Online Auctions: How Do They Work? Do They Fit My Needs?

Author(s):

Dr. Michael A. McGinnis, C.P.M., A.P.P.
Dr. Michael A. McGinnis, C.P.M., A.P.P. Professor of Marketing and Supply Chain Management, University of South Alabama, Mobile, Alabama 36688, 334/460-7907, mmcginni@usamail.usouthal.edu
Holly Allison
Holly Allison, Director of Marketing, Ariba, Inc., Burlington, Massachusetts 01803, 781/273-6728, hallison@ariba.com

86th Annual International Conference Proceedings - 2001 

Abstract. This paper provides an overview of online auctions. It will improve purchasing managers' understanding of online auctions, explain how they contribute to overall supply strategy, and describe how they can add value to purchasing and supply processes. The paper is organized into three parts. The first part provides an overview of auctions. The second part discusses online auction basics. The final part present strategies that will help purchasing professionals maximize the value of online auctions to his/her organization.

Introduction. According to one source, business-to-business (B2B) auction sales will jump from $8.7 billion in 1998 to $52 billion in 2002. B2B marketplaces have become established in a wide range of markets including chemicals, life sciences, food processing, metals, electronic components, automotive after-market, plastics, energy, and telecommunications among others. Streamlined sourcing has the potential to allow corporations and marketplaces to greatly increase their supply chain efficiency. Sourcing includes negotiated purchase of goods and services as well as multiple collaborative processes. These processes include analyzing purchases across commodity categories and business units, researching suppliers and supply markets, estimating savings opportunities, preparing Request-for-Quotes (RFQs), and staging competitive events to negotiate final purchase price and terms.

Before we discuss online auctions we would like to review some of the other e-commerce business models. Four common non-auction models are sell-side systems, electronic marketplace, buy-side systems and independent trading exchanges. These models are summarized as Exhibit 1.

Auctions: An Overview. There are three types of auctions. An "English Auction" is used when a seller offers a good or service. Bidding starts low and increases as the buyers compete with each other. There may be a minimum bid — where no bids are accepted below a predetermined amount, a reserve — where the maximum bid must exceed a predetermined amount, or the auction may be absolute — where there is no minimum bid or reserve. An English auction would be of interest to purchasing professionals who are seeking buyers for excess inventory and capital equipment.

The "Downward Auction" (also called a "Reverse Auction") is typically used when the buyer seeks to buy a good or service. Bidding starts at a predetermined price and declines as the bidders compete with each other. Downward auctions have been widely used for raw materials, and are increasingly used for fabricated components and services.

Finally, the "Dutch Auction" is used when the seller offers a good or service at a predetermined price and lowers that price by a specific amount at regular intervals. The sale is completed when a buyer accepts the offering price. While Dutch auctions have been used to sell financial securities, we are not aware of any online Dutch auctions for goods or services. However, they could be used to sell excess inventory and capital equipment.

Exhibit 1:
SUMMARY OF NON-AUCTION ECOMMERCE MODELS

Model and Brief Description
Advantages
Disadvantages
Sell-side System: A commerce-enabled Web site administered by the seller. Usually free to buyers.
  • Difficult to locate on the Web.
  • No way for buyers to track or control spending.
Electronic Market Place: An aggregate of electronic catalogs from a vertical market, administered by a third-party firm One-stop sourcing solution for buyers. No way for buyers to track or control spending patterns.
Buy-side Systems: A net-based procurement system hosted and administered by the buying organization. Requisitioners source from preferred suppliers on the company intranet.
  • The buying organization can reduce off-catalog buying and build leverage with fewer suppliers.
  • Reduced cycle times.
  • The system frees buyers to add value.
  • Very expensive to implement.
  • Costly and cumbersome catalog management.
  • Can washout distinctions of supplier-buyer relationships.
Independent Trading Exchange: An online marketplace maintained by a third-party, where multiple buyers and sellers can conduct business in a vertical market.
  • Minimizes buyer software and seller website investment.
  • Provides ecommerce opportunities to firms of all sizes.
  • Preserves quality of buyer-supplier relationships
There must be a critical mass of experienced buyers and sellers to be effective.

Online Auctions Basics. Online auctions provide buyers and sellers with the opportunity to reach more trading partners. The advantages for sellers include access to a wider range of customers, a better fit between customers and capabilities, and the identification of higher profit market opportunities. The advantages for buyers include access to a wider range of suppliers, better quality, and lower prices. The disadvantages for both include the time and expense of organizing the auction, software and staff training expenses, and maintaining integrity of the process. Online auctions can be conducted by the seller, the buyer, or through an independent trading exchange's online auction site. There is a wide range of services offered by online auction sites. These services are often tailored in to the needs of the buyers and sellers. Whether an auction is conducted by the buyers, the sellers, or through an independent trading exchange, a substantial amount of preparation is necessary if the auction is to be successful.

Five issues are crucial to successful online auctions (from the buyer's perspective). They are (a) careful identification and qualification of suppliers, (b) thorough preparation of specifications and/or statements of work, (c) software that supports the auction event, (d) confidentiality, and (e) integrity. The purchasing/supply manager's expertise is often essential to insuring that these crucial issues are addressed.

