Analyzing the Drop-Shipping Model for Online Stores
Web Commerce Today, Issue 16, November 15, 1998
drop-shipping, n. an arrangement whereby a mail-order or Internet merchant accepts orders for products, and then pays a manufacturer or distributor to ship the product to the customer.
Imagine a virtual store that can do business with no investment in inventory stock and no space given to storage! Says Nicholas T. Scheel, author of the definitive Drop Shipping as a Marketing Function, "It gives a chance for the entrepreneur to sell products for future delivery without needing a closet full of inventory."
Mail order companies have been using this approach for a long time, but with the advent of the Internet, many online storefronts are relying exclusively upon this approach. You receive an order at your online storefront for a product, and then fax the order and a packing slip to the manufacturer, who then, in turn, ships the order to the customer in your name. Often the customer can't tell that another company is involved at all, since your packing slip (and, perhaps, label) comes with the package.
There are a number of advantages to this approach.
1. No Money Invested in Inventory
The most obvious benefit, of course, is the low cost of starting up and running a business. While you need to develop relationships with manufacturers and distributors that will work with you on this basis, your money isn't tied up in stock. You can use it for advertising, setting up your online store, and other costs.
2. No Storage or Shipping Department
Nor do you need to provide storage space for your virtual inventory. Warehousing is handled by the manufacturer. You don't have to hire people to handle shipping. That function, too, is assumed by the manufacturer. Of course, you'll pay them a charge for shipping and handling to cover their costs. Maybe you could do it a bit cheaper yourself -- and maybe not. But usually the shipping and handling is a "pass-through" that you charge your customer and pay to your supplier.
3. No Disposal of End-of-Runs
If you ordered stock and don't quite sell out, you'd have to mark down the left-over product or dispose of it through a discounter. But since you don't have any inventory with the drop-shipping model, you don't have to worry about outdated products and end-of-runs. Nor do you assume any risk for the security of the inventory.
4. Add New Products Quickly.
Since you don't have to wait to get products in stock, you can add new products to your line as fast as you make arrangements with suppliers and post them to your website. The flexibility can be a real competitive advantage, especially in the early stages of your business as you're fine-tuning your particular niche.
But there's a downside to drop-shipping, too. You need to look at both sides of this business model before you adopt it as a strategy, our you could find yourself in major difficulty.
1. Shipping Calculation Artifacts
You need to determine how you'll charge for shipping and handling if you deal with a number of distributors. Since different companies charge different fees, you may need to attach a specific shipping price to each product. If your customer orders three or four products, each from a different manufacturer, the total shipping cost could be higher than if you were able to place the whole order with a single supplier. One alternative is to average your shipping costs over all your suppliers, figuring that what you lose on one sale you make up on another.
2. Increased Fraud Potential
Donal Gleeson, managing director of CollegeDepot.com says that an order for several items might increase your susceptibility to credit card fraud. "If products come from different sources of supply," says Gleeson, "we sometimes don't charge the customer's credit card until all the items have been shipped, unless we know something is out of stock. But if some items have already been shipped before we charge the card, and only then find evidence of fraud, the product is already on its way -- and we may be out the money."
3. Shipper Identification
If you do a lot of business with a particular supplier, you'll probably want to mail them some shipping labels to use on your packages. One wrinkle you may run into, however, is United Parcel Service's insistence that the shipper's return address is on the label rather than yours. UPS wants to be able to return the package to the party that paid them in case there's a problem. But your shipper might just refuse to comply with the requirement and get away with it. Or, if you do a lot of business with this merchant, perhaps they could be authorized to ship using your UPS account. This is probably not a serious problem, but just one you need to be aware of.
4. Vendors Back Out of Agreements
More serious, however, is the chance that a vendor could back out of an agreement to drop-ship for you. "Most vendors say they will drop-ship," says Gleeson, "but when they see they are getting orders in drops and drabs, they may tell you they won't do it after all." If that happens, your investment in setting up web pages for their products is wasted. "You don't really know the strength of your vendor until you've placed some orders and found they're above-board and honest," says Gleeson. He's found that the smaller vendors are often more willing to provide good service than larger suppliers.
