Bidders Beware: The Ins and Outs of Reverse Auctions

A project manager sits down at his computer at 9 a.m., logs into a Web site, and types in his company's bid for electrical construction services. Over the next hour, he watches the price for work continue to drop on his computer screen. He meets with his team to see if it's possible to submit a lower bid without sacrificing profitability. After submitting his drop-dead bid, he sees the number plunge

A project manager sits down at his computer at 9 a.m., logs into a Web site, and types in his company's bid for electrical construction services. Over the next hour, he watches the price for work continue to drop on his computer screen. He meets with his team to see if it's possible to submit a lower bid without sacrificing profitability. After submitting his drop-dead bid, he sees the number plunge until it gets to the point of no return. Not wanting to risk losing money on the job, he decides to walk away from the auction, and the contract is awarded to the lowest bidder.

Reverse auctions like the one described above have one primary mission — to get the lowest possible bid for products or services. Unlike traditional auctions in which the price goes up, reverse auctions drive down the cost until a specified deadline. This form of bidding often requires the bidders to disclose their prices to each other, which can be considered another form of bid shopping. The owner or general contractor may look only at one element of the construction bid — price — without taking into account the bidders' work history, experience, or other related qualifications.

Bidders may be pressured to reduce their main price variable — the amount of supervision and labor on the project — to levels that will endanger safety and decrease quality in order to win the job, according to the Construction Industry Cooperative Council of Minnesota. General contractors and subcontractors are demanded to lower their prices or risk losing the work, which can create an adversarial relationship between the entire project team, according to a 2002 paper by Dean Thomson and Jocelyn Knoll of Fabyanske, Westra, and Hart, a Minneapolis-based firm that provides legal services to the finance, real estate, and construction industries.

Proponents of reverse auction bidding argue that it allows owners to use the power of the Internet to reach the broadest market and obtain the lowest price. For example, A.T. Kearney Procurement Solutions, a Chicago-based comprehensive strategic procurement services firm, developed an auction technology that promises to shave weeks off the negotiation process, generate substantial savings, provide an even playing field for bidders, and ensure a collaborative bidding environment.

In reality, however, online reverse auctions often oversell and underdeliver, says Bob Emiliani, the president of Kensington, Conn.-based Center for Lean Business Management, LLC. Emiliani ran reverse auctions as a supply/commodity manager and now conducts research on this type of bidding method (visit to read his reports on reverse online auctions). Since FreeMarkets hosted the first online reverse auction a decade ago, the number of companies providing these services plunged from hundreds to dozens, he says. The reason for this decline is due to the lack of substantial benefits to the buyers or the sellers. The savings from a reverse auction are often cut in half, and sometimes even more, he says.

“Building owners may believe that they are going to save money on the construction job, but our research has shown that is not the case,” he says. “If you peel back the layers and look carefully at the measurement that the owners use to track savings and purchasing, you find out that the numbers are very easy to play games with, and a lot of savings turns out to be not a lot of savings.”

Reverse auctions were originally designed to procure commodities and other manufactured goods, but vendors and owners are now trying to apply this same process to construction. The Associated General Contractors of America (AGC) says that such a procurement method ignores the unique nature of this industry.

“The construction process is fundamentally different from the manufacturing process,” states a white paper by the AGC (Sidebar). “Manufactured goods are subject to little to no variability or change in the manufacture or application. Construction projects, on the other hand, are inherently variable. Each is subject to the unique demands of the project, such as the needs, requirements, personnel, and budgetary criteria of the owner, site conditions, design features and parameters, and the composition of the project team.”

According to the AGC, federal procurement laws recognize the inherent difference between construction and manufactured goods. In fact, two years ago, a memorandum distributed to all federal procurement executives advised them to not treat construction as a commodity for government procurement purposes. Other entities have followed the federal government's lead. Kansas and Pennsylvania have enacted statutes prohibiting the procurement of construction services through reverse auctions, while other states such as Minnesota have legislative authority to use reverse auction bidding to procure goods, but not services.

This type of bidding, however, is currently underway in several other states nationwide. According to the Construction Industry Cooperative Council of Minnesota, several large national “big box” retailers are using reverse auction bidding to select general contractors and subcontractors. During a reverse auction for a department store in Phoenix, the owner initiated a starting bid price, and then the subcontractors submitted bids at progressively lower increments of at least 1%, according to Roofing Contractor magazine. Although the auction was limited to 30 minutes, a three-minute time extension was added if a bid was placed in the last two minutes before the deadline.

While reverse auction bidding occurs frequently in the retail industry, it also happens in other markets and industries. For a more intimate view of this bid practice, two electrical contracting firms from the East Coast and the Midwest share their recent experiences with reverse auction bidding.

