Drop-Shipping in Retailer-Oriented Dual-Channel Supply Chain
Based on Customer Channel Preferences
Shan Yu1, Ming-rong Deng2
Department of Management, Zhejiang University, Hangzhou, China
(jhyushan@gmail.com)
Abstract - Nowadays, Drop-shipping plays an
important role in e-commerce. With the growing popularity
of online shopping, traditional retail enterprises have
established online stores, to expand sales and compete with
online retailers. Under the circumstances, the paper studies
whether retailer can make profits using drop-shipping in
dual-channel supply chain based on customer channel
preferences. Make some contributions to traditional retail
enterprises better using drop-shipping in online sales.
Keywords - drop-shipping; dual-channel supply chain;
channel preferences; Channel selection
I.
INTRODUCTION
The Drop-shipping is applied to online sales with
the development of e-commerce. Retailers receive online
orders, then suppliers who saves the products directly
send them to consumers according to retailers’ orders.
The emergence of e-commerce greatly reduces
information exchange cost between suppliers and retailers
in drop-shipping.
Drop-shipping has some advantages compared with
the traditional model which retailers hold inventory.
Retailers can reduce inventory costs, transportation costs
and under-stock cost, while suppliers can increase sales,
reduce advertising and other marketing costs. It is very
popular in the online sales because of these advantages.
According to the survey, 30.6 percent of online retailers
use the drop-shipping as their primary way to fulfill order,
while 44.5 percent as an alternative way[1]. Spun.com
Corporation (CD retailer) avoided $8 million in inventory
investment using drop-shipping. Amazon.com, through
the drop-shipping channel, sells mobile phones,
computers and unpopular books [2].
It is clear that drop-shipping has played an important
role in e-commerce. With the growing popularity of
online shopping, large traditional retail enterprises, such
as Suning, Gome, Intime, have set up online store, to
expand sales and compete with online retailers. Under the
background of traditional retailers opening up online store,
the paper establishes dual-channel supply chain including
traditional channel and online channel, studying whether
the retailer can make profits using drop-shipping. Hope to
make some contributions to traditional retailers better
using drop-shipping in online sales.
II.
LITERATURE REVIEW
Drop-shipping is first proposed in the marketing
field which focuses on qualitative analysis. Quantitative
analysis mainly concerns three aspects----channel
selection strategy, inventory strategy and supply chain
coordination.
In inventory strategy, Khouja(2001) proposed the
mixed inventory model of the retailer, which the retailer
holds inventory and use drop-shipping at the same time,
to circumvent the shortcomings of drop-shipping, such as
higher transportation costs and longer delivery time[3].
Lee and Chu(2005) pointed out that the retailer pushing
the risk of inventory to supplier does not necessarily
increase its profits as well as decrease the profits of
suppliers[4]. Bailey and Rabinovich(2005) find that when
the retailer's market share rises, retailers should use both
the traditional and drop-shipping channel. When the
products’ popularity is high, the retailer should be more
dependent on traditional channel[5]. Ayanso et. al(2006)
use Monte carlo simulation model to study the optimal
inventory rationing strategies for retailers using
drop-shipping[6]. Khouja et al(2009) studied the impact of
drop-shipping model on non-perishable inventory system,
and proposed two (Q,R) inventory models that allow a
retailer to use drop-shipping in case of a shortage during
lead-time[7]. Liu and Wang(2008) analyse threshold level
inventory rationing policies when retailer uses its own
inventory and drop-shipping to fulfill orders[8].
In the supply chain coordination, Netessine and
Rudi(2001) proposed that the supplier pay for a part of
retailers’ marketing costs, while the retailer compensates
for the surplus of supplier at the end of the season[2]. Yao
et al(2008) study the profit sharing between retailer and
supplier under drop-shipping model, and analyses the
relationship between order fulfillment and profit sharing.
They put forward countermeasures to improve the quality
of order fulfillment[9]. Gan, et al.(2010) studied
commitment-penalty contracts in drop-shipping supply
chains coordination with asymmetric demand information.
Thus, the supplier can obtain the retailer's demand
information, and maximize the expected profit[10].
Li(2006) analyzed drop-shipping supply chain
coordination with one supplier and multiple retailers, and
