From the November 2004 issue of Entrepreneur

When most people think of auctions, they picture the price going up. But there's a different game in the B2B world. It's called the "reverse auction," where suppliers and distributors underbid each other online in real time until the contract price drops as low as it will go.

Home Depot, Sun Microsystems and 3M are just a few companies that use reverse auctions. Almost half of large buyers used reverse auctions by mid-2003 and saw an average of 15 percent in cost savings, according to a recent National Association of Wholesaler-Distributors study. "Buyers have been adopting this quickly," says Adam Fein, author of the study and president of Pembroke Consulting, a Philadelphia management consulting firm that helps wholesale distributors, manufacturers and B2B tech companies build market share.

Dallas-based Southwest Airlines instituted reverse auctions last year to buy everything from bag tags to electricity, and it's saving an average of more than 15 percent on contracts. Southwest plans to put more contracts up for bid via reverse auction. "We're continuing to look for opportunities to use reverse auctions," says Ray Sears, vice president of purchasing for Southwest. "They're a good tool."

But reverse auctions have pros and cons. They let entrepreneurs break into the bidding process against larger suppliers and distributors, but business owners could lose their shirts through aggressive underbidding for large-volume contracts. "A person can lower their fees, expenses and prices so much that it [becomes] a bad business decision," says Nuri Otus, 42, a serial entrepreneur in Burlingame, California, who has been on both sides of the reverse auction process.

Savvy suppliers run extensive internal cost analyses before they go after reverse auction contracts to determine at what point a falling contract price will become detrimental to the bottom line. They also get an idea of a potential customer's service requirements. "Many small companies focus on their average costs," Fein says. "That's a dangerous strategy for pricing on the margins of these contracts where the profitability gets slim." And with more and more buyers getting into the game, the chance that reverse auctions will go away is slim to none.