Not Your Father's Auction

April 26, 2010
Some companies are revisiting a time tested transaction process to move large volumes of product in a cost effective and customer friendly way.

As industries evolve, most products or service offerings become more commoditized, and buying criteria become increasingly price-based. In some companies, 80% or more of revenues are generated by commodity products or services (often driving only 40-60% of profit). However, while most established industries have experienced some commoditization over time, rarely has the transaction model evolved with it.

In many cases, traditional sales and procurement processes-utilizing negotiated bilateral contracts-are costly and inconsistent with the underlying product margins and customer cost-to-serve. For products that compete on price, negotiating custom sales terms, conditions and prices is inefficient for buyers and sellers.

Despite believing they are negotiating a better result, research shows protracted negotiation raises transaction costs for the parties involved. And the intangible inefficiencies may be even more costly. High transaction costs prevent companies from serving all potential customers or segments. In addition, the inability of the bilateral process to provide credible market price information can lead to other serious business challenges, such as a delay in market development, restriction of product innovation, and inefficient capital decisions.

In response to market commoditization, some companies are successfully adopting what some might consider a traditional mechanism for selling commodity products, seller-side auctions (SSA), but with advanced designs and implementations to better achieve sellers' objectives.

Auctions are commonly used in procurement processes, but large scale SSA processes require more than off-the-shelf auction software and they offer far greater value. The evolution in technology, combined with advanced economic analysis of customer behavior, yields a standardized sales channel tailored to the specific market needs or seller objectives. Through SSAs, clients have moved anywhere from tens of millions to over hundreds of millions of dollars worth in product in the span of hours. And the bidders involved are uniformly satisfied, knowing they paid a fair market price, and a price that is in line with prices their competitors are paying.

What distinguishes the auctions of today from those of the past is the level of sophistication and customization that economic experts bring and that technology enables. SSAs currently are used by industries varying from global dairy markets and other agricultural commodities to telecom spectrum, and electricity transmission rights and wholesale power.

These SSAs have lowered information and transaction costs, lowered SG&A costs, improved customer relations, and established key industry pricing benchmarks critical for long-term planning and investment decisions. In some cases, prices have increased as a result of customers being concerned about purchasing parity with their competitors rather than the absolute price.

Benefits of Seller-Side Auctions

SSAs require a shift in the approach to the sales process. In bilateral negotiations, buyers and sellers each focus on establishing the price and terms of the sale. In an SSA auction, the terms of sale become standardized. Standardization levels the playing field for all customers, reduces large customer leverage and eases concerns about process equity for smaller customers.

The benefits of a more open and transparent process are widespread. They include:

Refocusing Sales Resources on Higher Margin Activities

An auction can reduce the time and direct costs associated with commodity transactions. This efficiency allows sales teams to refocus on value-added products and services, rather than facilitating commodity transactions, and increases the percentage of their time dedicated to prospecting for new customers.

Improving Revenue Visibility and Forecasting Accuracy

Bilateral contracting yields a portfolio of contracts with custom terms and conditions across customers. The varying conditions complicate revenue visibility and financial projections, and often create invisible risk to management. Prior to adopting an auction, CRA's agricultural sector clients often had difficulty with revenue transparency because contract revenues were disconnected from the market's fundamental conditions. This type of situation can lead to a depressed market valuation for a company. For both publicly traded and privately held companies, revenue visibility has implications for financial planning and resource allocation. SSAs offer standardized pricing and terms, thereby improving revenue visibility and forecasting accuracy.

Reducing Renegotiation Risk

Inconsistency across contracts affects supplier-customer relations, and lays a foundation for contract disputes, renegotiations, and even litigation. For example, in the coal industry, an overwhelming majority of the tonnages were exchanged under long-term contracts. In these markets, litigation costs evolved into a de facto option strike price. Once contracts were sufficiently out of market, litigation costs were justified and buyers would initiate the costly process of renegotiation through arbitration or litigation. By eliminating inconsistency in contracts, an SSA reduces a variety of contract risks.

Improving Customer Relationships

In auctions, buyers and sellers participate as partners rather than adversaries. CRA's dairy market client actually reports greater customer interaction as a result its SSAs. By allowing the market forces to reveal clearing prices, sales and procurement functions become more aligned around optimizing the customer's sourcing strategies for key commodity inputs. The sales force helps bidders use the auction to best achieve their sourcing goals. In addition, buyers and sellers work to tailor the auction process to meet customer needs over time.

Reducing Price Barriers and Providing Market Intelligence

For bidders, auctions greatly reduce the information cost associated with market participation. As the auction works towards a clearing price, bidders benefit from the collective intelligence of the entire marketplace. The reassurance the process provides, in turn, allows bidders to bid up to the full valuation, thereby benefitting sellers. In some cases, auction clearing prices from CRA's auctions in agricultural markets have exceeded client expectations and anecdotal prices outside the auction by as much as 25%. Such anecdotes illustrate that perceived industry knowledge can be inaccurate, even with a strong understanding of overall market dynamics, and that there is a need for market-oriented transaction mechanisms that produce credible price signals.

Attracting New Customers and Targeting Underserved Market Segments

By increasing transaction efficiency, the auction process can open underserved market segments which otherwise are too costly to serve. Individually, smaller customers may not warrant the requisite sales and administrative attention. Collectively, however, they can be an important source of incremental revenue. Auctions can serve incremental customers at almost no incremental cost. In addition, the fundamental benefit of the auction-to reduce transaction cost-works both ways in creating new sales opportunities. As a result of cost savings that flow to bidders, companies that were previously unable to profitably participate in the market under a bilateral negotiation framework may join the marketplace via an SSA. In nearly every CRA auction, regardless of industry, clients have found new customers or project partners that were "off the radar" prior to the launch of the auction.

Ideal Situations for Seller-Side Auctions

Determining if the current sales and procurement process has become misaligned with industry supply chain dynamics requires a comprehensive review of the overall market, including customers, products, and contracting processes. In our experience, the initial step is an examination of the current customer interface to identify voids between markets and existing processes. Potential to leverage an SSA approach may exist if:

  • Products have commoditized over time, but the sales channels have not
  • Customers buy not because of superior quality or product differentiation but simply because of an existing relationship-such customers should be considered at risk
  • Sales or procurement representatives spend significant time facilitating transactions for products or services that compete primarily on price
  • Customers do not pay for many of the services they demand
  • Contracts have stipulations, such as take or pay, fixed price, delivery specifications, and graduated volume discounts, and lack remediation language
  • Price decreases are often passed onto customers but increases are almost never recovered from them

The sales channel is the ultimate interface between customer and vendor. Misalignment between the sales channel, the industry, and the product can adversely affect operating efficiency and customer relations. An auction represents one option for standardizing the flow of information between buyer and seller in a way that may be customized to a company's goals, thereby providing a number of highly effective and relevant efficiencies.

Robert Lee and Kearney Klein are consultants with Charles River Associates and advise companies across a range of industries on auctions, competitive bidding processes, and other trading mechanisms.

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