Drop shipping is a supply chain management method where the inventory does not flow through the retailer. Unlike cross-docking, the retailer doesn’t even briefly hold the products in order to dispatch them to the customers. Customers’ orders are delegated directly by the retailer to the suppliers, wholesaler or manufacturers to be fulfilled by them, often without the customer even realizing it thanks to private label shipping services. With the rise of e-commerce, this method has become increasingly popular, with platforms offering easy ways for first-time entrepreneurs to start their business with close to zero capital. However, it comes with pros and cons: not being responsible for holding inventory or organizing deliveries allows for low levels of investment as it means avoiding entire classes of costs (capital costs, carrying costs, transportation, etc.), but margins are reduced, the purpose and value of the retailer is narrowed, and so is their control over the supply chain, with potential backfires on returns or the retailer’s reputation.
Pros and cons of drop shipping for e-commerce
Drop shipping is, in many ways, a more extreme version of cross-docking. Therefore, it comes with similar pros and cons, only accentuated.
Not bearing the responsibility of holding inventory or dispatching goods has multiple advantages. Numerous upfront investments can be avoided altogether due to the absence of entire categories of costs: warehousing costs, capital costs, inventory services costs, transportation costs, including insurance, hardware, manpower, etc. While cross-docking still entails some of these costs, in particular transportation and usually a limited warehousing capacity for the dispatch center, with drop shipping, the costs disappear entirely.
The overstocking risk related to fluctuating demand is transferred from the retailer to its suppliers, as orders are fulfilled only after actually being placed by the customers. There is no need to forecast demand with any kind of accuracy. Usually payments are made in advance, especially for e-commerce, and the money goes from the retailer to the supplier only after being transferred by the customer. This reduces working capital expenditures, which makes drop shipping attractive to first-time entrepreneurs low on funds.
While drop shipping is prevalent among SMB (Small and Medium Businesses), it can also make a lot of sense for larger companies. In particular, it allows retailers to test new categories of products with almost no inventory risks. Broadening a catalog can be a plus - attracting new customer segments or renewing the interest of loyal customers -, and drop shipping diminishes the risk of dead stocks when customer demand turns out to be nonexistent.
Some categories of product can also be favorable for drop shipping, unrelated to the size of the retailer. Products requiring specialized logistics, such as oversized products or highly fragile products, are prime candidates. For instance, large bathtubs can require special transportation, with the inside of the truck specifically fitted to absorb shocks. Beyond oversized home appliances, dangerous products such as chemicals, explosives, etc., usually also require special equipment or vehicles. In these situations, suppliers themselves are usually best placed to provide the kind of care needed for transportation, making drop shipping advantageous when it comes to non mainstream logistics.
The flip side of the coin is the margin. There is a price for externalizing entire aspects of supply chain management and pushing them onto others. The suppliers do include the aforementioned costs in their pricing. It means lower margins for the retailers. Lower margins can be acceptable for businesses with low working capital, but they also imply lower profits. Higher risks offer the opportunity of higher rewards.
By looking for suppliers who are willing to drop ship their goods, retailers also limit the number of suppliers they have access to. If the best suppliers price-wise or quality-wise are not offering drop shipments as an option, then competitors who leverage those suppliers have a strategic advantage. In particular, those competitors may leverage MOQs (Minimum Order Quantity) or MOVs (Minimum Order Value) to get access to price breaks that are not available with drop shipping.
Also, unlike cross-docking, drop shipping cannot consolidate multi-item orders into a single shipment unless all the items come from the same supplier. This puts drop shipping at a disadvantage for situations where customers are routinely passing sizable orders, as it happens frequently in B2B retail.
Then, drop shipping doesn’t absolve retailers from inventory constraints. Returns can be a challenge. If goods are damaged, or simply not satisfactory, returns are seldom taken care of by the suppliers and they usually fall back on the retailer. This is the reason why some classes of goods that entail a lot of returns should be avoided entirely when it comes to drop shipping - for instance some types of garments where sizing is important, such as women’s trousers.
Another drag, which also applies to cross-docking, is the swiftness of the delivery. It will be very dependent on how fast and reliable the supplier is, and delivering through drop shipping will usually be slower than serving from stock. More than that, the risk of getting back orders is high. The item sold to the retailer’s customer might in fact be out of stock at the supplier level, and the delay might be significant - something for which the retailer has no control over whatsoever, but that might result in unhappy customers. Customers might be more tolerant when it comes to niche products - which makes them goods candidates for drop shipping -, not so much for products easily found and with a fierce competition. Canceled orders can quickly kick in.
