While around 45% of internet retailers still rely on the traditional model of owning and supplying stock directly to customers, just under a third fulfill orders primarily through drop-shipping, whereby the wholesaler stocks and owns the inventory, and ships products directly to customers at the retailer's request.
When choosing between traditional and drop-shipping channels, the retailer trades off a higher wholesale price against inventory risk, and the wholesaler trades off the lower margin against inventory risk, with transportation costs also playing a role.
In this paper published in Management Science (June 2006), authors Serguei Netessine of the Wharton School, University of Pennsylvania, and Nils Rudi, associate professor of technology and operations management at INSEAD, analyze the comparative advantages of inventory ownership in the traditional channel, and risk-pooling under drop-shipping.
They model a dual strategy, whereby the retailer owns some stock locally but relies on drop-shipping to provide less popular orders and back-up for items out of stock. They point out that the internet kiosks found in some major retailers' stores represent this dual strategy, as the internet option enables a customer to order products they cannot find in the store.
The dual strategy is modeled as a non-cooperative game among retailers and wholesaler, because they manage their inventories competitively, and recommendations for managers are explored through the structural properties of the equilibrium situation. The authors find that in some situations the dual strategy reverts to a pure traditional or pure drop-shipping channel when it becomes optimal for the wholesaler or retailer to hold no stock.
Critical parameters for choice of channel include demand variability, the number of retailers in the channel, wholesale prices and transportation costs. Overall, the results confirm that no channel option is uniformly preferred over the others and that channel choice depends on companies' environments. While retailers tend to prefer the dual channel as drop-shipping gives them a 'safety stock' at no extra cost, wholesaler preference is not so clear.