Turning Japanese…a view beyond the English eAuction

As I briefly touched on last week eAuction technology has moved on somewhat in recent years and is now utilised to procure a whole variety of goods and services outside of the stereotypical, and obligatory, stationary re-tender. Auctions themselves are nothing new; the position of Emperor of Rome was auctioned off in 193 AD, but these days there are so many different parameters available to the procurement professional who is able, if needs be, to run a whole array of multi-attributable and variable eAuctions.

Many procurement professionals however still remain unenlightened to the vast toolkit at their disposal and are merely preconditioned into persisting with the classic “English reverse” eAuction. This standard approach is appropriate in a wide range of circumstances but may not always be so. I would like to briefly describe the other forms of eAuctions available, their respective mechanisms, strengths and weaknesses.

1.         Forward English Auction

·           Mechanism

Anyone who has attended a property auction or is familiar with eBay will be familiar with the way this works. Essentially bidding starts at a low price and rises as participants place progressively higher bids. This process continues until either the period allowed for the auction of this item is closed or until no higher bids are received. The seller is also able to set a minimum price for the sale (reserve price) which if not met would result in the auction being aborted and no sale occurring.

·           Example

Numerous examples to mention however the £22.5bn UK 3G auction is probably the most oft cited procurement case study.

·           Strengths

Any English auction has the advantage of price discovery which is particularly useful for goods with an unknown or vague market value (art is a good example). The seller in an English auction does not limit the maximum possible bid ex-ante which is in contrast to other dynamic auction types

Exceptionally useful when there a high number of very closely matched participants.

·           Weaknesses

There are a number of weaknesses levelled against English auctions and I will try to summarise a few of them here. The first is that open auctions such as the English format allow for potential collusion amongst bidders. There are numerous papers on this subject and some high profile examples but it is a definite watch out.  Secondly the so-called “winner’s curse” is rampant in these auctions due to strong competition and incomplete information about the product being sold. In the long run, and I am writing this from the perspective of the procurement professional running the auction, although a fantastic price may be achieved it may not be sustainable. A third disadvantage for both buyers and sellers with the English auction is that everyone must be in communication over the course of the auction, which can be expensive and difficult.

2.        Reverse English Auction

·           Mechanism

Another one we are all familiar with. In a reverse auction the bidding price goes down and the buyer award contract to the supplier who bid the lowest price depending upon the buyer's specific needs with regards to quality, lead-time, capacity or other value-adding capabilities etc.

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·           Example

Pretty much everything…including stationary.

·           Strengths

Transparency and competition often yields exceptional results and also from a stakeholder management perspective vibrant reverse eAuctions are actually quite exciting to watch. A well-managed event, I will be doing a separate blog piece next week on the process that needs to be followed, ensures that everyone is bidding on exactly the same parameters. In markets which allow for multiple, reputable participants the reverse eAuction is a valuable tool.

·           Weaknesses

I have glossed passed the strengths somewhat because I am conscious that this article is more about other eAuction types available however it would be remiss of me not to Segway onto them by discussing some of the weaknesses of reverse English eAuctions.

There are three distinct advantages that exist for buyers. The first and foremost is that, if not managed correctly as per my previous post, that the ongoing relationship between buyer and seller will be irrevocably damaged. Jap (2000) reports of one instance where a supplier was so upset with their treatment they refused to bid for another seven years. Positioning from the buyers’ perspective is most definitely the key.

Related to this lack of trust is the fear of commitment. Sellers fear that buyers are simply awarding work based on the lowest price but will re-run the exercise (a la office consumables) once the contract needs to be renewed. Why would anyone commit any additional capital, tooling, training etc to such a relationship?

The third potential disadvantage for buyers is that too few suppliers will respond to the reverse auction announcement and a competitive environment will not develop. Although in theory, only two competing firms are required to conduct an auction in reality results are only really achieved when upwards of four or five suppliers choose to actively participate.

There are also disadvantages for the seller although I will only touch on them here. Primarily sellers are suspicious that the possibility exists that the buyer is only using the reverse auction as a negotiation ploy. The buyer may have identified a preferred supplier before the auction and has no intention of awarding business to the lowest bidder so any participant is really just time wasting. A second risk (and this doesn't necessarily translate to an advantage for the buyer, is that the seller may get caught up in the race. It is very easy to become exceptionally competitive and offer unreasonably low prices that may actually be below cost. It may also be true that a rogue bidder in the event has no intention on actually completing on their bids but drags down the entire supplier cost base as a result. Again this may or may not be seen as an advantage on behalf of the buyer, depending on whether the outcome is sustainable or not. For those wishing to see a nicely worked example of this last scenario I’d recommend the auction scene from the ‘Dad’s Army’ Christmas episode ‘The love of three oranges’.

