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Chapter 6.5

Implement Reverse Auctions to Reduce Purchasing Costs


Summary

Reverse auctions have become a popular feature of e-commerce systems. Reverse auctions allow multiple sellers to bid to provide goods or services electronically with the price falling from bid to bid. The buyer awards the contract to the lowest bidder at the end of the auction. The Texas Attorney General issued an opinion that reverse auctions are not permissible under current state law. State law should be changed to allow state agencies to use reverse auctions.


Background

Electronic commerce is fundamentally changing the way business is conducted. Business and government can notify vendors of their need for goods and services, make their requirements and specifications known, or request and accept bids and proposals, all electronically.

In 1997, in recognition of this changing environment, the Texas Legislature passed Senate Bill 820, which required the General Services Commission (GSC) to establish and operate an electronic procurement marketplace, including an electronic commerce network.[1] In February 2000, GSC awarded a contract to implement a Web-based electronic procurement system pilot project. Entering through a common portal, purchasers and other authorized users can search for the source of products and services; access existing state term contracts; and solicit, receive, evaluate and award bids. Other options allow purchasers and authorized users to receive shipping notices and invoices, use automated vendor performance management, and access state-owned inventories (warehouse, central supplies, etc.). In April 2000, the first electronic transactions were placed through this system. The project was designed to continue at least through August 2000, but has been extended until August 2001.[2]

Another practice, on-line reverse auctions, has become a popular feature of e-commerce systems. Unlike normal auctions that have a single seller and multiple buyers (with the price rising from bid to bid), a reverse auction features a single buyer and multiple sellers, with the price falling from bid to bid. The reverse auction ends when no seller is willing to offer a lower price within the designated time period.[3] The process starts with the buyer communicating clear specifications about what is to be purchased. Prospective sellers provide information to prove that they can deliver the goods or products if they are the lowest bidder.

On-line reverse auctions are not currently part of the Texas pilot project but other governmental entities are using them. One of the first states to use reverse auctions is the Commonwealth of Pennsylvania. Pennsylvania contracts with Freemarkets, Inc., a business-to-business e-commerce firm, to conduct “reverse” Internet auctions. Under the terms of this arrangement, the vendor receives a monthly fee and a performance fee.[4] The monthly fee, called the “base monthly fee,” is the greater of $55,000 for each month the contract is in effect, or 0.75 percent of the cumulative bid volume for each monthly period. The performance fee is 10 percent of the sum of the monthly fee from the state plus a percentage of any savings from the auction when compared to historical purchase prices.[5]

Pennsylvania’s initial reverse auction efforts included coiled aluminum for license plates, anthracite coal, road salt, diesel fuel, reflective sheeting for roadway signs, copy machine paper, a telecommunications system and office furniture for a new state building. Pennsylvania’s reverse auctions saved about $1 million on the purchase of anthracite coal, and $4 million on office furniture when compared to existing state contracts. Overall, the estimated savings during the first 15 months of the reverse auction program total $10.2 million. Additionally, by having the vendor, Freemarkets Inc., participate on a “shared savings” basis, Pennsylvania reduces the financial risk of the venture.[6]

Items typically considered candidates for reverse auctions include high-volume, commodity-type materials.[7] However, reverse auctions may also be appropriate any time the buyer can clearly specify what is to be purchased, leaving price as the only variable to be considered.[8] For example, the Naval Supply Systems Command (NAVSUP) conducted its first reverse auction, also using Freemarkets, Inc., on May 5, 2000 for components of airplane ejection seats. In this case NAVSUP was able to clearly specify what the sellers were to provide, thus price was the only variable to consider. NAVSUP estimates savings of about 29 percent over the historical price for these items, with the final contract awarded for $2.37 million[9].

TxDOT purchases a variety of commodities that are generally considered good candidates for reverse auctions. Examples of these commodities and the dollar amounts purchased in fiscal 1999 are summarized in Exhibit 1.

Exhibit 1

Selected TxDOT Commodity Purchases

Material Category
1999 Fiscal Year Purchases[10]).
Aggregate, Base and Cement
$25,483,652
Gasoline, Diesel Fuel
9,047,938
Traffic Paint and Beads
3,591,144
Office Machines, Furniture
2,318,146
Drainage, Culvert, etc.
1,060,768
Total
$41,501,648

Source: Texas Department of Transportation.

In July 2000, GSC requested an Attorney General (AG) Opinion to clarify whether it has the authority to conduct reverse auctions. On December 15, 2000, the AG Opinion was issued and concluded that reverse auctions are not permissible under current Texas law and that specific statutory authorization would be required.[11]


Recommendations

A. State law should authorize reverse auctions and allow the General Services Commission (GSC) to delegate the authority to conduct reverse auctions to other state agencies.

