What Is a Reverse Auction? How It Works, Example, and Risks

What Is a Reverse Auction?

A reverse auction is a type of auction in which sellers bid for the prices at which they are willing to sell their goods and services. It is the opposite of a regular auction, where a seller puts up an item and buyers place bids until the close of the auction, at which time the item goes to the highest bidder.

Understanding a Reverse Auction

In a reverse auction, the buyer puts up a request for a required good or service. Sellers then place bids for the amount they are willing to be paid for the good or service, with the winner being the seller prepared to accept the lowest amount.

Reverse auctions gained popularity with the emergence of internet-based online auction tools that enabled multiple sellers to connect with a buyer on a real-time basis. Today, reverse auctions are used by large corporations and government entities as a competitive procurement method for raw materials, supplies, and services like accounting and customer service.

Example of a Reverse Auction

Bidding for government contracts is an example of reverse auctions. In this type of auction, governments specify requirements for the project, and bidders, which are approved contractors, come up with a cost structure to finish the project.

For instance, when the U.S. Department of Defense (DoD) has a need for a certain service or good—such as, say, 50 fighter jets—it posts a message reaching out to potential suppliers. In this message, the DoD outlines what it needs and by when and invites interested contractors to submit price proposals within a set time frame. The winner is generally the party willing to do the job specified for less.

Caveats of a Reverse Auction

It is important to note that the reverse auction does not work for every good or service. Goods and services that can be provided by only a few sellers are not necessarily ideal for reverse auctions. In other words, a reverse auction works only when there are many sellers that offer similar goods and services to ensure the integrity of a competitive process. 

In addition, there could be a tendency to focus on the lowest bids by sellers with less regard for the quality of the goods or services. The adage “cheap for a reason” has the potential to apply in such instances where a buyer suffers from the suboptimal quality of the lowest-priced set of goods or services purchased through a reverse auction.

Last but not least, a buyer must be thorough in communicating all of the specifications to the auction participants. A failure to do so could leave the purchaser with a winning bid that does not capture all of the sought-after attributes.

The Bottom Line

Reverse auctions can make a lot of sense when there are many sellers in the market and price is the most important factor. They save time and money, which is no small thing for a business, although sometimes this can come at the cost of sacrificing quality.

Detailed contract specifications should rule out suboptimal quality goods and services winning bids. However, depending on the good or service in question, sometimes it is better and generally more efficient over the long run to pay a little more for greater quality.

The old adages “you get what you pay for” and “cheap for a reason” apply here. For some goods and services, this may not be an issue. For others, it is a game changer.