Inventory Risk Allocation in the Presence of Sales Effort

In the traditional channel, a retailer stocks the product from a manufacturer and sells it to consumers. In contrast, the retailer in the drop-shipping channel relays the consumers’ requests to the manufacturer who stocks and delivers the product to consumers. Due to their different structures, the two channels lead to different inventory risk allocation, prices, sales effort, and profits for the manufacturer and retailer. Thus, we investigate the manufacturer’s and retailer’s preferences for the traditional, drop-shipping, and dual (combination of the traditional and drop-shipping) channels. First, in contrast to Cachon (2004) and Netessine and Rudi (2006), we illustrate that the traditional channel can be Pareto-optimal when considering the retailer’s sales effort. This is because the retailer in the traditional channel has a high order quantity, yielding a high sales effort, which benefits the supply chain. Second, in the dual channel, the wholesale price using the traditional channel is lower than that using the drop-shipping channel, which is called the drop-shipping markup. We find that the sales effort can increase with the drop-shipping markup. Third, the retailer can order more quantity in response the increasing demand uncertainty. Finally, when considering the shipping cost, we find that a channel without the order quantity (i.e., drop-shipping) is less likely to be Pareto-optimal. However, that with the order quantity (i.e., traditional or dual channel) has a greater chance of being Pareto-optimal. Put differently, the order quantity can mitigate the impact of the shipping cost on the alignment of the retailer and manufacturer’s profits