The online auction event requires a substantial amount of preparation by all participants. This means that sellers have an in-depth understanding of the bidders, and the bidders have a thorough understanding of the specifications and/or statements of work that they are bidding on. This preparation may take weeks or months to complete.

While the actual auction event may take only several minutes to a few hours, the following outlines the basic steps that are typically found in an online auction.

  • The identity of bidders is not revealed to other bidders.

  • Bids are disclosed to all bidders, however the identify of bidders is not revealed.

  • Predetermined time limit. Beginning and ending time of the auction is established in advance. Most auctions include provisions for extending the ending time in order to discourage last minute preemptive bidding. Examples of rules that might be used to extend bidding are discussed below. The coordination of event timing among participants in multiple time zones throughout the world is not a major challenge.

  • Rules for extending bidding (overtime) will be tailored to the auction event. For example, the following rules might be used to extend bidding.
    • Each bid made in the last minute extends the auction into overtime by one minute.
    • Each bid made during overtime extends the auction by one minute.


  • Most auctions begin with a benchmark price. English auctions may have a minimum bid and downward auctions may have a maximum bid.

  • In English auctions bidders compete against the previous highest bid, in downward auctions bidders compete with the previous lowest bid.

  • At the end of bidding the high bidder (in an English auction) buys the items offered for sale, or the low bidder (in a downward auction) receives the order. This step challenges the integrity of the auction process. Manipulating the results by negotiating the low price with a preferred supplier (or high price with a preferred buyer) undermines confidence in the online auction process. Many independent trading exchanges insist on firm commitments to conduct business with the winning bidder.

  • Finally, thorough administration of supplier performance (in downward auctions) or buyer performance (in English auctions) is necessary to insure that the winning bidder performs as agreed.

Online auctions are not a substitute for thorough preparation and execution of buying decisions by purchasing and supply managers. Auctions are not appropriate when: (a) the size of the purchase is small compared to the overall market, (b) when there are few interested bidders, (c) when specifications/statements of work are not complete, (d) when there are likely to be changes in specifications/statements of work are likely to be revised during the contract, or (e) where special tooling or set-ups may be required.

Maximizing the Value of Online Auctions. Basically, purchasing and supply managers do not need an Internet strategy. They need a sound business strategy that uses the Internet as an enabling tool. This generalization is applicable to any e-commerce endeavor, including online auctions.

While some large organizations may conduct online auctions in-house, many buyers will benefit from using the auction site of an independent trading exchange. These sites specialize in planning, organizing, and conducting online auction events. Auction sites earn revenues through a combination of markups on the value of transactions, transaction fees, membership fees, and commissions. Purchasing and supply managers should examine the fee structures of prospective auction sites and negotiate a compensation agreement that meets their needs.

To get the most from any e-commerce site, whether to buy or sell (including auction sites), purchasing and supply managers should look for liquidity, functionality, the ability to integrate the supply chain, and domain expertise. Liquidity means that the site should be focused, but broad enough so that it can scale up quickly. Functionality means the site should offer a wide range of information on products and industries, discussion groups and forums and bulletin boards, and information for professional development. Supply chain integration means the site should enable trading partners to complete transactions online and integrate these transactions into each of their enterprise level software systems. When a site has domain expertise, it is a definitive online source for industry product and innovation information.

To maximize the value of online auctions, purchasing and supply managers should approach them in a way that is aligned with their business strategies including material and service purchases, delivery, cost reduction goals, inventory policies, supply base management, and any other issues relevant to their organizations. Exhibit 2 summarizes some key questions that purchasing and supply managers should consider when using online auctions.

Exhibit 2:
KEY QUESTIONS TO ASK WHEN CONSIDERING ONLINE AUCTIONS

Key Question
Think About...
What should we purchase through an exchange and in what percentages? Consider "B" items, not commodity or highly engineered products. This is where the supply base is most fragmented.
How do we change the roles of the purchasing managers and design engineers? Purchasing and supply managers must understand that they are buying and that the design engineer must understand the product life cycle. However, each must understand that their roles compliment each other and each must understand each others' challenges and potentials.
What incentives should we create in the organization to insure success? Reward thoughtful initiative and success. Do not punish past performance that made success possible.
What decision support tools and information systems will be need to manage e-buying? Investigate the integration capabilities of your enterprise level planning system with available e-commerce tools and independent trading exchanges.
What return-on-investment (ROI) should we expect on e-commerce initiatives? This is a function of your organization's investment policy. The required ROI should be no different than the hurdle rate for any other program.

Conclusion. Online auctions can play an important role in purchasing, and supply chain management strategies. However, purchasing and supply managers should recognize that all e-commerce strategies work well only when they are based on a sound business strategy.

Thorough planning and preparation are essential prior to the online auction event. This planning and preparation must include careful identification and qualification of suppliers, thorough preparation of specifications and statements-of-work, adequate support software, confidentiality, and integrity. Thorough planning and preparation is also essential if a third-party auction site is used.

Issues to consider in any e-commerce site include liquidity, functionality, integration capabilities, and domain expertise. Finally, the purchasing and supply manager should negotiate a compensation agreement with the e-commerce site that best matches his/her organization's objectives.


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