Reverse Auction Bidding

Reverse Auction Bidding

September 1, 2002

By Dean B. Thomson

The authors of this month’s Briefing Paper prepared an article on reverse auction bidding which has been adopted by the Minnesota Construction Industry Cooperative Committee (CICC) as its position on the topic. The CICC is a committee, currently consisting of representatives from twelve industry organizations, that studies and makes recommendations regarding construction issues in Minnesota.

As this month’s Briefing Paper, we are reprinting the CICC’s position paper which you will soon also be able to find included in the CICC’s widely used Blue Book.

INTRODUCTION

Reverse auction bidding (“RAB”) is a process in which a buyer of goods and services continues to solicit bids from sellers until the buyer is satisfied it has received an acceptably low price. As used in construction, the process usually entails using a dedicated internet web site. At a scheduled time, the bidding for a project opens and all interested bidders submit their prices to the web site. The host web site then posts the prices on the site for all bidders to see. The bidders’ identities usually remain anonymous. Bidders are then given a certain period in which to offer any lower price that they may choose to submit. Thus, the auction proceeds in the “reverse” of a typical auction in that bids are expected to go down rather than up. Once no further bids are received after a certain period following the receipt and posting of the last bid, the auction is closed. Award is then made to the lowest bidder.

Reverse auction bidding differs from traditional sealed bidding in which sealed bids are received and opened at a specified time and the project is awarded to the lowest responsible bidder. Under the traditional method, general contractors submit their bids, or pre-selected general contractors solicit bids from subcontractors, and there is no opportunity for subsequent bidding after the specified time for bid opening.

The use of RAB is increasing for the purchase of construction commodities. For example, the Minnesota Department of Administration recently obtained legislative authority to conduct RAB to procure construction goods, but not services. See Minn. Stat. § 16C.10, subd. 7. More recently, the reverse auction technique has been extended by some public bodies, e.g., Pennsylvania’s Department of General Services, to procure construction services. Several private companies, especially large national “big box” retailers are using RAB to select general contractors and subcontractors.

The RAB process has many perceived costs and benefits. In this paper, the CICC intends to discuss the current debate over this new construction procurement method in the context of three issues: (1) savings, (2) bid shopping, and (3) best value. CICC believes that a better understanding of the perceived advantages and disadvantages of RAB will allow interested participants to decide whether or not using RAB would enhance or detract from their particular project.

A.  Savings

1.  Advantages

Advocates of RAB claim that owners or taxpayers gain significant savings through use of the process. For instance, the Minnesota Department of Administration conducted a reverse auction for the aluminum it uses in license plates. Because the prices started at $1.555 per pound and dropped to $1.029 in 45 minutes, the state claimed that the process saved taxpayers about $150,000 over the course of five years. As summarized by the state, “A reverse auction gets to the absolute lowest price a vendor will offer, as opposed to a bid price [under the traditional sealed bid approach] that might not be the bottom line price.” The press secretary for Pennsylvania’s Department of General Services commented that in reverse auction bidding, bidders “see each other’s bids and keep going down, and we get a better price. It’s very exciting because the bids will drop $10,000 at a time.” According to the press secretary, the contractors prefer online bidding because they can see the other bids, as opposed to bidding blindly with sealed bids. Several large national retailers who use RAB, claim similar savings successes based on historical cost data.

2.  Disadvantages 

Critics of the process argue that the claimed savings generated by RAB are illusory and that the process could actually cost owners and taxpayers more than traditional sealed bidding. Owners often point to the drop in pricing from the first bid to the last as proof of the cost savings generated by RAB. Opponents argue that bidders in the RAB process do not start at their lowest number as they have to in the traditional sealed bid method. Instead, opponents assert that it is common for bidders in an auction setting to start with a high bid, see what prices their competitors are bidding, and then reduce their bid only if forced to do so by competition. Thus, downward movement from inflated initial bids should not be viewed as savings.

Proponents attempt to show savings from the RAB process by comparing the resulting low bid to historical bids obtained under the traditional sealed bidding method. Skeptics argue that it is difficult to demonstrably prove that the same savings for that particular bid would not have been achieved by using the traditional sealed bid method. Changes in market cycles can just as easily explain savings as the particular bidding system used.

Critics also contend that knowledge of everyone’s bids gained in the open RAB process does not necessarily extract the lowest bid. For example, in traditional sealed bidding, it is assumed that bidders will submit their lowest price at the time of bid opening exactly because they do not know what their competitors are bidding. If a bidder does not immediately bid its lowest price in traditional bidding, the bidder will forever lose its opportunity for the work.

In RAB, however, the bidder does not start with its lowest bid, and only reduces its bid if forced to do so by competition. The open competition may not force a bidder to submit the lowest price it would have submitted had it been bidding blindly in a traditional sealed bidding process. Critics contend there is significant evidence that RAB does not flush out the lowest price for the owner or the public. Indeed, if RAB truly saved owners money, it would have displaced traditional sealed bidding long ago.

