Procurement Auctions in E-Commerce

Southern Business Review, Fall 2003 by Barrett, Robert T, Pugh, Robert E

While the idea of minimizing supply chain cost within the buyer's organization is clear, the structuring of a procurement so as to solicit competitive bids from suppliers needs closer examination. The rationale for structuring procurements to reduce buyer cost depends on the quantity/ price relationships governing the economic behavior of suppliers. Each potential supplier in a competitive procurement has a cost curve that governs the unit price at which the supplier can provide a specified quantity of a good or service during a specified time period, although the supplier often will not have perfect information on his cost curve. A graph of these cost curves may be thought of as having quantities, Q, of the good or service to be provided on the horizontal axis and the unit price, P, on the vertical axis. Figure 1 shows some illustrative cost curves. These curves are typically concave upward, although not always so. The typical concave upward patterns arise because, for a supplier, some quantity (Q) generally exists that the supplier can deliver at the lowest unit price in a specified period. If Q is significantly increased or decreased, then the unit price will usually increase. From Supplier A's cost curve, in Figure 1, it is seen that the goods and services may have very different cost curves depending on firm size, efficiency, production commitments, and other factors.

As an illustrative example, if Suppliers, A, B, and C, have cost curves as shown in Figure 1 and a buyer seeks to buy Q units of a good or service from these firms at the best possible price, if the buyer requests bids on a quantity Q, then Supplier A will bid a unit price of P^sub A^ for a total price of Q x P^sub A^. This bid will be lower than the bids made by Suppliers B and C, assuming that all suppliers bid in accord with their cost curves. If, however, the buyer divides the procurement into two equal parts of size Q/2 and specifies that each supplier can bid on one part or on both, then the results will be different. Now Supplier B will bid a unit price of P^sub B^ for Q/2 units and Supplier C will bid a unit price of P^sub C^ for Q/2 units; and while each supplier may make other bids, the buyer will select these two bids with a total cost of Q/2 x P^sub B^ Q/2 x P^sub C^ to satisfy his or her requirements. The total price of the procurement structured in the second way is clearly lower than the first since the average of unit prices P^sub B^ and P^sub C^ is less than the unit price P^sub A^, assuming all suppliers bid according to their cost curves.

A more realistic procurement problem would have a large number of potential suppliers, and the procurement would be divided into a number of parts of various sizes. Structuring the procurement in this way provides each potential supplier an opportunity to bid on a combination of parts that the supplier's firm can handle efficiently and offer at a competitive price. To structure procurements in this way, a buyer must solicit bids that provide information about the supplier's cost curves. This information enables the buyer to purchase quantities from suppliers that each supplier can handle efficiently and at low cost, thereby reducing overall procurement cost. This contributes to the primary goal of supply chain management to minimize costs (i.e., maximize efficiencies) across the supply chain.