Reverse Auction – Meaning, Advantages and Disadvantages
Reverse auction is inverse of the process of auction. In auction, a seller puts forward the product that he or she wishes to sell and the buyers have to bid or compete against each other for obtaining the product. The bidding occurs in terms of higher prices. But in case of a reverse auction, the role of the buyers and sellers are reversed. Here, the sellers compete or bid amongst themselves to obtain business from the buyer. Thus, the bidding occurs in terms of lower prices. The process of reverse auction can be found in both business and consumer auctions. In business, it takes the form of procurement auctions, e-auctions etc. of the government or the private sector industries. In consumer auctions, although not very common, is visible in few sales processes.
Origin of Reverse Auction
The use of reverse auctions as an auctioning strategy can be traced back to 1995. Its founder was a consultant at McKinsey and an executive at General Electric named Glen Meakem. Since there was no taker for his idea, he formed a separate entity named FreeMarkets with the help of his colleague Sam Kinney. The entity aimed solely at organizing reverse auctions, wherein ‘market makers’ and ‘commodity managers’ were employed who ran online tender processes and market operations for managing such auctions were undertaken.
It was not until 2000 that the practice was adopted in a widespread manner, so the online portal almost ran a monopoly for 5 years. But due to the practice becoming common, its importance reduced and the prices also fell considerably. Later in 2004 the entity was bought by Ariba. But it nevertheless paved the way for reverse auctions in multiple fields including business to business and business to consumer transactions.
Advantages and Disadvantages
Reverse auction has both advantages and disadvantages for both the sellers and the buyers.
Advantages for Seller
Reverse auction opens up a vast sea of opportunities for the sellers in terms of entry into new sectors of the economy and expanding business with the existing buyers. Unlike a general auction, the seller here does not have to limit himself to a single product that he wishes to sell and attract buyers of only that product. Instead, the seller can look for the various demands being made by buyers in different sectors and decide to enter or explore any such area of demand through an efficient competition. A buyer who has already had an experience with a seller is likely to choose that very seller in the bid. This helps the seller to expand his horizon of business with one buyer and build a strong business relationship.
Opportunities irrespective of size of business
In a reverse auction, a platform is provided for the big and small businesses to compete together in a bid. It brings to light many of the lesser known businesses and can be presumed as an advertisement of their presence in the market.
Advantages for the buyer
Unlike a general auction where the buyer has to select only among the sellers who are offering a bid, here the buyer can put up his own demand for a bid. He also gets to choose among the various sellers of the product in terms of competitive prices and quality.
As it is mostly used in procurement auctions, the professionals can save time by streamlining the process of production and not seeking separate and full proposals from every seller. The whole set of formalities occur through a single process of auction.
Drawbacks for Sellers
Probability of incurring losses
One of the major drawbacks for a seller in a reverse auction is that he does not get to choose the price for his product. Often, in order to win the bid he may end up lowering the prices significantly. This may lead him to incur loss in the contract.
In order to lower prices, the sellers may have to ignore several costs incurred by them in terms cost of service of contract that include delivering the product and invoicing. This may lead to acceleration in the loss.
Drawbacks for buyers
Less informed choice
A reverse auction only deals with lowering of prices. It does not give information on other costs involved in a contract. This may lead a buyer to choose a seller who offers an apparently low price but who provides poor quality product, high cost of delivery or poor customer services. This can affect the buyer’s business considerably at a later stage.
Cost of monitoring
As the bid does not provide a clear picture of the dealings with the seller, the bid may lead the buyer to choosing a seller with whom the cost of monitoring and managing the project becomes high.
Reverse Auction in India
Recently, the Ministry of Power has decided to introduce reverse e-auction in the bidding for short-term power procurement. This is mainly being done with the aim of helping the DISCOMs which require most of the short-term power. The adoption of reverse e-auction here has certain major benefits for the suppliers and the buyers. As noted by the power rating agency-Ind Ra, the producers will benefit as there is likely to be a rise in the demand for power through reverse e-auctions, which have a direct impact on the volume of power being produced and sold to the power exchanges. A major benefit for the buyers (DISCOMs) and the ultimate consumers of electricity is that it is resulting in fall in the power tariffs due to fall in the prices of power.
But, even in the midst of fall in prices, the problem of hidden prices in reverse auction cannot be ignored. So the power procurers have to incur additional costs in terms of interstate delivery of power, charges of transmission etc, which will not contribute in any manner to improving their cash flows. They will have to go in for refinancing of their debt, from high cost of procuring to high cost of undertaking the project.
Thus, in order to adopt reverse auctions, certain mechanisms like analysis of additional costs of contract have to be developed. In the absence of these, the whole idea behind reverse auctions i.e. improving the financial health of the IPPs (Independent Power Producers) will be futile.