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Glossary Index

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Glossary term

Drop shipping

Quick definition

Drop shipping is a distribution method where the retailer does not physically store products, but works with a drop-ship supplier to allocate orders to a manufacturer. The manufacturer then fulfills the order directly to the consumer.

Key takeaways

 

Drop shipping is a way for retailers to introduce a new product or revenue stream to customers without needing to pay for merchandise up front or store it themselves. 

A successful drop-shipping strategy requires companies to understand their customers, know the associated costs, and develop a good relationship with their supplier. 

The drop shipping model has low profit margins, so it should rarely be a company’s main focus. 

In the future, drop shipping could allow digitally native companies to open physical stores, giving customers a chance to experience products before purchasing.


Q: How does drop shipping work?

A: An e-commerce business decides to offer a new product to customers. Instead of buying mass quantities of that product and storing it and shipping it out themselves, the company researches until they find a manufacturer interested in working with a retailer to distribute their products. The retailer contacts the manufacturer and reaches an agreement: the retailer will host the product listing on their website and make the sale, and the manufacturer will ship it out. The manufacturer is the entity that both produces, stores, and ships the product. 

The two companies — the retailer and the manufacturer — draft a contract laying out the price and shipping costs of the product. The retailer may agree to pay the manufacturer $75 for a product, so they might choose to list the product for $100 on their website, leaving them with a profit of $25.

Q: Why do companies choose drop shipping?

A: Many online stores will use drop shipping to expand their product offering to customers. It’s a low-risk way to test potential merchandise without having to pay for inventory up front. A home goods retailer, for example, might be considering offering a line of outdoor supplies. Instead of purchasing the inventory, finding a place to store it, and risking taking a loss if products don’t sell, they can work directly with a drop-ship supplier of outdoor goods. They can promote the items on their own site to gauge the interest level of the consumer base without spending money on the inventory in advance.

It’s also a helpful option for new startups, as these companies don’t usually have a ton of cash on hand. The manufacturer takes care of the storage and shipping, so there’s a low barrier to entry on the part of the retailer.

Q: Are drop-shipping contracts exclusive?

A: It’s rare that a drop-ship supplier will only sell products to one company. They may be selling to other companies directly, working with other drop-shipping retailers, or selling the products on their own.

Q: Are drop shipping businesses legal?

A: The concept of drop shipping is 100 percent legal. It's not necessarily a business strategy — it’s a fulfillment method. A manufacturer has 1,000 units of product, but it’s generic, so drop-ship suppliers provide the product to these retailers to apply their own brand to it. And each supplier agreement has different terms, which is where the legal aspect comes in. There's always an agreement between the retailer and the drop-ship supplier that have specific terms that will be legally binding.

Q: Who is liable in the case of a product defect?

A: The liability will be laid out in the contract between the retailer and supplier. It often depends on who has more leverage — a drop-ship supplier for a large corporation will likely have the upper hand when it comes to determining which side takes responsibility.

Q: How can companies successfully use drop shipping?

A: A company that wants to start drop shipping a new product needs to make sure it fits into their larger strategic goals. They need to consider their customer base and current offerings to identify what kind of product to potentially bring into the mix, or what area has room for growth. So it starts with a proof of concept that aligns with the company’s objectives and meets the customers’ needs.

The next step is to find a reputable drop-ship supplier and start building a relationship. Because supply chain is out of a retailer’s hands if they're using a drop-ship supplier, one of the biggest things they lose is quality control. Staying on top of that with the supplier is key. Although the retailer has no contact with the product, they will be the ones blamed if something goes wrong. Working with a poor supplier will negatively affect a brand’s reputation. Closing the loop with the supplier when issues with quality control arise can keep the process working well. 

The biggest factor that determines drop-shipping success is how well a retailer knows their business. They need to know where their costs are coming from, what their margins are, and how much it costs to acquire a customer. If the cost to acquire a customer is low, that helps your margins. But if it's $50 to acquire a customer, and the average order value is $50, and the margins with drop shippers are 12 percent, the retailer isn’t going to make any money.

Q: Should companies eventually bring drop-ship inventory in house?

A: It depends on the strategic goals of the company. Profit margins tend to be low with drop shipping. The drop-ship supplier is the one who has all the fulfillment costs, but usually the retailer has all the costs of acquiring the customer, running the advertising and promotions, and driving demand. Retailers often aren’t able to generate a lot of new cash. 