5. Poor Communication on Shipping Status
The chief difficulty with drop-shipping is the lack of timely communication about what is in stock and what is back-ordered. Some vendors will phone or fax immediately to let you know about the shipping status of an order, but some won't communicate much at all. Unless you are tracking every order to make sure that a shipping confirmation has been received, you could be in trouble with your customer.
6. Customer Service and Repeat Business
"It's the customer, stupid," probably ought to be the election year motto for online storeowners. If your customer doesn't receive the goods he's ordered in a timely fashion, he won't shop in your store again. But unless your vendors provide excellent service and quick turn-around of orders there is great potential to create problems you'll need to solve. The ability to provide top-notch customer service distinguishes winning companies from "also-rans." If you outsource your product fulfillment, you've greatly diminished your ability to control the quality of service. Can you afford to do this?
7. Competition with Stocking Merchants
The final problem with drop-shipping is economic. For you to compete on price, you need to keep your costs shaved to the bone. While outsourcing shipping is by far the most convenient and capital-friendly approach, it may or may not be the most inexpensive approach overall. When you're dealing with cut-throat pricing by competitors, the company that has the best control of costs will come out ahead. Your competitor may be able to beat you in price and customer service if he has an in-house inventory ready to ship.
Economics
First, to make any Internet product viable, you need to have a minimum total order of $10 to $20. Without that, the customer is faced with shipping costs too high in proportion to the total order, and you are faced with certain credit card transaction fees and processing costs that don't vary much for an order of $5 or $50.
Next, you need to evaluate the cost difference between purchasing stock and drop-shipping. This can vary a great deal from one industry to another, and from one manufacturer to another. Nicholas Scheel says that for drop-shipping single products, a manufacturer might offer you a discount of 40% to 50% off the suggested retail price, while if you stock a gross of the product you might be able to get a 60% or greater discount. These, of course, are just estimates, since there is so much variance.
Gleeson says they try for products which average 25% to 30% gross margin. "Sometimes the vendor can't give us that," he says, "so we have to load the price a bit." For some products they get a 50% to 60% margin. For others, such as "care packages" for college students that take a lot of handling, they might only have a 12% margin.
Scheel says that even if you drop-ship 95% of your line, you might want to stock certain products. You may need a product in order to round out your product line that a supplier won't drop-ship. Or you may have fast-moving items that you can ship easily yourself.
Setting Up Relationships with Drop-Shippers
To set up an online store with a drop-shipping model, you'll need to develop suppliers who will agree to drop-ship to your customers. This isn't always easy. Many manufacturers don't want to be bothered with drop-shipping. They prefer to sell stock to full-function middlemen who then redistribute it to retailers. So you need to look carefully for manufacturers who will drop-ship.
On the other hand, some small art and crafts manufacturers see drop-shipping as the ideal outlet for their products, since it frees them from the limitations of a solely local market for their products. Smaller manufacturers can find it difficult to even get on the shelves at the bigger stores, so they may value a relationship with you.
Scheel sells mailing lists of drop-shipping manufacturers in various industries: archery and bowhunting, musical instruments, auto after market, outdoor equipment, consumer electronics, office supplies, craft products, photo and cameras, fishing tackle, ski products, giftware, tableware, housewares, toys and hobbies, luggage, and video software. He also sells the Drop Shipping Source Directory of Major Consumer Product Lines (http://www.drop-shipping-news.com/order.html). When you contact a manufacturer, Scheel offers an important tip: "Be sure to ask prices for both inventory stock and drop-shipping, or they may throw your inquiry in the wastebasket."
Now the Ball's in Your Court
You need to weigh the drop-shipping model carefully before you launch your online business. It tends to favor the smaller entrepreneur who's just getting started. As companies get larger, they may move toward doing their own inventory control and shipping so they can compete better on the basis of price and service.
The smaller business, however, is most able to compete by finding a niche and serving that niche as fully as possible, rather than going head-to-head on price. CollegeDepot.com, for example, aims to be a one-stop shopping point for the college student. "A big frustration with shoppers on the Internet," says Gleeson, "is that they get fed up when they have to shop too long. When a customer is on our site, we try to make it convenient to buy. Our customer is often buying for convenience or uniqueness, rather than price." Drop-shipping works for CollegeDepot.com. It may work for your business, too.
Related topics in this issue:
(Editor: In future issues we'll examine other fulfillment approaches, such as using fulfillment houses. Stay tuned.)