B.  Bid Shopping

1.  Advantages 

Proponents of RAB contend that the process of shopping for the lowest price will not be misused because it is (or should be) based on strict, published protocols. Accordingly, the process should not be critically labeled as “bid shopping” simply because it reduces contractor profit. Owners argue that bid shopping, a process where a general contractor seeks price reductions from its subcontractors, commonly occurs after the prime contract is awarded on traditionally bid projects. Owners criticize this form of bid shopping because the savings a general contractor “shops” out of subcontractors is kept by the general contractor, not passed on to the owner. As a result, the general contractor becomes richer while the owner receives lower quality work from the general’s unhappy and unqualified subcontractors. Proponents argue that, even if RAB is bid shopping, at least it is done openly and consensually and the benefits go to the owner, not the general contractor.

2.  Disadvantages 

According to its critics, RAB institutionalizes a new form of bid shopping, a practice in which repeated demands are made upon general contractors and subcontractors to lower their prices or else they will lose the work. Critics argue that this form of bid shopping encourages an adversarial project relationship among all project participants (e.g., the owner, contractor, designer and subcontractors) because the practice forces contractors to reduce necessary profit and contingency dollars from their bids. Critics fear that in order to make money in this environment, contractors will make claims for extra work at every opportunity. The result will be less cooperation and more litigation. Bid shopping also reduces quality and safety by encouraging bidders to take short-cuts, because bidders have been left without adequate profit and contingency funds. The industry has long recognized that it is not in the owner’s best, long-term interest to extract the last profit dollar from the construction process. This is why reputable general contractors do not bid shop and why bid shopping is bad for the owner, no matter who ends up with the purported savings.

C.  Best Value and the Commodities and Service Distinction

1.  Advantages

Advocates of RAB contend that private and public owners must continue to reduce costs, especially in this demanding economy, and reverse auction bidding leverages internet technology to ensure owners reach the broadest market and obtain the lowest price. To those that argue lowest price may not result in best value to the owner, proponents respond that quality concerns can be protected by well drafted contract documents to which bidders must agree as a condition of participating in the RAB process. Advocates argue RAB is appropriate for procuring construction services as well as commodities as evidenced by current negotiations among all types of owners and service providers regarding price. Therefore, if a construction owner can obtain the lowest price and assured value through RAB, then the method provides the owner with the best value whether purchasing services or commodities.

2.  Disadvantages

Everyone favors expanding markets and fair competition through responsible use of internet technology. The market-broadening advantages of the internet, however, are equally applicable to traditional sealed bidding as they are to reverse auction bidding.

Reverse auction bidding may be appropriate for purchasing commodities, but construction services are not commodities. Commodities are typically produced with fixed factors of production. Therefore, a buyer can purchase commodities through a reverse auction bid with some assurance that it will receive the same quality in each unit because the amount of labor and supervision spent on each unit is the same.

In contrast, the factors of production in construction are more fluid, with the main quality and price variable being the amount of labor used to build and supervise a particular project. The amount of labor used to construct a building can vary from one location to the next, even if it is the same design, due to code variations, different labor pools, and a different team of contractors. Whereas price variations may not affect a purchaser’s ability to receive identical units of a commodity, price variations may very well affect whether a purchaser can receive identical construction projects from one location to the next.

The RAB process pressures construction bidders to reduce their main price variable – the amount of labor and supervision used to build the project. RAB critics express concern that the RAB process may induce bidders, in their efforts to be the lowest bidder, to reduce labor and supervision to levels that will endanger safety and lessen quality. Many contractors fear that when costs must be reduced, proper site safety is one of the first costs to be cut. Such a result would not be good for contractors, labor, the owner, or the public.

Owners may believe that they are protected against unsafe construction practices or poor quality by their contract documents, but a process that induces bidders to imprudently reduce the hours bid for labor and supervision will only lead to lawsuits to enforce quality and safety obligations. The adversarial relationships and loss of partnering that RAB will cause will be more costly than any purported savings garnered through the process. When it embraced “partnering” decades ago, the industry recognized that value is not solely defined by low price. Therefore, many RAB critics assert that owners’ desire for the best value in terms of price and quality, reliability and safety is best achieved through traditional sealed bidding, not reverse auction bidding.

CONCLUSION

The use of RAB is in its incipient stages in the construction industry. Therefore, demonstrable proof of savings due to the process is, and may always be, difficult to establish. CICC does not support any procurement method that results in or induces poor quality work or unsafe working conditions. The construction industry in Minnesota has an enviable reputation for quality, value, safety, and collaboration among owners, contractors, subcontractors and designers. Whatever procurement method is used, it should be designed to further, not lessen, these values.

This discussion is generalized in nature and should not be considered a substitute for professional advice. © FWH&T

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