Supply chain choice with financial constraints on the internet: Drop shipping vs. traditional channel
Introduction
Our study is partially motivated by the new internet supply chain practices on global e-commerce platforms (e.g., Amazon.com, ebay.com, Alibaba.com, Shopify.com, Oberlo.com, JD.com), and we investigate the choice of supply chain between drop shipping arrangement and a traditional channel with financial constraints on the internet. Unlike the traditional channel where online retailers own and manage inventory, drop-shipping refers to an order fulfillment approach in which online retailers focus on customer acquisition while forwarding orders to wholesalers, who handle the orders and deliver to customers directly at retailers’ requests (Khouja, 2001, Yu et al., 2017). In e-commerce, drop shipping and traditional channel are two predominant supply chain structures. According to E-DSS.org1, more than 30% of online retailers adopted drop shipping on Amazon.com in 2011, and 22–33% of online retailers use drop shipping as their primary method of order fulfillment2. However, major online retailers, such as Amazon.com, JD.com and Zappos.com, rely primarily on a traditional channel.
With the development of e-commerce, financial constraints are the main problem for online retailers, and limited working capital often constrains online retailers’ procurement decisions. For example, Alibaba.com has been holding its annual “Singles’ Day” shopping carnival since 2009, and the e-commerce giant grossed a turnover that exceeded $0.15 billion within just three minutes of opening the sale for the day in 2018, while loans to 3.43 million online retailers reached $0.3 billion during the shopping carnival, increasing by 37.4% compared with 2017. As a new order fulfillment method, drop shipping benefits the whole supply chain due to risk-pooling effects, when a wholesaler supplies multiple retailers. Besides, it also provides a new mode of operation for financially constrained online retailers. Since online retailers need not carry inventory, a limited working capital cannot constrain retailers’ purchase decisions under drop shipping, which appeals to many new and small online retailers with financial constraints. Meanwhile, many companies are providing platforms for start-ups to achieve drop shipping, such as Doba.com, Oberlo.com, and major retailers like ebay.com and Amazon.com. However, we also observe that giant online retailers, such as Amazon.com, Zappos.com, and JD.com, are abandoning the drop shipping channel gradually and investing in warehousing and other infrastructure required for a traditional channel. Under the traditional channel arrangement, online retailers must store and manage inventory, but most online retailers are financially constrained, as they do not qualify for bank financing due to their poor credit rating. Thus, trade credit is an important external financing tool widely used in online retailing (Giannetti, Burkart, & Ellingsen, 2011), and trade financed through trade credit reaches $ 25 trillion and occupies 90% in global merchandise trade. Most online retailers mainly rely on trade credit financing under traditional channels, provided their wholesalers are willing to finance.
Most commodities sold on the internet, such as clothing, electronics, cosmetics, and books, are seasonal products with relatively short selling periods. Meanwhile, according to a recent survey (International Post Corporation, 2018), footwear & apparel, consumer electronics, and health & beauty products are the three most popular categories of consumer products sold on e-commerce platforms. Such products have a short selling period, demand is uncertain before the selling season, and the leftover inventory owns salvage value at the end of the selling period, which implies that most retailers face a newsvendor-like problem when selling products online. Since the inventory is managed by wholesalers under drop shipping and managed by retailers under traditional channels, the two supply chain structures result in different risk allocation among the channel members, which in turn affects their stocking decisions and profits. Under drop shipping, retailers sell products on the internet without inventory risk, but they may not reach their optimal order quantity since wholesalers determine the inventory levels. In a traditional channel, online retailers own and manage the inventory, but they must undertake inventory risk. However, online retailers could shift partial risk to wholesalers through trade credit, conditioned on the latter’s credit limit, which rests on retailers’ financial resources. When the retailer’s capital constraint intensifies, both wholesaler and retailer may select different supply chain structures since risk allocation under traditional channels changes with the retailer’s capital level, which affects the whole supply chain choice on the internet.