discuss existence and uniqueness of Nash equilibrium[11].
In channel selection, Netessine and Rudi (2001)
found that the structure of the supply chain power
influences inventory decision-making and supply chain
profit. They point out both channel members prefer
drop-shipping agreements over the traditional agreements
for a wide range of problem parameters[2]. Netessine and
Rudi (2006) analyses the channel selection with one
distributor and multiple retailers. Through modeling and
analysis, they obtained optimal channel selection policy
in a certain range of parameters, including demand
uncertainty, the number of retailers, wholesale prices and
transportation costs. In addition, they improve the supply
chain system using dual strategy, which combines
drop-shipping with the traditional model. In detail, the
traditional model is regarded as the main method to fulfill
order, while drop-shipping as a backup[12].
However, all these studies are based on a single
channel or dual-channels with identical demand
distribution assumptions. However, Kacen,et al.(2002)
analyses the customer preferences between the traditional
and online stores, and propose the customers have
channel preferences[13]. Chiang and Monahan(2005)
studied the dual-channel supply chain inventory decisions
based on different market demand in the traditional retail
channels and direct sales channels[14]. Xiao et al.(2009)
study the optimal inventory policy and admission policy
when retailer sells through its own physical and online
stores, also sells through third-party websites by means of
affiliate programs[15].
Under the background of traditional retailers
developing online channels, the total customer demand
splitting into two channels is more realistic. Therefore, we
study the conditions of large retailers adopt drop-shipping
based on this branch.
III.
ANALYTICAL MODEL
We model a supply chain with two echelons: one
supplier and one dominant retailer. In traditional channel,
the retailer holds inventory to meet the physical retail
store market demand, while in online channel, the retailer
use drop-shipping to sell goods.
Under the framework of newsvendor model, the
retailer faces different customer in traditional and online
channel. Customers of the two channels are not
interchangeable, that is, customers have channel
preferences. Some customers choose traditional channel
due to its value-added services, while others choose
online channel because of its convenience. If their needs
can’t be met, they may choose other alternatives in the
same channel. In addition, the consumers online is more
concerned about the trend of price, preferring to wait for
discounts, which is different from customers in traditional
stores[16]. Therefore, we assume that the two channels has
different demand distribution function.
Based on the customer preference, retailer develops
online channels will reduce the customer demand of the
physical store. It is necessary to study whether the retailer
can use network channel to make more profits.
Compared with traditional model which retailer
holds inventory, this article studies the channel selection
strategy of dominant retailer and supplier, analyzing the
impacts of some parameters on channel selection, such as
the demand preferences, wholesale prices, retail prices,
production costs and other parameters.
A. Notations and assumptions
The total customer demand is X . The probability
distribution and density function of the demand is F ()
and f () . The total customer demand is split into two
channels. The traditional channel customer demand is X1 ,
distribution and density are F1 () and f1 () . The online
channel customer demand is X 2 , distribution and density
are F2 () and f 2 () . X 1  aX , X 2  bX ,and a  b  1.
In traditional model, the retailer orders q; In
drop-shipping, in the traditional channel retailer orders q1
with price w . In online channel, retailer orders quantity
q2 with price w .A reasonable drop-shipping contract
should contain a higher wholesale price than the
traditional channel because the supplier will bear the
transportation costs and inventory risk. In reality, w is
usually 10% -20% higher. The selling price is p, the
supplier production cost is c, and the cost of understock
and overstock are 0.
B. Traditional model
In traditional model, retailer orders q at the
beginning of selling season and holds inventory.  R 0 、
 S 0 、  T 0 are the profits of supplier, retailer and total
supply chain. To simplify the problem, we assume X is
uniform distribution in 0,u  . The distribution and
density function are
F ( x) 
x  0, u  .
The
order
f ( x) 
quantity
is
1
u
for
q
p  w . Thus,
u ( p  w)
)
 R 0 
p
2p
u ( w  c)( p  w) ,  u ( p  w)( p  w  2c) .
T 0 