3.        Dutch Reverse Auction

·           Mechanism

A Dutch auction involves an item being offered at a very high price, well in excess of the amount the seller expects to receive. The price is then lowered in decrements until a bidder accepts the price…one bid will close the entire auction.

A slight reverse on this, and more common in a procurement environment, is a reverse Dutch auction. Here the buyer specifies a starting price, price change value, time interval between price changes, and the reserved price. The auction opens with the first item with the specified start price and increases by the specified price change value after a fixed interval. The start price keeps on increasing until a supplier places a bid or the start price reaches the reserved price. Once the bidding is closed for the item, the auction moves to another item sequentially. The auction is closed when the bidding for all items is completed.

·           Example

Dutch auctions emanated, unsurprisingly from flower markets in Holland but in modern times the United States Department of the Treasury also raises funds for the U.S. Government using a Dutch auction. A variation on the theme has also been taken up by pricedrop.tv

·           Strengths

The primary advantage of Dutch auctions is speed. Since there are never more bids than there are items being auctioned, the process takes relatively little time to complete and actually from a buyer’s perspective are quite easy to set up. They can also be used quite readily when competition in the market is actually quite limited and traditional auction techniques may not yield results.

·           Weaknesses

The prime weakness of Dutch auctions and in fact of all non-traditional eAuction techniques is a lack of general understanding as to how the process works and as such the level of training that is required to ensure the smooth running of an event. Compounding this, although thankfully things are improving, up until very recently few of the eAuction service providers actually provided a Dutch auction solution and options are still less limited than one would like.

It should also be noted that in an event a Dutch auction would only see a single bid and as such the buyer would be blind as to how others may have bid in the event and how they stand in relation to the single bid received.

3.1.    Yankee Auction

·           Mechanism

Firstly a caveat, this is not something I have ever run myself however it is based quite heavily on the principles of a Dutch auction so I thought I’d add in a little section on the Yankee auction. Quite simply the buyer requests bids for a lot which consists of multiple units of the same item. Each seller can bid on part of the lot at a fixed price and at the end of the eAuction the buyer takes the lowest price bids, in ascending order, until a full lot is reached. As a quick example assume there were 100 items in a lot and bidder A offered to sell 50 items @ £100 each, B offered to sell 50 items @ £120 and C offered to sell 100 items @ £200 each then the buyer would allocate the full lot in a split capacity to both bidders A and C. The best way to imagine it would be a bit like ‘Dragon’s Den’ where they need to walk away with all the money but can solicit bids from multiple Dragons. Well that helps me visualise this anyway!

4.        Japanese Reverse Auction

·           Mechanism

My personal favourite eAuction form but please excuse my bias. The Japanese auction gives participants a few minutes to simply state whether or not they can commit to a dictated price level.  All those who said ‘yes’ are allowed to progress and all those who said ‘no’ are eliminated.  The price level then drops by a certain amount and the question is repeated to those who previously said ‘yes’.  The eAuction continues in this vein until all participants have ‘opted out’ of the auction.

Japanese Auction can be used in a forward, upward price direction, such as the negotiation of rebates amongst a supply base.  In this example as it is fairly meaningless to give suppliers feedback on their rebates in relation to the market (they could be providing different goods and services at different spend levels) the forward Japanese auction allows the buyer to negotiate with each supplier individually yet.

Since it is fairly meaningless to give suppliers market feedback on their rebates, as each supplier could be contracted for different goods and services and different spend levels, the Japanese Auction presents itself as a superb way to negotiate with each supplier individually yet in parallel and in a single auction.

Japanese Auctions lend themselves well to procurement professionals who prefer a negotiation restricted to their handful of preferred bidders as opposed to those who choose to proactively source from the wider market, assuming such a market exists at all.

·           Strengths

Japanese auctions are particularly popular with retailers as the approach can be a relatively successful one in markets dominated by a handful of major players or where general market liquidity is low.

Although I am not totally on-board with the ethics of this a Japanese eAuction can even be used for a single-source negotiation and has been used in this way in the past; achieving benefits where other auction types would obviously fail.

