Buy-Side Dutch Auctions: Commodities, Tulips, and the Bubonic Plague
If you are in Procurement, no doubt you have heard the term “Dutch Auction”. But what is it, and when would you want to use it, or not use it?
Dutch Auction is new in SAP Sourcing 7.0 (released in July 2011), but in practice it has been around since the 1600’s. Just like the rise and fall of the Tech Bubble in the 1990’s, imagine an era when tulips were all the craze in Europe, and in particular the Netherlands. The flower, introduced to Europe in mid-16th century, became extremely popular and grew into the must-have luxury status symbol–the iPad of that time. But alas, tulips and flowers in general don’t sell well when they become a few days old, and tulip merchants looked for a way to sell the flowers quickly, especially at the end of a long day. So how could merchants rapidly sell tulips before their value literally wilts away? And if that wasn’t hard enough, how can they sell before the buyer base succumbs to the other development that was sweeping through Europe at that time, namely the bubonic plaque?
Answer: Dutch Auction. Bark out a high price, and see if anyone raises their hand to buy at that price. No takers? Yell out a lower price, and look for hands. Continue until the hands go up, and then sell to them at that price.
Now, that was a sell-side Dutch Auction. What about buy-side? You’ve probably witnessed this several times without even realizing it. Picture yourself waiting at an airport gate for a plane that is overbooked. The gate agent calls out that he wants to “buy” a seat back for $100. Nobody responds. The gate agent then offers to buy a seat for $200, and then maybe $300. At some point a volunteer “seller” steps forward, and the deal is done. Very fast. Very efficient.
So in a buy-side Dutch Auction, the price starts low and keeps rising until a bidder “raises his hand”. It takes just one bid, and the auction ends and the transaction is complete. (To be completely accurate, the bidding occurs at the individual line item level.)
But when would this work for you? There are many opinions, and there is not necessarily a one-size-fits-all answer. But here are some guidelines:
- You have many bidders. While Dutch Auctions can be conducted with any number of bidders, it is most efficient with a large number of bidders. As a buyer, you want the bidders to each have their finger on the trigger, ready to bid out of fear that someone else will pull the trigger first. The more bidders there are, the more competition to be the first to bid. Also, there is always the risk of some level of collusion among the bidders. The more players in the game, the less likelihood of potential foul play.
- The auction is driven by price. If there are other factors, such as delivery time, warranty, terms and conditions or other variables, it is best to negotiate via an RFP or RFQ, which could eventually lead to an auction. Caution: all supplier bidders should be pre-qualified to ensure the proper and consistent level of quality, sustainability factors, and other potentially differing attributes. You essentially want to “lock down” all other non-price variables.
- Dutch Auction would result in more favorable results than other auction formats. This is a tough call without actually sampling the market. It is difficult if not impossible to run both a regular reverse English Auction and a Dutch Auction to compare the two results, since conditioning suppliers to bid in two strikingly different formats in two separate events for the same product may not be acceptable business practices. Still, you may want to extrapolate from your past procurement events to gauge the relative effectiveness of a Dutch Auction.
- The product being sourced is commoditized and competitive. Look for products that can be readily procured in the open market with reasonable price competition. In a Dutch Auction, these products yield much better results than products with some level of specialization. Many common raw materials, as well as MRO’s and general services, may fall into this category.
- Supplier indifference versus supplier relationship. If your procurement goal for the event is based more on the product and price versus establishing a long-term relationship with the supplier, auctions in general may be an excellent vehicle for driving down prices. But in a number of very critical situations, establishing a solid relationship with the supplier is deeply valued, especially if factors such as service, guarantees, support, or expediting is important. In a global trading environment, cultural and customary practices regarding supplier relationships may also play a strong role, and should be considered before conducting an auction of any kind.
- RFx quotes show a pricing pattern that may yield better results in an openly competitive auction. This is also a tough call, but if your pre-auction RFX quote analysis shows a bidding behavior where the price quotes are lumped together, you may obtain even lower prices through a more openly competitive bidding of a Dutch Auction. Again, you need to ensure that all other variables, especially quality, are equitable and “locked down”. Alternatively, a huge variation in RFx quoted prices may signal an opportunity for a Dutch Auction if you feel that there is a certain price elasticity that may lend itself well to competitive bidding.
- Your suppliers are trainable. You’ve probably seen your share of low-tech Luddite suppliers. A key to a successful auction is supplier training. A Dutch Auction is different from the more familiar standard reverse English Auction, and you want to ensure that your suppliers understand and are comfortable with this type of event.
- The quotes you got from an RFx is too high. If you receive RFx quotes that are significantly higher than your current or historic price points without a reasonable market reason, you may want to consider conducting a Dutch Auction. Keep in mind that SAP Sourcing Dutch Auctions has certain safeguards to prevent you from paying over your historic price or other price point. You can do this by setting a ceiling price (if no one bids, the Dutch Auction line item closes if the price hits the ceiling price) as well as setting a reserve price (you, the buyer, are not obligated to buy unless the bid price is at or below the reserve price.
So there you have it—the main considerations and guidelines for using Dutch Auctions. Now, we could also go into the benefits of Dutch Auctions and other auction types, such as maximizing savings, providing alternative procurement and sourcing options, creating supplier competition, and performing high-volume transactions quickly. We could also delve into some clever auction techniques, such as running an auction for a small quantity just to establish acceptable price points. And then there are some purely theoretical, unconventional, and non-recommended practices such as running a Dutch Auction with a single bidder (the bidder wouldn’t know that he is the only bidder, but he’s really competing against himself!) But all these are better addressed in separate blogs. Until then, thanks for reading and I wish you the best should you decide to “Go Dutch”.