2p
p
where
 S 0
optimal
and
x
u
q  u (
,
2
,
C. Drop-shipping model
Retailer use drop-shipping in online channel.
Supplier determines their production, that is, the number
of products for online sales.
x
1
F1 ( x) 
, f1 ( x) 
au
au
F2 ( x ) 
x
1
, F2 ( x) 
bu
bu
Retailer first determines order quantity q1 in
traditional channel, then supplier determines production
quantity qs .Thus, production quantity online q2 , where
q2  qs  q1 .
The profits of retailer and supplier are  R1 ,  S 1 ,
where
q1
q2
0
0
 R1   ( p  w)q1  p  F1 ( x)dx  ( p  w)(q2   F2 ( x)dx)
q2
 S1  (w  c)q1  w(q2   F2 ( x)dx)  cq2
0
The optimal order quantity in traditional and online
channel is q1 , q 2 , where
w  c
pw

)
) , q2  bu (
w
p
au ( p  w)2 bu ( p  w)(w2  c 2 )
 R1 

2p
2w2
au (w  c)( p  w) bu (w  c)2
 S1 

p
2w
q1  au (
 T1 
IV.
au( p  w)( p  w  2c) bu(w  c)  w( p  c)  c( p  w)

2p
2w2
(1) Conditions of increasing retailer’s profits
Define  R   R1   R 0 as the payoff when retailer
adopted drop-shipping, where
bu  p( p  w)( w2  c 2 )  w2 ( p  w)2 
R  
2 pw2
Proposition 1:
Retailer’s expected profits will increase when
adopting
drop-shipping
if
p( p  w)(w2  c 2 )  w2 ( p  w)2  0 . Especially when
w  w , the condition can be simplified as w3  pc 2 .
(2) Conditions of increasing retailer’s profits
Define  S   S1   S 0 as the payoff when supplier
adopted drop-shipping, where
bu  p(w  c)2  2w(w  c)( p  w) 
S  
2 pw
Proposition 2:
Retailer’s expected profits will increase when
adopting
drop-shipping
if
p(w  c)2  2w(w  c)( p  w)  0 . Especially when
w  w , the condition can be simplified as
( w  c)(2w2  pw  pc)  0 .
(3) Conditions of increasing both of their profits
Situation 1: Both of their profits increase.
Under the circumstance, the two conditions
 R1   R 0 and  S1   S 0 should be satisfied, ie:
2
2
2
2
 p ( p  w)( w  c )  w ( p  w)  0 (1)

2
(2)
 p ( w  c)  2w( w  c)( p  w)  0
and
2w( p  w) p  w ,

w( w  c)
wc
EXAMPLE
Suppose
a  0.3 , b  0.7 , u  10000 , c  30 , w  150 , w  180 , p  300
.
The payoff of retailer adopting drop-shipping is  R ,
where  R  62500 . For supplier, the payoff is  S , where
D. Conditions of selecting drop-shipping model
Proposition 3:
If  S1   S 0
Define T   T1   T 0 as the payoff of total supply chain
when adopting drop-shipping, where
bu(w  c)  w( p  c)  c( p  w) bu( p  w)( p  w  2c)
T 

2w2
2p
Proposition 4:
The supply chain’s expected profits will increase
when adopting drop-shipping if T  0 . Especially when
w  w , the condition can be simplified as
w3 ( w  2c)  pc 2 ( p  2w) .
 R1   R 0 .
Especially when w  w , If  S1   S 0 ,  R1   R 0 .
If  R1   R 0 and w( w  c)  2( w  c) ,  R1   R 0 .
w  c
Situation 2: Profit of total supply chain increases, and
divides to both parts.
 S  7500 . Under this condition, both parties will prefer
to adopt drop-shipping.
In addition, we can find the relationship between
a , b , c , w , w or p and  R ,  S or T . For example,
the relationship between w and  R is as follows:
5
R
1
x 10
0.5
0
-0.5
-1
-1.5
60
80
100
120
Fig. 1. Relationship between
140
160
w and  R
180
w
.
Because of the limited space, we will not enumerate
all the relationships of each other. Several conclusions
will be given in part V.
V.
CONCLUSIONS
Compared the drop-shipping model with traditional
retailers hold inventory model, this paper have found the
condition when supplier and retailer will choose
drop-shipping in retailer dominant dual-channel supply
chain. First of all, for the products with relatively high
wholesale price and low production costs, retailers and
suppliers are preferred drop-shipping. For suppliers, it
assumes the risk of holding inventory, lower production
decreases the risk. For retailers, higher wholesale price
increase their risk of holding inventory, so they also
prefer drop-shipping. Secondly, the proportion of demand
preferences between the different channels does not affect
the drop-shipping choice, but if the choice is made, the
proportion has positive correlation to the profit. In
addition, if the suppliers can use drop-shipping to
increase profits, then the retailers will also make profits in
a wide range of parameters. Hope that these findings can
provide some guidance to retailers for channel selection
strategy.
However, there are some limitations of the study.
Firstly, based on the demand distribution of uniform
distribution assumption, we don’t get more general
conclusions under other demand distribution. Secondly,
the customers have channel preferences, but sometimes
they will change for the products they want are out of
stock. Thirdly, the studies of supply chain coordination in
drop-shipping is not rich. Nowadays, drop-shipping has
been widely used in practice. So it is very important and
necessary to study drop-shipping in dual-channel supply
chain.
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