The Drop Ship Business Model
Drop shipping has been a key term in the eCommerce industry since it began to take off in the late 90’s. Up until the drop ship business model was created, manufacturers, distributors, and retailers worked through traditional wholesale relationships. (Learn more about supplier relationships by reading my article)
The retailer bought the product from the distributor or manufacturer and stored it in its warehouse or physical retail shop. As the retailer sold the product to the customer, they either shipped the good directly to their address or the customer walked right out the door with it.
A Hybrid Wholesale Model
The drop ship business model created a hybrid of the traditional wholesale relationship that made the ability to hold inventory easier for the retailer. Needless to say, its popularity quickly took off.
In the past 20 years as eCommerce has grown and grown becoming an evermore source of shopping for consumers, drop shipping has stuck around and millions of business owners have started their online retail companies by utilizing it.
So…How Does Drop Shipping Work?
Drop shipping is a wholesale model highly dependent upon regular communication between the retailer and the manufacturer or distributor. The main difference that is its main attraction is that the retailer does not have to ever touch the product.
Allow me to illustrate the 7 steps of the drop ship business model.
1. Manufacturer gives retailer permission to sell their product, product information, and inventory levels to list the product in their online store.
2. Retailer lists the products in their online store.
3. Shoppers browse the products in the online store.
4. The retailer receives orders from customers on their online store. They collect the billing information, shipping information, method of payment, email, and phone number.
5. The retailer communicates that product information to the manufacturer. The retailer pays the manufacturer for the product plus shipping using a credit card or through net 30 terms.
6. The manufacturer accepts the order and ships the product directly to the customer. The manufacturer sends tracking information to the retailer. The retailer sends the tracking information to the customer.
7. The customer receives the product. If they have issues, they contact the retailer for customer service. The retailer handles all communication with the end customer.
The drop ship business model provides retailers with the ability to sell products without ever having to touch them. There are many advantages and disadvantages to the drop ship business model.
The Advantages of Drop Shipping
1. You never touch the product
One of the most appealing aspects of the drop ship business model is that you, as the retailer, do not have to hold and handle the products that you are selling. Your relationship with the manufacturer or distributor makes them responsible for storing all of the products after being made and than shipping them out one by one to the customer.
2. Advertise a larger inventory
With traditional wholesale relationships, the retailer’s inventory that they are able to advertise to consumers is limited to the amount of products that they can afford to purchase and store in a warehouse. With the drop ship business model, retailers can advertise hundreds, if not thousands, of products simply through the relationship with the manufacturer or distributor.
3. Low investment to startup
As I’ll talk about further in this column, starting a drop ship business and immediately making money is not as easy as others on the Internet may make it sound. However, it is true that there is a low startup investment needed to launching a drop ship business.
You don’t need an office, you don’t need a warehouse, you don’t need to purchase products up front, and you don’t need a physical retail location.
You simply need Internet, a website, or a marketplace where you will be selling your products to online consumers. You’ll also need a state resale certificate so that you can form the drop ship partnership with the supplier. A state resale certificate will be required by most reputable manufacturers so that you do not have to pay sales tax on products and to prove that you have the right to sell products.
4. Cash flow positive
A fourth advantage to the drop ship business model is that it is cash flow positive. This means that you receive the money into your business before you have to pay for the product and shipping. Here’s how.
You don’t pay anything to form the drop ship relationship and list a manufacturer’s products on your site. When you make a sale, the customer pays you for the product. You now have that money in your bank account. You then submit the order to the manufacturer and they charge you for the cost of the product and shipping.
In a traditional wholesale relationship, the retailer is required to purchase large quantities of product long before the make a sale. In this case, the retailer may spend $10,000 to purchase inventory for their online store. Until that inventory is sold, they are fighting to get back to being profitable.
Both can be wildly profitable. Being cash flow positive is beneficial though when you are starting a new company or do not have a large amount of cash in the bank.
The Disadvantages of Drop Shipping
1. A bad reputation
Because of the surface attractions of drop shipping, the business model has very much been abused in the industry in the past 15 years. Many manufacturers have experimented with the model and found that they struggle to maintain positive profits because of the labor that goes into shipping products on a one by one basis.
