Perishability of Online Grocers*, The

Decision Sciences, May 2007 by Cattani, Kyle, Perdikaki, Olga, Marucheck, Ann

ABSTRACT

In this article we explore the profitability of different operations models used by online grocers and develop a linear demand model in a competitive setting to better understand the trade-offs made by two competing online grocers in choices for distribution strategy (leverage or direct) and product focus (perishable or nonperishable). We find that the results derived in the duopoly setting are different from those in a monopolistic setting. Specifically, we determine that there is a threshold value for the secondary competitive effects in the demand function that determines how the prices and profitability of an online grocer will be affected by the supply chain length of its competitor. There is also a threshold value for the ratio of supply chain lengths of the two competitors that determines whether product perishability increases or decreases profits. We demonstrate that the existence of this threshold is robust when considering capacity constraints. Further, we show, assuming that supply chain length can be optimized, how the relative size of the infrastructure change cost (when compared with that of the competitor) coupled with the perishability of the product determines the profitability of an investment leading to a shorter supply chain.

Subject Areas: Game Theory, Noncooperative Games, Online Grocers, Perishable Products, Service Operations, and Supply Chain Design.

INTRODUCTION

Interest in supply chain design within the service sector is growing. While some insights derived from manufacturing supply chains can be transferred to service industries, customer perceptions of product quality remain a key differentiator between manufacturing and service supply chains (Akkermans & Voss, 2003). Our research context is the online grocery industry, which combines a traditional supply chain for a product (groceries) with a service (delivery), and we consider the issue of product quality, especially for perishable products.

The online grocery industry experienced a dramatic surge in the number of new entrants during 1998 and 1999. After the well-publicized bankruptcy of Webvan in 2001, the future of the online industry seemed uncertain. Yet with online grocery sales estimated at over $3.7 billion in 2004, the industry is being revitalized by a number of new entrants using a variety of business models (Reyes, 2004). The lack of any single dominant model in the industry suggests that further research could contribute insights to the relative profitability of alternate strategies used by online grocers. Based on different strategic choices exhibited by online grocers, two research questions emerge that serve as the foundation for our research.

The first question relates to the choice of distribution strategy. In a relatively conservative model, an online grocer aligns or affiliates itself with an established firm in the grocery industry to leverage existing assets and resources. In this case, the leverage grocer uses the same supply chain as the traditional grocer and fulfills its orders from either an established local distribution center or from the supermarket shelf. Our definition of a leverage grocer is consistent with the store-based picking strategy described by Boyer and Huit (2006). This strategy is currently used by U.S.-based firms Albertson's, Safeway, and Harris Teeter, as well as UK-based Tesco. In addition to the marketing advantage of using an established brand, the primary operational advantage of the leverage strategy is the lower incremental investment required when the online channel is offered to the customer. While the leverage model makes for easier introduction of an online grocery channel, it offers few efficiencies for an online grocer's supply chain relative to that of a traditional bricks-and-mortar grocer. A supply chain that has been optimized for the traditional channel might not be optimal for a direct or online business. The investment required to shorten the supply chain or decrease variable costs will likely be relatively high for a leverage model. Because the same supply chain must accommodate the traditional bricks-and-mortar grocer, conflicting needs between the two channels can create inefficiencies in the supply chain, leading to higher costs.

Alternatively, apure-direct grocer bypasses traditional stores by using a dedicated distribution facility to serve the online channel. UK-based Ocado and U.S.based Fresh Direct use the pure-direct distribution model, as did Webvan. Although this strategy requires a significant investment in dedicated warehouses and product inventories, the costs required to optimize the supply chain for online sales likely will be lower than those in the leverage model, because the pure-direct supply chain does not have to accommodate sales in traditional stores. Thus, the puredirect model's benefits include the potential for greater efficiencies for online sales and a shorter supply chain length (Tanskanen, Yrjôlà, & Holmstrom, 2002; Laseter, Berg, & Turner, 2003; Starr, 2003). A shorter supply chain can lead to reduced costs through increased inventory turns, reductions in storage and handling involved in supply chain activities, and less spoilage of perishable goods. For example, Fresh Direct purchases directly from growers or producers, and ships the products directly to customers. By shortening the supply chain, Fresh Direct reduces costs and can offer a fresher product than a leverage grocer can offer (McLaughlin, 2005).