State law should allow reverse auctions to be conducted by GSC, and other state agencies to use reverse auctions under authority delegated by GSC or state law. State law should allow GSC to contract for reverse auction services and enter into a share-saving arrangement to mitigate the costs and increase vendor participation. Reverse auctions would be a complementary process to the state’s ongoing e-commerce project, not a replacement for it.

GSC should contract for the reverse auction service, using the Pennsylvania reverse auction program as a model, in order to expedite implementation. GSC should ensure that the contractor would set-up and train clients, including state agencies and vendors, on using the service and conducting the auction. Selection of a reverse auction provider should be based on proven ability to successfully conduct Internet auctions and to provide cost-effective, onsite technical assistance to potential auction participants.

GSC should develop guidelines for using reverse auctions on delegated purchases and determine whether it is beneficial to have the same contractor provide reverse auction services for delegated purchases or if separate vendors should be used.

B. State law should be changed to set targets for using reverse auctions to purchase commodities used by TxDOT.

State law should require that at least 10 percent of the commodities identified in Exhibit 1 be purchased using reverse auctions in fiscal 2002 and the amount should increase at 10 percent each year until at least 50 percent of these commodities are purchased using reverse auctions. The provisions should apply to both GSC, when purchasing on TxDOT’s behalf, and to TxDOT.


Fiscal Impact

The General Services Commission may incur some costs to establish a reverse auction process for the state; however, based on reverse auctions in other states such as Pennsylvania, auction vendors can absorb the cost of set-up in exchange for a commission.

Using reverse auctions is expected to result in savings of 15 percent of the historic costs, based upon the experiences of several major corporations.[12] Using the material categories and dollar purchases for fiscal 1999, identified in Exhibit 1, and subjecting 10 percent of these purchases, or about $4.2 million, to reverse auctions in fiscal 2002 would result in savings of about $623,000. Using reverse auctions to purchase 20 percent of these commodities, or about $8.3 million, in fiscal 2003, would result in a savings of about $1.2 million. By 2006, when at least 50 percent of these commodities, or about $20.7 million, would be purchased using reverse auctions, the savings would total slightly more that $3.1 million. The estimated savings below represent amounts to the State Highway Fund that could be directed to Texas Department of Transportation roadway construction and maintenance programs to bring the highway system into to the 21st Century.

Fiscal Year
Savings to the State
Highway Fund Available to Redirect
2002
$623,000
2003
$1,245,000
2004
$1,868,000
2005
$2,490,000
2006
$3,113,000

Endnotes

[1] General Services Commission, “TxG2B: Texas Government-to-Business Coordinating Council” (http://www.gsc.state.tx.us/elec_comm/ectf.html)

[2] General Services Commission, “TxG2B: Texas Government-to-Business Coordinating Council” (http://www.gsc.state.tx.us/elec_comm/ectf.html).(Internet document.)

[3] William Matthews, “Bold New Bid,” Federal Computer Week (http://www.fcw.com/fcw/articles/2000/0417/cover-04-17-00.asp).(Internet document.), and telephone interview with Michael Luna, General Services Commission, Austin, Texas, January 4, 2001.

[4] Pennsylvania Department of General Services “Schedule 1” section of contract with Freemarkets, Inc., Harrisburg, Pennsylvania, July 5, 2000. (Internet Document.)

[5] “Historic Price” is defined in the Pennsylvania/FreeMarkets contract terms as “the dollar value of an item as agreed to by the client (State of Pennsylvania) and FreeMarkets prior to services being provided...”

[6] Pennsylvania General Services Office, Harrisburg, Pennsylvania, July 5, 2000.

[7] William Matthews, “Bold New Bid,” Federal Computer Week (http://www.fcw.com/fcw/articles/2000/0417/cover-04-17-00.asp)

[8] Pennsylvania General Services Office, Harrisburg, Pennsylvania, July 5, 2000.(Internet Document.)

[9] Naval Inventory Control Point, NAVICP News Release, May 8, 2000 (http://www.navicp.navy.mil/news/reverseauction.htm)

[10] E-mail communication from Glenn Hagler, equipment purchasing manager, Texas Department of Transportation, July 14, 2000. (Internet Document.)

[11] Letter from Jim Muse, executive director, General Services Commission, to The Honorable John Cornyn, Attorney General of Texas, July 10, 2000; and Op. Tex Att’y Gen. No. JC-0316(2000).

[12] Shawn Tully, “Going, Going, Gone!” Fortune Magazine, March 20, 2000, vol. 141, number 6, p. 132.