The model is used successfully by top online retailers, but it definitely has left a nasty taste in the mouths of many manufacturers and industry individuals.
2. Lack of access to leading brands
The drop ship business model hits a wall when you want to start selling top brands within your niche. Let’s take Fisher Price as an example.
They are a huge, international toy and kids manufacturer that sells their products around the world to the largest retailers. They receive $10,000 orders from retailers on a daily basis.
Unless you get a selection of their products from a distributor, you will not be able to sell their products because drop shipping simply does not offer them any advantages. They are already everywhere and make the margins that they desire.
A company that large, and many like them, simply do not drop ship.
3. Lower profit margins
The drop ship business model tends to provide lower profit margins than traditional wholesale relationships. Since the manufacturer is holding the inventory and shipping it to the customer, they tend to offer smaller discounts to drop shippers.
It’s also common that manufacturers will add a drop ship fee to each order to account for the labor that pick, packs, and ships the products to the customer. Manufacturers have started to implement this into their drop ship relationships to ensure that they remain profitable while shipping products out one by one.
4. Inventory management
Since you’re not holding the inventory in your own warehouse where you could keep close track of the exact quantity of each product that you have listed on your site, you have to create a robust system to update inventory by communicating with each manufacturer.
This requires increased communication between you and the manufacturer that does not exist in traditional wholesale relationships. You need to create a system for them to send inventory updates to you on a daily or weekly basis so that you can make sure you are not selling out of stock products.
You then need someone on your team who can interpret their inventory files and updates your product data accordingly. If this system is not well flushed out, you can get into a situation where you are selling products that are not in stock. This leads to angry customers. Angry customers leave bad reviews. Bad reviews lead to less sales. Less sales lead to your company going under…
5. Reliance on the manufacturer or distributor
The drop ship business model forces you to trust the operations of the manufacturer that you are working with. You aren’t in control of the shipping process so you have to hope that the manufacturer’s operations are strong.
A common downfall of drop shipping is poor communication from the manufacturer and inefficient operations. Here’s an example…
You start working with a new manufacturer. Their products start selling well and you are sending them order everyday. They weren’t expecting the increase in orders and start sending incorrect products to your customers. You now have to set up a return, send the product back to the manufacturer, and get them to send the right product out to the customer.
This can make customers angry and it can be extremely nerve racking as the retailer.
The Drop Shipping Craze
If you are thinking about starting your own online store, you are definitely going to come across thousands of articles advocating the drop ship business model. They’re going to tell you how easy it is, how much money you can make, and how quickly you can make it happen.
These pages fool millions of people around the world everyday…so don’t feel bad if you started imagining how much money you can make. I call this the Drop Shipping Craze.
Because of its low investment to start, it has become a topic on the Internet that is praised as yet another “get rick quick” operation. I am here to tell you the truth.
The Reality of Drop Shipping
Here’s the reality…It’s Hard!
And it’s not going to make you money overnight. It requires hours of time to research, launch, and create systems to properly manage each aspect of the operation.
It bothers me that so many people online portray drop shipping as a business that you can build within a few days. It’s simply not true. It takes time to build a reputation as a reseller or retailer and to form meaningful relationships with manufacturers that have drop shipping capabilities.
I takes time to choose whether you are going to sell on a marketplace or build your own online store. It takes time to properly list the products. It takes time to create and structure the drop ship relationships with the manufacturers. It takes time to manage orders, inventory, and customer service.
If you’re starting your own online store, it takes time to build a community of people that will want to buy from you.
However! It can be done if done right.
I built my first drop ship business when I was a sophomore in college and I worked extremely hard to build it into a legitimate business with 60 employees and $7.5 million in revenue in 2014. The business made a lot of money, but it didn’t happen overnight. It took years to perfect the drop ship business model and there were still improvements that we could make each day to get even better at it.
Additional Drop Ship Resources
Below, I’ve included some of my favorite drop ship resources for you to learn more about how it works.
Tony Hsieh, founder of Zappos, explains how they used drop shipping. Read Here
PracticaleCommerce writes a great article on drop shipping
Wayfair.com….close to 85% of their inventory is sourced through drop shipping