Other situations where the Japanese Auction can be used effectively are when there are large cost differences between bidders, despite both quoting for the same specifications.  With your typical Ranked Auction, the participant in first place is unlikely to be challenged, even though they may have some residual margins to expend.  However, utilise the Japanese Auction and even that participant will be asked to improve their offer.

It’s also often the case that whereas the winning bid in an English reverse event is normally slightly lower than the second best bid (why would they bid even lower when they know they are the winner?), in a Japanese, the most competitive bidder can, and often does continue to bid lower. So the buyer can benefit.

·           Weaknesses

The first problem, as is the case with Dutch auctions, they are not broadly recognised, which means participants will require a greater degree of hand-holding and reassuring.  Secondly, they offer little to the participants in the way of market feedback, although post-auction you can certainly provide feedback at your own discretion and to whatever extent you wish.  Thirdly, they operate in a rigid manner with participants only able to accept or decline each price level rather than to come in at their own price level.  It could mean that some participants have to wait a little longer to submit their final offer, although the end goal of establishing the market price is still achieved.

·           Example

Difficult to find examples and specific case studies but in 2008 a jumbo, black Densuke watermelon fetched a whopping £3,100 (650,000 yen) at a Japanese auction in 2008!

5.        Sealed Bid

·           Mechanism

A type of auction process in which all bidders simultaneously submit sealed bids to the auctioneer, so that no bidder knows how much the other auction participants have bid. The highest (or lowest depending on the auction form) bidder is usually declared the winner of the bidding process.

·           Strengths

Sealed bids are also used to ensure a “fair and open competition” where the buying organization does not have the opportunity to influence the bidding process or steer the selection of a particular company by sharing competitive bid information during the evaluation process.

·           Weaknesses

All the uncertainty related to the price of a product must be translated into a single bid, which cannot be adjusted when more information is revealed. Hence, if there is significant uncertainty about the price of the product being procured, the potential for an inefficient outcome increases since there is no price discovery.

Practical realities such as budget constraints and inter-dependency in the products’ values, in the case of multiple products, can make bidding in a sealed-bid auction exceedingly difficult unless the auctioneer allows the bidders to express these constraints in their sealed bids, which in turn can make it difficult to determine the winners.

·           Example

Often used for refinancing credit and foreign exchange, among other (primarily financial) venues.

6.        Vickrey Auction – Second price, sealed bid

·           Mechanism

Bidders submit sealed envelopes in one round of bid submission. The highest bidder wins the item, but at the price offered by the second-highest bidder (or, in a multiple-item case, the highest unsuccessful bid).

·           Strengths

The Vickrey auction gives bidders an incentive to bid their true value and allows for a focus on life cycle costing. The two-step approach can balance price and value in a manner that does not complicate the process and helps alleviate the practice of awarding business on the basis of the price tag only.

·           Weaknesses

The approach does not allow for price discovery and there is a risk that sellers use shill bids to increase profits – something that the buyer will need to be aware of.

·           Example

This type of auction is rarely used aside from setting the foreign exchange rates in some African countries.

7.         Elimination (aka survival) Auction

·           Mechanism

Multi-round sealed-bid auctions in which low bids are successively eliminated in every round with the low-bid price announced and needing to be met or exceeded in subsequent rounds

In the first round, all bidders submit a sealed bid. As a function of these bids, the auctioneer announces which bidders “survive” to the second round, a minimum bid for the second round, and, most importantly, all losing bids. In the final round of a survival auction the remaining bidders have seen bids submitted by all of the others and as such have some sense of the information possessed by the others.

·           Strengths

This approach combines the speed and predictability of sealed-bid auctions with the desirable properties of ascending-bid auctions.

·           Weaknesses

This isn't really an event favoured by buyers or sellers owing to the nature of the way the event is run.

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It is always possible of course to run a series of or a “multi-phase” auction, which may involve moving from a reverse English auction into a sealed bid or vice-versa etc. There are also probably multiple auction formats that I have not described in full detail here which I’d love to hear about!

I think the principle though is that there is an opportunity amongst the procurement community to vary their approach to the use of eAuctions and I hope this blog has provided a rough overview of the events available. In the next blog I will be discussing the ideal process to follow when setting up an eAuction and the potential pitfalls to avoid for both buyers and sellers.

SRM and eAuctions - two peas in a pod?

My time in procurement has been interlinked quite strongly with the rise web 2.0 as a powerful business tool and an advance in technological solutions, some of which are shaping the way procurement functions around the globe operate on a day to day basis.