Additionally, it is more of a challenge to track deliveries through drop shipping, especially when multiple suppliers with different processes are involved. The retailer might be unable to locate any goods once he has transferred the order in a kind of “fire and forget” manner. As a consequence, he might be unable to provide satisfactory customer support in that regard.
Last but not least, the retailer’s brand and reputation is on the line whenever orders are to be fulfilled. By making other parties fulfill the orders, he places his reputation in other’s hands. Unhappy customers won’t complain to the supplier, wholesaler or manufacturer, they will complain directly to the e-commerce through which they bought the items in the first place. Building trust is one of the hardest things for e-commerces, and even a few shipment mishaps can shatter this trust. By having no control on inventory, the risks attached to inventory costs are lessened, but another class of risks appears. They should be weighed carefully against one another.
Drop shipping made easy doesn’t equal success
Drop shipping has gained momentum over the last two decades. Online commerce has progressed tremendously and involves companies of all sizes, from giants to niche boutiques. On the lower end of the spectrum, drop shipping has made it possible to start selling goods without leaving one’s home with a mere personal computer, an internet connection and close to no upfront capital.
Webshops like Shopify now offer the possibility to set up a shop in a few clicks, and also display marketplaces to easily select dropshippers from platforms such as AliExpress, as well as tutorials to guide beginners through this process. This can even be automated to a great extent. Technically, dropshipping has never been so easy; and yet, the dream of a fully automated well-oiled machine, piloted from home or as a side business or hobby to make money is rarely successful.
Drop shipping indeed takes out a decent chunk of the supply chain management issues: production, warehousing, even delivery. This begs the question of the added-value of a pure “drop ship” retailer. Market forces tend to eliminate middlemen that do not generate added-value. In this regards, several points can be highlighted:
- Visibility: the first focus for the retailer using drop shipping should be the visibility and brand reputation. The retailer’s value lies in displaying a certain array of products in an attractive and visible way. This is true for a retailer with a brick-and-mortar showroom, as well as for e-commerces. For e-commerces, the key is often SEO and publicity, potentially through creation of content, paid ads, social media, and so on and so forth. Specialized skills as well as manpower are usually involved. This is also the main reason why aspiring entrepreneurs often end up with a nice online shop, a ready-to-use drop shipping process and zero orders, as customers never even reach their online shops.
- Ergonomy: wholesalers are seldom easily accessible to private persons and mostly they don’t try to be. On the contrary, ordering from a retailer should be easy, with a well-oiled process, a nice and friendly interface, a good return policy, potentially advice and tests from other users encouraging customers to order, etc. Everything should seem easy and reassuring from the customer’s point of view.
- Selection: as mentioned above, the retailer’s value lies in selecting the right array of products (attractive, coherent, good level of variety, etc.) and therefore, being able to select the right suppliers is key, especially when it comes to drop shipping, because the retailer will be the one directly impacted by their mistakes. It’s all about finding a nice set of suppliers, with a good balance between price and quality, and making sure that the quality of service from the suppliers (goods delivery, low level of backorders, few returns, etc.) is up to standards. Again, the retailer will be the one blamed if anything goes awry.
Drop shipping allows e-commerces to remain pure digital players. However, online competition is fierce, and for e-commerces to be successful, they still have to be very good digital players. This requires a lot of time, effort, and often money. These investments are, in a way, more at risk with pure drop shipping for the reasons stated above, concerning quality of service and reputation. Also, if an e-commerce goes through all that effort to be successful and grow, getting to the next level and starting to hold inventory or to use cross-docking may not be so far-fetched.
Lokad’s take on drop shipping
Drop shipping doesn’t have to be the sole option for customer shipments. In fact, it should be used sparingly, for the right products and with the right suppliers. The most profitable retailers are edging their bets by mixing several fulfillment methods, serving from stock, cross-docking or drop shipping - whichever option is the most profitable one. The retailer dynamically switches from one method to another, leveraging predictive supply chain optimization systems - Lokad being one of them - to properly simulate the costs attached to each method, versus margin and customer loyalty.
Gaining more flexibility and finding the right balance requires a certain type of logic, but also flexible tools with the ability to perform such simulations quickly, partially in an automated way. This is the type of agile supply chain management that the Quantitative Supply Chain advocates.