To the best of our knowledge, most related literature assumes that both retailers and wholesalers own adequate financial resources and neglect financial constraints when considering the supply chain choice in e-commerce, and our study fills this gap in the field. In this study, we compare two supply chain structures, including drop shipping and traditional channels, and analyze the impact of a retailer’s financial constraints on the supply chain structure on the internet. The main problem can be described as, “considering the capital level of an online retailer, what is her channel structure in the e-commerce supply chain consisting of a wholesaler with sufficient capital and multiple retailers with financial constraints?” To answer the main research question, the other sub-problems are: (1) Under what conditions will a wholesaler determine the supply chain structure for a retailer on the internet? (2) When a wholesaler offers two channel options conditionally, how will an online retailer’s financial constraints influence the selection of supply chain? (3) What is the impact of trade credit policy on supply chain structures on the internet? In this study, we formulate single-period newsvendor models for both wholesalers and retailers. By comparing each supply chain member’s payoffs under different channels, we find that the wholesaler prefers to adopt drop shipping when the critical fractile exceeds a certain threshold and traditional channels when the critical fractile gap between the wholesaler and retailer is relatively small. If the retailer’s critical fractile is comparatively large, the wholesaler provides two channel options conditionally, and the retailer determines the supply chain structure based on her preference and capital level. Under the given circumstances, traditional channels become the supply chain choice when the online retailer pays a corresponding cash pledge, or the drop shipping fulfillment method dominates. Moreover, we find that the wholesaler may decide the supply chain structure under full trade credit but always offers two channel options under partial trade credit.
The main contributions of this study are as follows. First, we investigate supply chain structures in e-commerce while considering the retailer’s financial constraints and analyze the impact of the retailer’s financial constraints on the choice of supply chain between drop shipping and traditional channels. Second, we consider trade credit financing under traditional channels and identify the initial payment for the wholesaler to grant trade credit. Furthermore, we study the supply chain choice on the internet under full and partial trade credit separately and provide management insights by identifying the decision zones for the supply chain structures under different trade credit policies.
The remainder of this article is organized as follows. Section 2 reviews the relevant literature. Section 3 constructs profit-maximizing inventory models for both wholesalers and retailers. Section 4 analyzes the choice of supply chains on the internet. Section 5 focuses on the numerical experiment, and Section 6 provides the concluding remarks and directions for further research.
Section snippets
Literature review
We investigate the impact of an online retailer’s financial constraints on the choice of supply chain between drop shipping and traditional channels, and our study is closely related to two research fields in the existing literature, that is, the interface of operations and finance and dual-channel supply chain coordination.
Our study belongs to the interface between operations and finance, especially the impact of financing on ordering and inventory. Xu and Birge (2004) discuss the production
Problem description and modeling
We consider a supply chain consisting of a wholesaler and multiple online retailers. Wholesaler W is the supply chain leader with sufficient capital and supplies to m retailers, with retailers adopting drop shipping and the remaining retailers using traditional channels. Before the sale, each retailer orders at unit wholesale price , and the wholesaler fulfills the orders at unit cost c. During the selling period, m retailers sell the products at unit price p, and the unsold
Comparison of supply chain channels
In this section, we compare two supply chain structures. Based on the cash pledge , there are two types of trade credit, including full and partial trade credit, in a traditional channel, and we also discuss the supply chain choice with different trade credit policies.
Numerical experiment
This section employs several numerical examples to further explore the impact of retailer R’s financial constraints on her supply channel structure. As regards the configuration, we consider the demand function that follows an Exponential distribution with the mean thousands/period. It is noted that the results in our study are robust for other distributions, such as Normal distribution.
Fig. 4 shows the wholesaler’s supply chain choice under full trade credit, and we consider and
Concluding remarks
In this study, we investigate the impact of an online retailer’s financial constraints on her supply chain structure between drop shipping and a traditional channel. Our research provides the following managerial insights for supply chain choice on the internet. First, drop shipping benefits supply chain members in online business if the wholesaler’s critical fractile is much greater than that of the online retailer. In this case, the wholesaler only provides drop shipping regardless of the
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