Having It All

RESEARCH SHOWS HOW TO STRUCTURE PROCUREMENT AUCTIONS TO INDUCE BETTER BIDDER BEHAVIOR

Research By Tunay I. Tunca

Individual consumers compete against each other in traditional online auctions. When the bidding stops, the highest price wins. The opposite happens when large-scale buyers use online auctions to procure goods and services for their companies.

Instead of multiple buyers driving up prices for one seller, multiple sellers undercut each other to woo one buyer. The winner of these reverse auctions is often the supplier with the lowest bid price, but not always.

In many cases corporate buyers must also control for quality — especially when procuring complex goods or services. The trick is finding the right balance between price and quality. New research, co-authored by Tunay I. Tunca, Professor of Management Science and Operations Management at the University of Maryland’s Robert H. Smith School of Business, provides clues for closing the gap between these competing considerations. Using data from General Electric’s legal services procurement process, the researchers show how buyers can structure reverse online auctions to generate substantial savings for their companies when quality considerations exist. The process involves five basic steps.

1. Know what you want. Price matters most when procuring simple commodities or services that look the same regardless of the source. Motorists shopping for unleaded gasoline, for example, can find similar fuel at any reputable station. Quality matters most when products or services vary widely and the stakes are high. Art collectors, for example, must pay a premium for masterpiece paintings — the opposite of a commodity. Likewise, wealthy parents do not bargain shop for their children’s education or health care. Most business transactions fall somewhere between these extremes. Price and quality both matter, which means corporate buyers need to understand their true preferences.

2. Be open about the procedure. When quality and price matter, buyers should let potential suppliers know that both considerations will shape the winner selection process. GE informs law firms vying for its legal services contracts that selection will be based on quality considerations such as specific personnel, relevant experience and availability, as well as economic considerations, such as suppliers’ bid prices and ability to comply with transaction-related policies.

3. Stay flexible. When quality considerations exist, buyers should announce up front that bidding results are nonbinding. Although GE sets clear scoring rules for its legal services sourcing, the company does not commit to necessarily award the contracts to the suppliers with the best scores. Instead, GE reserves the right to award contracts to the most suitable law firms after observing scoring results. This open-ended, two-stage award structure has several advantages over the traditional closed-ended approach, which binds buyers to select auction winners based on announced scoring rules. Significantly, an open-ended structure allows buyers to keep their true preferences for price and quality private. This can intensify competition, as discussed in the next step.

4. Guard your preferences. Although clear rules are needed, buyers who use an open-ended award structure do not need to disclose their true preferences, especially when quality considerations factor heavily. If bidders know that a company is willing to pay a premium, then high-quality suppliers have leverage to keep their prices inflated. If bidders know that price and quality both factor in the process — but not the extent that each variable is preferred — then high-quality suppliers must lower their prices to compete more aggressively with lower-quality participants.

5. Open the playing field. Successful implementation of online auctions hinges on the willing participation of qualified bidders. To encourage rigorous competition, buyers must take steps to ensure a fair process. Among other things, they must guard against an incumbency advantage. Newcomers will be turned off from participation if they perceive favoritism for long-term suppliers. Even if an incumbent or another high-quality supplier wins a new contract in the end, aggressive bidding from multiple players can help drive down prices.

READ MORE

“An Empirical Analysis of Price, Quality and Incumbency in Procurement Auctions,” co-authored by Tunay I. Tunca, appears in the summer 2014 issue of Manufacturing & Service Operations Management. Full Citation: Tunay I. Tunca, D.J. Wu and Fang Vivian Zhong, An Empirical Analysis of Price, Quality, and Incumbency in Procurement Auctions, 2014, M&SOM, 16(3), 346-364.