Online retailers' promotional pricing, free-shipping threshold, and inventory decisions: A simulation-based analysis

We consider a two-stage decision problem, in which an online retailer first makes optimal decisions on his profit margin and free-shipping threshold, and then determines his inventory level. We start by developing the retailer’s expected profit function. Then, we use publicly-available statistics to find the best-fitting distribution for consumers’ purchase amounts and the best-fitting function for conversion rate (i.e., probability that an arriving visitor places an online order with the retailer). We show that: (i) a reduction of the profit margin does not significantly affect the standard deviation of consumers’ order sizes (purchase amounts) but increases the average order size; whereas, (ii) variations in a positive finite free-shipping threshold affect both the average value and the standard deviation of the order sizes. We then use Arena to simulate the online retailing system and OptQuest to find the retailer’s optimal decisions and maximum profit. Next, we perform a sensitivity analysis to examine the impact of the ratio of the unit holding and salvage cost to the unit shipping cost on the retailer’s optimal decisions. We also draw some important managerial insights.