I will be blogging over the next few weeks and months on my observations and thoughts on a wide array of procurement technologies, both how they are currently utilized and how they will continue to develop over the coming years.

To start off this blogging exercise I will be covering e-auctions and specifically the link between e-auctions and successful supplier relationship management (SRM), an association seen on both the buyer and supplier side seen as highly paradoxical. It’s easy to see why. A common view, from the supplier side, is that eAuctions are a highly aggressive sourcing technique devoid of any (or limited at best) human interaction. SRM on the other hand is still viewed with a modicum of suspicion by procurement professionals who view long term relationships as areas of untapped opportunities for savings rather than an effective tool for achieving long term value.

On closer inspection however the two tools can make for happy bedfellows.  A core part of the success of SRM involves an element of trust, openness and transparency. The openness and transparency should ensure there are no surprises for either party involved and that includes the ongoing assurance of the commercial competitiveness of whatever good or service is being purchased. This in turn generates trust, both for the buyer and the supplier, that the goods or services will not be retendered without prior discussion.

The underlying commercial structure of an account is not the be all and end all, and nor does it need to be.  A good SRM however will ensure that a mechanism exists to define how and when the competitiveness of the goods or services provided will be ratified. It may be that the approach, agreed by all parties involved, is to confirm the competitiveness in the most transparent way possible – a full market test. If this is the case then it would make sense to test the market in the most efficient, effective and ultimately transparent way possible, utilizing the latest available eAuction technology.

I would also take umbrage with the view that the use of eAuctions removes the use of a key part of any procurement activity, the important skill of human-human communication and interaction. Generations of individuals are now growing up adapting to the world of social media and differing communication channels. Whilst interaction through technology has its drawbacks it also has massive advantages as well and let’s face it, we aren’t going back to a time before computers and the internet. I’m not saying that interaction through these channels is better, just different.

Over time we will begin to adapt and see this form of communication as totally normal but for now let’s address the oft-raised concern that eAuctions embody an impersonal procurement approach or indeed have an effect on a supplier relationship or their ongoing performance. I think it simply comes down to the way that the use of the eAuction is positioned in the first place. If positioned, as outlined above, as part of a defined, transparent way, to validate the cost effectiveness of an account then there are no other methods so effective at the job.

So in conclusion eAuctions and SRM are not mutually exclusive and do not need to be seen as such. An effective SRM must include an agreed mechanism to test the commercial validity of the account and an eAuction is the must transparent, effective and efficient way of conducting the market test. The technology isn’t going away and needs to be utilised by procurement teams to manage relationships and realize further benefits.

Next week I will be discussing the various different types of eAuction available to the procurement professional along with their respective appropriateness, strengths and weaknesses.

A holistic approach to working capital - Why increased payment terms don't always result in a benefit

We have seen many articles and news stories over the past few months regarding the ethical positions of organisations and their procurement teams. I would like to specifically focus on what I have seen happen in the past when firms decide to focus heavily on implementing quick win payment term extensions which, of the 3 elements of working capital (payables, receivables and stock management) the easiest element to focus.

Payment terms negotiated and agreed as part of any supplier contract have a direct impact on the organization’s cost of working capital, the lifeblood of any business.

For Procurement however payment terms can be a double edged sword. Extended payment terms may help lower the cost of working capital but they don’t always support healthy supplier relationships or indeed their finances. Further this easy approach doesn’t make sense as, looking at this holistically, it costs a fortune, especially in our post 2008 world.

With interest rates so low even exceptionally cash rich organisations achieve little more than 1% on their cash holding and extending payment terms for a further 30 days will see them gain minimally (less than 0.01%). The supplier on the other hand may have to pay a 3%+ factoring cost to cover that extra period with additional costs for early payment. Although firms implementing these changes may not see it as such the reality is that these additional costs will not only be passed downstream but back upstream as well.

In many instances procurement departments don’t even consider working capital, and there are benefits to be had from tying the two areas together. Extending payment terms isn’t necessarily the right answer though.

Procurement should look more generally at their supply chain to understand the potential benefits of supply chain finance. By understanding the working capital requirements of suppliers, significant sourcing cost can be generated by imaginative use of discounts in return for early payment. Supply chain techniques like dynamic discounting should be developed and managed by Procurement who should take the lead in identifying and prioritizing suppliers.

It may also be true that a slightly more managed approach, such as supplier discounting, provides an important fail safe mechanism for a supplier during turbulent times and for the buyer, it helps to mitigate the risk of the supplier failing.

