New recipe for restaurant, app contracts

In a study published online March 28 in the INFORMS journal Management Science, Dr. Andrew Frazelle, assistant professor of operations management in the Naveen Jindal School of Management, and co-authors Dr. Pnina Feldman of Boston University and Dr. Robert Swinney of Duke University examined how to best structure relationships between food-delivery platforms and the restaurants with which they partner.

Other platforms in the sharing economy, such as ride-hailing and vacation-rental services, allow people to sell access to resources that would otherwise be generating no revenue for them, Frazelle said. The interests of the resource owner and the platform are reasonably well aligned in that more transactions are good for both.

"However, restaurant delivery is different," Frazelle said. "Delivery orders represent incremental business on top of the restaurant's existing dine-in operation. More business sounds good, but it comes at the cost of a commission charged by the delivery platform."

Platforms such as Grubhub, DoorDash and Uber Eats collect customer orders online, transmit them to restaurants and deliver the orders to customers. While this service helps restaurants expand their markets, the study found the relationship has inherent flaws.

The most common contractual relationship between platforms and restaurants, in which the platform takes a commission, or a percentage cut, of each delivery order, has two key issues, according to the study.

First, the standard contractual relationship offered by most platforms is one of simple revenue sharing. Revenue on each order is split between the platform and the restaurant according to a pre-negotiated rate. The platform's share of the revenue is typically about 15% to 30%, leaving the restaurant with only 70% to 85% of its normal revenue on each item sold.

Second, a large volume of delivery orders might place a strain on restaurant operations.

"Delivery orders from the platform can potentially harm the dine-in experience by clogging up and slowing down the kitchen, and the expectation of a long delay could deter higher-margin dine-in customers from purchasing," Frazelle said. "Combine that with the fact that the platform earns money only on delivery orders, while the restaurant earns money from both dine-in and delivery orders -- but different amounts for each because of the platform's commission -- and we have a recipe for conflict."

Food Delivery During COVID-19

Frazelle said food delivery was already growing before the COVID-19 pandemic, but it received a significant boost when people were under various degrees of stay-at-home orders.

DoorDash reported that more than 6 million people delivered orders on its platform in 2021.

"During the pandemic's early stage, delivery and takeout were restaurants' only sources of revenue, and delivery platforms were arguably critical to their survival, especially for smaller, independent restaurants," Frazelle said. "But given the platforms' commissions and the already low margins in the restaurant business, delivery orders are often not very profitable, if at all, for restaurants, many of which lack the clout to negotiate more favorable terms."

Cities, including New York, Seattle and San Francisco, instituted laws limiting the commissions that platforms could charge to protect restaurants' profit margins.

The commission caps were well intentioned, Frazelle said, but they didn't change the fact that platforms and restaurants have different objectives.

Resolving the Conflict

This motivated the researchers to identify an alternative contract -- a variation of the current industry standard -- that improves outcomes while still granting full pricing power to the restaurant for the dine-in channel and to the platform for the delivery channel.

The researchers developed a model and found that different possible pairs of dine-in and delivery prices would generate higher or lower aggregate revenue, or the sum of dine-in and delivery revenues, with certain prices achieving the maximum possible aggregate revenue, Frazelle said. The optimal solution trades off the incremental revenue from delivery orders against the negative impact that those orders have on dine-in revenue through the excess congestion that they generate, finding the right balance of dine-in and delivery.

"If the same company were to control both the dine-in and delivery channels, then it would jointly determine the respective prices to maximize the aggregate revenue," he said. "But of course, the prices are usually set by two different companies, and each seeks to maximize its own revenue. The key is to design an appropriately structured contract so that when each party maximizes its individual revenue, the resulting prices also maximize the aggregate revenue."

The researchers propose that for each delivery order, the platform pays the restaurant a percentage revenue share and a fixed fee. They find that appropriately chosen values of these parameters yield the maximum aggregate revenue, thus providing a simple and implementable way to alleviate common issues and improve the coordination of the food-delivery supply chain.

Additional Implications

Although it would not be as ideal as implementing the proposed contract, Frazelle said if a restaurant has some influence over the menu price on the delivery platform, it could set that price higher than on its dine-in menu to offset the platform's commission.

The study also has implications for consumers, Frazelle said. When deciding whether to use a food-delivery platform, it's important to understand the different contributors to the price and how the revenue is split between the restaurant, platform and delivery driver.

"The app doesn't always reveal this breakdown," he said. "It may only show a food total, service fees and delivery fees. Even if the food total shows $25, the restaurant may receive substantially less than that."

If customers notice menu prices at a given restaurant are higher on the platform than for dining in, they should consider that this might be the restaurant protecting its profit margin. Even with the price increase, after deducting the platform's commission, the restaurant might receive even less than if the customer dined in.

Frazelle said that delivery platforms are widely seen as a necessity for many restaurants, despite the lower profit margin on a delivery order. A restaurant not on a delivery platform risks losing an order to its competitors that are, and that loss could be of a repeat customer.

"Time will tell the degree to which dining habits are permanently changed, but delivery is indeed expected to retain a significant market share even post-pandemic," he said. "This makes it all the more urgent to improve the relationships between restaurants and platforms."