The Cost Of Keeping Up With Consumers

Online retail giants like Amazon and Walmart rely on independent third-party sellers for their vast array of product offerings and trust them to know their markets for specific items. But consumers don’t like when the products they want are unavailable, and neither do the retailers. They need their independent sellers to be able to fulfill orders on time and manage inventory effectively. New research from the University of Maryland’s Robert H. Smith School of Business pinpoints the best way for online retailers to make sure that happens.

Yi Xu, associate professor of operations management at Maryland Smith, worked with Wenqiang Xiao of New York University. They looked at the challenges online retailers face to incentivize third-party sellers to stock enough inventory to meet orders and penalize them for running out of inventory, therefore losing out on sales.

Right now, online retailers commonly use commission contracts, where the retailer gets a cut of of every unit sold on the platform. Xu and Xiao say their analysis of this practice shows it doesn’t work well and potentially results in a significant profit loss for retailers. On one hand, the retailers need to charge a lower commission to motivate the seller to hold enough inventory to meet orders. But on the other hand, they say, to extract more surplus from sellers with higher demand potential, the retailer needs to charge a higher commission. “We find that this tension between incentive provision for capacity installation and surplus extraction leads to inefficiency of the commission contracts,” the researchers write.

Instead, Xu and Xiao say the best way to make sure third-party sellers have the capacity to fulfill orders is for online retailers to charge them low commissions on products and implement a simple performance-based penalty contract such as a lost-sale penalty contract. This means that if a seller runs out of stock and can’t deliver a product a customer orders, they have to pay the online retailer not only the commission, but also a penalty. They say combining the reward of low commission with a lost-sale penalty is the most effective for online retailers:

“Under a lost-sale penalty contract, both reducing the commission and increasing the lost-sale penalty strengthen the seller’s incentive to install capacity, because the former acts like a carrot rewarding the seller for installing higher capacity and the latter acts like a stick penalizing the seller for his insufficient amount of capacity that more likely results in lost sales,” the researchers write.

Xu and Xiao say if online retailers include both this “carrot” and “stick” in their contracts with third-party sellers they will incentivize the sellers to make the right decisions about products and hold the appropriate amount of inventory.

Read more: “Should an Online Retailer Penalize Its Independent Sellers for Stockout?” is featured in Production and Operations Management.