So in a nutshell, firms should take a broader view of procurement costs and consider the wider implications of payment term changes in the supply chain. There may be further hidden opportunity costs of not using supply chain finance that simply focusing on extending payment terms can blind you to.

All of this does involve a pretty joined up approach between Procurement, Finance and the Treasury team. Clearly there is a downside to “days payable outstanding” (DPO) for early payment and in a siloed world that’s all that Finance may focus on.

Of course all I have really done here is focus on one element of working capital, namely the payment process, but there may be wider benefit in procurement considering their impact on working capital more generally as well (stock management etc.). For example a buyer, incentivised solely on achieving a favourable unit price, may negotiate a rate at 50% below the market price but if the company ends up with 10 years stock the deal may not necessarily be of overall value to the business.

Working capital provides the financial foundation to any commercial business and has traditionally been seen as being within the realm of a firm’s finance function. A joined up approach with Procurement however may help organisations to develop a more rounded view on the subject. Such an approach may help firms uncover further benefits and, again linking to the recent headlines, avoid such ethical quandaries. 

Natural Resource Scarcity: The Implications for Procurement

Economic development around the world has continued to drive up the demand for natural resources that are required to build infrastructure or produce new consumer products.

In simplistic terms an increased number of consumers in new places and an increased buyer power amongst those consumers heighten the level of demand. This increased demand will need to be met with an equivalent increase in supply and that may not be possible. In such a scenario the supply of critical resources will no longer be a question of money; securing the limited amount of natural resources available will become the key challenge for procurement teams.

Geopolitics, limited suppliers, price rises and sustainability concerns are just some of the drivers of resource constraints and we are seeing examples of these issues today.

One such example surrounds the supply of rare earth metals, which are used extensively in now common place technologies such as fuel cells, LED lighting, batteries, mobile phones and wind turbine generators. Worldwide demand for these metals already exceeds supply, over 90% of which is from mainland China, and this gap will not be closed unless major new supply sources are developed.

Food or water could be also be highlighted as other areas of scarcity. Global food reserves recently hit an all-time low and, married to continuing population increases, are unlikely to improve in the short term. A recent FT article cited access to water as one of the most significant business risks to the mining industry.

Scarcity is an issue that is on the sustainable procurement agenda now but is moving towards the centre of business strategy in certain industries, with a focus on securing long term supply cost efficiently and sustainably. Firms that are unable to protect themselves from the threat will face significant challenges to their growth plans and long term competitive advantage.

Procurement is often the first function in a business to be confronted by the impact of scarcity (challenges in supply, price increases etc.) and so should be well placed to take a lead in elevating
the topic onto management’s strategic agenda. Other functions such as R&D (innovation) , Marketing (forecasting) and Supply Chain also have a key role to play in developing responses to the scarcity challenge, but may not be as sufficiently engaged.

Social Media and Procurement

Over recent years social media has revolutionised the way that people interact with each other, at both an individual and a global level. Businesses have recently begun to leverage social media, transforming the approach that they take to functions such as sales, marketing and their customer handling.

Now firms are beginning to see that social media can also be used effectively by procurement, offering an unparalleled level of opportunity for collaboration and information sharing which, if harnessed, can offer huge performance improvements.

These improvements can be broken down into three separate areas:

• Efficiency: Social media offers information on tap and enables users to exchange their relevant knowledge, discuss specific topics and raise or address any immediate concerns in a controlled setting. Social media can be used to reduce the time people spend chasing each other down, allowing them to spend more time working effectively.

• Innovation: Social media allows procurement professionals to engage suppliers directly and manage the information flow back and forth in an efficient manner. Such an approach provides an open platform for change which can help speed up the innovation and development process. Bringing suppliers into the innovation process as soon as possible, or enlightening them to a problem that needs to be solved, encourages collaborative working and helps foster strategic partners.

• Decision making: It’s important for procurement professionals to stay up to date on relevant suppliers and their offerings. Using public forums available on social networks, procurement professionals can study what suppliers have to say about industry issues, new opportunities, upcoming trends or market expansion plans. The information can also be used to give procurement professionals deep insights about the general supply market and help them mitigate risk in their purchasing decisions.

New procurement professionals are active users of online communities such as LinkedIn and Facebook and traditional technology providers are working to modify their offerings to include “collaboration modules”, bringing together traditional purchasing with social media. Although very few companies have yet adopted social media as an integral part of their procurement process this is expected to change in 2015.