Dropshipping Explained

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Here we look at understanding drop shipping as a business strategy and determining if it will work for you. Let's begin by quickly reviewing the distribution chain as a way to understand how drop shipping fits into the model.


Traditional Distribution Chain

In a traditional distribution chain, you as the seller (sometimes known as the reseller) purchase an inventory of products from manufacturers, wholesalers or distributors.

  • Manufacturer - the creator of the product

  • Wholesaler - usually provides products to distributors; may sell directly to retail buyers

  • Distributor - works to distribute products to as widely as possible. Purchases from manufacturers and wholesalers

If you purchase from the manufacturer, you pay the manufacturer's wholesale price (MWP). If you purchase from a wholesaler or distributor, you pay the MWP plus the mark-up charged by anyone else in the distribution chain. For example, let's say you purchase from a distributor who purchases from a wholesaler, and that the original manufacturer's wholesale price (MWP) was £10.00 per unit. Below is what you would pay in this example:

£10.00 (MWP) + the wholesaler's markup of 10% (£1.00) + distributor markup of 10% (£1.10) + handling/shipping (£.50/unit) = £12.60/unit.

You maintain an inventory of the product, market and sell it to your customers at a marked up price that will cover your costs of marketing, inventory and so on, for example, £20.00/unit. (£5.00 to cover your costs and £2.40 profit/unit).

You package and ship the product to your customer, charging your retail price plus the cost of shipping and handling. £20.00 + £3.00 shipping/handling. Your profit is £2.40/unit.


Drop Shipping Model

In the drop ship model, you arrange to sell products offered by selected manufacturers, wholesalers and/or distributors.

You do not purchase inventory. Instead, you promote the products through photos and information provided by the supplier and/or by showing sample products.

When the customer orders the product, you collect payment then transfer the order and payment to the supplier who then packages and ships the product directly to the customer, often with your shipping label or other branding.

In this model:

  • You transfer shipping costs to the customer. (You will save £.50/unit; your customer will pay more for single order shipping.)

  • You may be able to reduce your £5.00 overhead costs because you don't need to purchase in bulk, store and handle the merchandise. Say that saves you £1.00/unit.

Now you have two choices. You can either:

  1. Sell the product for $20.00/unit and increase your profit to $3.90/unit ($2.40 profit + $1.00 saved on overhead + $.50 saved on shipping) or
  2. Pass on some of the savings to your customers in order to be more competitive and sell a greater volume of products.

Sounds perfect, doesn't it? Well, you're absolutely right; drop shipping can be a wonderful way to build or expand a business for many reasons. Of course, there are some drawbacks as well. Let's take a look at the advantages and disadvantages of drop shipping next.


Advantages of Drop Shipping

Drop shipping truly offers exciting opportunities, especially for new and small businesses (though many major retailers use drop shipping as well).

  1. You don't need to purchase and manage inventory. In a traditional retail or reseller setting, you purchase enough inventory to be able to fill customer orders as they come in, most of the time. If you are just starting out in business, the inventory costs can be huge. Even if you are established, it may be difficult to afford expansion into a new line or stocking up in anticipation of the holiday buying season or the spring growing season.

  2. You don't need to store inventory. Unless your inventory is paper clips, tacks and staples, you will need to have some sort of storage capability. (Even small items can be difficult because they need to be stored so that they are accessible for the "picking and packing" process.) Storage is one more overhead cost that needs to be considered in your pricing.

  3. You don't have to deal with unsold stock. Most companies try to have enough stock on hand to meet demand. If demand falls short, you have product sitting on your shelves that you need to move in order to either get some return or simply free up cash for the business. Companies often resort to "inventory" or "warehouse" sales, selling at very low prices, sometimes under cost, to move inventory remainders.

  4. You don't need to handle the product. Shipping product requires manpower to do the picking and packing.

  5. You don't need to manage relationships with shipping firms (UPS, DHL, Royal Mail etc.)

  6. You can try out new products with almost no investment. If you are a web retailer, you just put up the new products on your website and if they sell, you make money. If not, you only lose the time you spent putting up new information.

  7. Your customers never have to know that there is a third party involved. Most drop shippers will place your shipping label on the merchandise.


Disadvantages of Drop Shipping

Okay, so what's the catch?

  1. Sometimes your supplier will mark up your products to cover their costs of drop shipping so the MWP price may be higher than the price for a bulk shipment. Usually the savings in your overhead costs more than covers the mark up.

  2. You are not in complete charge of the customer relationship. If your drop shipper makes a mistake, the error will reflect poorly on your company.

  3. You can become more vulnerable to rationing. For example, if you resell gaming electronics and ABC's newest version is selling like hotcakes, your orders may not be filled and you can't do anything about it.

  4. You won't know about quality problems until you hear about them from your customer. When you handle and ship product yourself, you can be certain that the ceramic piece is not chipped or the model includes all of the accessories.

  5. You could lose your customers to the manufacturer who decides to go retail. For example, if a manufacturer who drop ships cosmetics for you decides that, now that it has the name and address of your customers, it can send a reminder to replenish supplies by reordering on their website, you have been cut out of the loop. However, in reality, if a manufacturer chose to do that, they would quickly lose their distribution network and could be in breach of contract with their resellers. So, while customer encroachment is a possibility, it's not likely to happen. And, you will place restrictions in your agreement with the supplier to prevent this problem.


Is drop shipping a good strategy for you?

Every business situation is different but there are some general considerations that apply.

  1. Drop shipping is an excellent approach to get into business. This approach allows you to start up with very little capital investment and very little risk. If you are starting out, this may be a great way to test the market.

  2. If your company offers or intends to offer a wide variety of products, wholesalers or distributors are in a much better position to manage many different products; that's their expertise.

  3. If your product demand is highly variable or apt to change quickly with fast-moving trends, you may be better off letting the supplier manage the ups and downs of the marketplace by keeping the inventory on his shelves, not yours.

  4. Is your strength marketing and customer relations? It needs to be; you have essentially outsourced the fulfillment function and your business now depends on your ability to promote products and manage a relationship through third parties.

  5. Does your industry offer drop ship opportunities? More and more industries do.


What have you learned?

By the end of this section, you should know that:

  • Drop shipping differs from the traditional supply chain.

  • Drop shipping offers many advantages such as low costs of entry, reduction of risk and elimination of many overhead costs and elimination of inventory management.

  • There are some risks associated with drop shipping such as loss of control of the complete customer relationship.

  • You should analyse your business situation to be sure drop shipping is the right solution for you.


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