The choice to bring drop shipping in house depends on how well the drop ship inventory is moving and if retailers prefer to use drop shipping for a few products or as a way to retain customers, rather than expand the customer base.

Q: Does drop shipping benefit customers?

A: Many of the benefits of drop shipping are on the merchant side — low overhead, low risk — but customers do benefit as well. The flexibility that drop shipping provides to merchants as a way to quickly begin offering new products to customers makes it easier for a retailer to start providing a wider variety of products to their customers and to consider what product their customers might need. If a customer is a fan of a product or brand, and they want the retailer to offer more options, instead of spending months designing and developing a new product, the retailer can turn to a drop-shipping supplier and start offering the product the next week.

Q: How does drop shipping tie into a larger business strategy?

A: It’s hard for a business to be profitable if they’re only relying on drop shipping. Drop shipping should be a way to augment another larger revenue stream to expand a retailer’s already existing in-house catalog. Drop shipping can provide a temporary solution if another revenue stream is cut off and the retailer needs to figure out a way to still offer a product and avoid losing customers.

Q: Is there a difference between advertising in-house inventory and drop shipping products?

A: To a customer it should be relatively incognito because the retailer has branded the drop-shipped products as their own product. But there are differences. Since drop-shipped products have lower margins, and a retailer might make more of a profit on a product they produce and store in house, they have to be careful when evaluating how to spend their marketing budget.

Q: How do store-wide promotions affect drop-shipped products?

A: Every discount or promotion includes fine print and exclusions. There are rules the retailer can apply to certain SKUs so the coupon doesn’t work for a drop-ship item, because the low profit margins mean a discount might cause the company to lose money.

However, in certain cases a retailer might include the drop-shipped products in a promotion. They may lose money on that specific sale, but it could lead to customer retention or customer acquisition, which will be more profitable in the long run.

Q: What mistakes do companies make when drop shipping?

A: One pitfall online businesses run into when implementing a drop-shipping business model is trying to launch everything at once. By doing their research and taking everything one step at a time, companies can ensure a smooth implementation. 

Other mistakes include relying on drop shipping as the main source of revenue and not understanding costs or margins and pricing products incorrectly. When it comes to margins, retailers need to consider the cost of the physical item and the costs to the supplier, as well as the costs of acquiring customers. Advertising costs need to be figured into the margins across the inventory, including drop-shipped products. 

Retailers also may make the mistake of not developing a good relationship with their supplier. If possible, retailers and suppliers should try to meet face-to-face. The relationship then becomes less transactional and more of a partnership. Both companies can work together to figure out how to provide a good experience to what is technically a joint customer. If both the retailer and supplier do a good job, the customer will come back and place another order.

Q: How did drop shipping start?

A: The earliest iteration of drop shipping developed in the days of catalog ordering. Catalog companies would put together a collection of products they didn’t make. They didn’t manufacture that catalog of a thousand different products, but it gave them a way to build the brand, promote a large product mix directly by sending it to the mailbox of every house in the neighborhood, but then keep their costs low by not physically holding any of that inventory.

The concept has been around for a long time, but the explosion of e-commerce platforms like eBay, and the internet in general, has made it more accessible to a lot of businesses.

Q: What is the future of the drop shipping business model?

A: Drop shipping is becoming more competitive because companies are so crunched for margins. If businesses think about drop shipping more strategically and consider where drop shipping can provide the best opportunities, it will exist for a while. 

Drop shipping may come into play more if physical stores start holding less inventory onsite. There are now experiential stores with extremely limited inventory. Customers can come in and try on a shoe or a piece of clothing, then order online directly from the store. This opens up an opportunity for digitally native companies built on drop shipping to set up physical stores, because they don’t need to hold the full inventory and can still use drop shipping to deliver products. As long as drop shipping is included in omnichannel experiences like these, it will continue to exist and work for businesses. 

And with artificial intelligence (AI), companies can start incorporating better forecasting into the relationship between supply and demand, between the retailer and the drop shipper. They will  be able to predict in a more accurate fashion what is going to sell and when, so that the supplier will understand how much product they need to have on hand. In that scenario, AI helps the drop shipper lower their costs and manage their inventory better. That could then be passed on to the retailer and then lower costs for consumers.

Another potential benefit of AI will be intelligent sourcing. A drop-ship supplier could have warehouses in multiple different regions and geographies, so having intelligent sourcing algorithms that let these suppliers know the best way to fulfill a specific order based upon the promises that were made to the customer could also be a possibility.

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