Online bidding in the Garden State. John Conroy, the president of Xcelecom, a Hamden, Conn.-based electrical and V/D/V firm, says his company's clients have started to use more electronic communications and tools rather than paper-based systems. As part of the trend to speed up communications and cut costs, some have opted to use Internet reverse bidding auctions. He says these auctions are especially popular in New Jersey, where a general contractor uses reverse auctions for its projects with an electrical contract value of at least $10 million. The general contractor puts the entire bid spec package out on the Internet a few weeks before the auction and invites subcontractors to participate in a prequalification process. Each bidder uses a unique log-on ID to submit the bid at a specified start time. After about a half an hour, the auction begins. Bidders can submit multiple bids as long as they're lower than the current bid.

“Reverse auctions are like an eBay nightmare,” Conroy says. “We put our number out and end up in a downward spiraling, gaming type atmosphere. Any differences in how each competitor is planning on building the project, or in quality of work, or even in ability to build within the slated timeframe, seems to be ignored in this type of process.”

In all five of the reverse online auctions that Xcelecom's member company has participated in, the final number has gone well below the company's and any reasonable competitor's cost. Conroy says unless the winning bidder has a better way to do the job than anyone else in the industry, he suspects the company will most likely run into financial problems once the project is underway.

“The company that wins the auction may not realize until a year or two into the job that they are going to lose money,” he says. “In a situation in which the subcontractor fails, the project still has to be built. It becomes more of a problem for someone else to step in. That low bid may turn out to cost a lot more by the time it's all said and done.”

Reverse auctions might work for fully designed construction projects without the potential for a lot of changeorders, particularly where all the bidders are rational, highly qualified, and equivalent in terms of management depth and experience. The minute that you add complexity to the project or a bidder has design drawings that are only partially complete, it becomes nearly impossible to identify the true low bidder, Conroy says.

Conroy says although most of the New Jersey electrical contracting firm's projects are procured through traditional bidding methods, the company sees reverse auctions come up about once a month. He says he hopes that this trend won't spread across the country.

“In a down economy, it's understandable that customers or the general contractors would try to use this sort of process because people are hungry for work,” Conroy says. “In a strong economy when you've got plenty of work and can price higher, I don't think this approach would work as well. Many people would look at it and say, ‘Why should I bother? There's plenty of other work out there that I have a fair shot at. I'm not going to waste my time on this.’”

Automotive auctions. New Jersey isn't the only location where electrical contracting firms are contending with reverse auctions. Nearly 10% of the projects that Westlake, Ohio-based Lake Erie Electric bids on were done through this method up until six months ago.

President Peter Corogin says reverse auctions became popular in the automotive industry because the manufacturers wanted to investigate new bidding strategies for purchasing construction services in hopes of reducing costs. But times have changed, and the novelty of reverse auctions has started to fade away.

“Our recent experience has shown that the automotive companies we bid work for appear to have cooled on this type of format,” he says. “We've also declined, and will continue to decline to participate in most of the reverse auctions.”

To participate in the bidding process, Corogin says the firms submit their price and then keep revising their bids until they decide they're not going to lower their bid anymore. Owners are generally supposed to close the auction at a specific time, but in Corogin's experience, they sometimes leave it open for a half hour beyond the specified deadline.

“It's the worst type of auction and is very frustrating,” Corogin says. “You have to determine what your price is for the job and be prepared to walk away at your number. The guys who chase the market often get into trouble.”

Sidebar: An Opponent's Point of View of Reverse Auction Bidding

Associated General Contractors of America (AGC) issued a white paper on reverse auctions for the procurement of construction. Here are some of the key findings of the report.

  • Reverse auctions don't guarantee the lowest price. Bidders may never offer their best or lowest possible price because they recognize that as the auction progresses, they will have the option to provide successive bids. As a result, this bidding method may not lower the cost of construction.

  • Reverse auctions may encourage imprudent bidding. Reverse auctions create a highly competitive environment in which contractors have to deal with multiple rounds of bidding in quick succession. This leaves little time for the bidders to accurately reassess their costs before placing a lower bid.

  • Sealed bidding ensures that the successful bidder is responsive and responsible. This procurement process ensures fairness and value for the owner by evaluating the bid proposals based on a variety of objective criteria apart from price.

  • Reverse auctions may contravene federal procurement laws and certain state laws. Federal procurement laws don't address the use of reverse bid auctions to procure construction, but the Federal Acquisition Regulation (FAR) and current procurement statutes have a clear policy of not disclosing contractors' price information.

Source: Associated General Contractors of America

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