Decision, Operations and Information Technologies
The Cost Of Keeping Up With Consumers
Jun 14, 2019

The Cost Of Keeping Up With Consumers

How Online Retailers Can Make Sure Their Sellers Meet Consumer Demand

Jun 14, 2019
Decision, Operations and Information Technologies
As Featured In 
Production and Operations Management

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.

About the Author(s)

Yi Xu is an Associate Professor of Operations Management at the Robert H. Smith School of Business at the University of Maryland. He received his Ph.D. in Operations Management from The Wharton School, University of Pennsylvania. His research interests include product assortment optimization, pricing, innovation and new product development, supply chain management, and Marketing and Operations Interface. His research articles have appeared in Management Science, Marketing Science, Production and Operations Management, and Manufacturing and Service Operations Management, among others.

How Sellers Can Better Understand Demand
For B2B sellers, knowing how much the buyer is willing to pay is difficult. New research from Maryland Smith is helping to figure it out.
Jan 05, 2021
The Issue Companies Have With Moving Up
New research shows service providers at the lower end of the value chain mostly find that their efforts to move up yield limited success.
Dec 15, 2020
What Online Retailers Get From Recommendation Lists
New research shows with online shopping, retailers’ use of recommendation systems increases their overall sales and consumer click-throughs and conversion rates. The effect is greatest for mobile shoppers.
Dec 15, 2020
Robert H. Smith School of Business
Map of Robert H. Smith School of Business
University of Maryland
Robert H. Smith School of Business
Van Munching Hall
College Park MD 20742
SmithInfo@umd.edu