pro and con on these auctions. The arguments went back and forth on the merits of the auction process until a PRSM retailer from the crowd got up and said:

“My firm, with 4,000 retail outlets, has done 150 reverse auctions in the last year or two.  Out of that 150, all 150 were failures. They did not work. My firm spent far too much time babysitting the inexperienced winners, and what we saved on products and services; we spent that much and more trying to manage under-funded vendors.” Before the man sat down, he said, “by the way, my company is still doing reverse auctions. The CEO is committed to this process to drive efficiency.  Go figure!”

Professor Dean Kashawaggi at Arizona State University has done extensive research on the construction industry. He found that most projects contain a flaw before they even start. The flaw is that projects are on a tight timetable, and by the time a firm selects the “low bid” general contractor, and that winner starts looking for the “low bidder” in each subcontracted trades, the project is driven towards failure by the lowest of the lows. Professor Kashawaggi’s work proves that low upfront prices bring a cascade of higher long-term costs in errors, change orders, shoddy work, and unaccountability. His research demonstrates that it’s not an “efficient” process after all.

While correct, the Kashawaggi findings are not widely embraced because purchasing managers are under the gun, and want to make decisions based purely on hard numbers. ”Hard” numbers can be illusory and not foretell the entire story.  Kashawaggi has demonstrated in his research that time after time upfront low price comes with unacceptable high costs in bad management, loss of value-added services, and poor performance.  Is this what your company wants?

Facilities and purchasing managers are paid as professionals to apply reasoned judgment based on the best interest of their own reputation and that of their companies.  They should not fear to choose the best value-added provider.  To be “the best” that provider has to form a working relationship with the facilities manager and provide the lowest long run cost at the requisite quality and reliability—even if their initial bid is not the lowest.  In the long run, firms are better off partnering with a few companies who truly understand their requirements, assure their success and provide the highest level of trust.  To do less is inadequate.

Reverse auctions are a new wrinkle driven by the prospect of more for less.  The research shows that it invites unsavory practices such as cutting corners and even leads to outright cheating. In reality your job and your firm requires a high level of professionalism, expertise, and devotion to accountability.  The prospect for low price often doesn’t entail any of these essentials.

If corporations used reverse auctions to drive salary costs down, perhaps CEOs would better understand the full ramifications of this process as they became less and less competitive in attracting and retaining the best talent.  It signals a characteristic race to the bottom.  Anyone can offer and accept the lowest bid—especially if the focus is only on winning today, instead of succeeding tomorrow.