Shipping Unpredictable Demand for Online Sellers: Risk Penalty vs. Flat Rate

Abstract

1. Problem Definition: We study the coordination of an E-commerce supply chain between online sellers and 3rd party shippers to meet random demand surges, induced by, for instance, online shopping holidays. 2. Academic/Practical Relevance: Motivated by the challenge of meeting the highly unpredictable demand surges in E-commerce, we study shipping contracts and supply chain coordination between online sellers and 3rd party shippers in a novel model taking the unique features of the shipping industry into account. 3. Methodology: We compare two shipping contracts: the risk penalty (recently proposed by UPS) and the flat rate (used by FedEx), and analyze their impact on the seller, the shipper, and the supply chain. 4. Results: We discover that against the common belief, the sophisticated risk penalty is not much better than the simple flat rate for the shipper. Although both the risk penalty and the flat rate can coordinate the supply chain, the risk penalty does so only if the shipper makes zero profit, but the flat rate can provide a positive profit for both. These results represent a new form of double marginalization and risk-sharing, in sharp contrast to the well-known literature on the classic supplier-retailer supply chain, where risk-sharing contracts (similar to the risk penalty) can bring benefits to all parties, but the single wholesale price contract (similar to the flat rate) can achieve supply chain coordination only when the supplier makes zero profit. We also find that only the online seller, but not the shipper, has the motivation to vertically integrate the seller-shipper supply chain. 5. Managerial Implications: Coordinating the seller-shipper supply chain is an important way to meet the unpredictable demand surges in E-commerce. Our results imply that the risk penalty is unnecessarily complex because the simple flat rate is just as good as the risk penalty for the shipper and is better for the seller-shipper supply chain as a whole. Our study also explains and supports the recent practice of online sellers (e.g., Amazon.com and JD.com), but not shippers, to vertically integrate the supply chain by consistently expanding their shipping capabilities.