Drop-Shipping—Internet Retailers' "Little Helper"?

Drop-ship, or Keep in Store?

Many Internet merchants increasingly try to fill orders as they receive them, without necessarily having the relevant goods in their possession. The idea is for a retailer to take an order, which is then electronically transmitted or routed to the manufacturer (or distributor, or wholesaler), who drop-ships directly to the customer. Typically, the drop-shipper will package and ship the item, usually in a day or two (if the item is already manufactured and stored), and either the shipper or the retailer is responsible for shipping costs, depending on the arrangement between the two parties. In general, shipping is the function that performs tasks for the outgoing shipment of parts, components, and products, including packaging, marking, weighing, and loading for shipment.

The product is shipped with the packing slip in the retailer's name—sometimes even in boxes carrying the merchant store's logo or label. The buyer should be none the wiser, and returns are thus typically sent directly back to the manufacturer or middleman. The packing slip is a document that itemizes in detail the contents of a particular package, carton, pallet, or container for shipment to a customer. Details include a description of the items, the shipper's or customer's part number, the quantity shipped, and the stock-keeping unit (SKU) of items shipped.

The idea of drop-shipping is not new. The APICS Dictionary defines it as the means "to take the title of the product but not actually handle, stock, or deliver it, e.g., to have one supplier ship directly to another or to have a supplier ship directly to the buyer's customer." Certainly, drop-shipping has advantages, such as allowing a merchant to have a very diverse portfolio or mix of goods, with reduced or eliminated inventory and warehousing costs. Additionally, because it requires no up-front investment, even in the extreme and unlikely case of not selling anything, the retailer is not out of anything. In other words, there will be no unhappy customers and no expensive (potentially) obsolete inventory.

But relying on drop-shipping (which is also sometimes referred to as "virtual inventory") is neither as easy ("no fuss, no muss") nor as profitable as it may appear at first glance. For one thing, although merchants who entirely rely on drop-shipping are not putting much capital at risk, they can expect lesser profit margins, since many retailers thereby have to buy at manufacturer's suggested retail price. In other words, profit margins on drop-shipped items tend to be lower, because merchants who buy inventory this way share a percentage of the sale with the manufacturer—typically from 8 to10 percent, in which case there is much less wiggle room for the retailer to mark it up. Furthermore, given the nature of the open market and the leveled playing field (courtesy of the Internet, in part), there is a myriad of other sellers with exactly the same idea, since the Internet can enable almost everybody to connect with the same supplier pool, and sell. Only the likes of Wal-Mart or Target, which have more than enough clout and volume, can hope to drive more sales and more margin (see Retailers Join Forces for a "Make or Break" Attempt in Their Competitive Landscape).

For more information on the challenges facing retailers, see Consumers Shop Everywhere: Understanding Multichannel Sales), Retailing Trends—Shopping Anyway and Everywhere, and The Challenge of Fulfillment.

The Challenges of Drop-shipping

Returning orders and reverse logistics can be a special pain for retailers with virtual inventory, since most wholesalers' raison d'tre is to make money from shipping and handling. That is to say that while they may accept a return, they will certainly not refund the customer's shipping and handling charge, nor will they refund the shipping and handling charge to the merchant for returned items. Therefore, in case of too many returns, retailers have to be careful to make sure that at the end of the day, they are not losing money on the pick, pack, and ship element.

Furthermore, there is a concern that companies that use drop-shipping risk relinquishing control over when and how an item is shipped, especially if the arrangements still revolve around "pedestrian" faxing and phoning communication methods. This translates to many possible customer service problems which have traditionally been greatly attributable to incompatible computer systems between trading partners. For example, if an order is not confirmed, is it due to a misplaced fax, or to out-of-stock inventory at the supplier's warehouse, or is the supplier simply non-responsive?

When the computer age dawned throughout the 1970s and 1980s, retailers all built their own information technology (IT) systems to handle tasks like inventory management, merchandizing, purchasing, invoicing, shipment tracking, and so on. With the advent of the Internet in the late 1990s, those same retailers launched web divisions, which again typically built separate and incompatible systems of their own. Distributors and manufacturers, likewise, have come up with their own distinctive IT systems, and hardly anybody's system can speak to anybody else's in the same language, or about the same things (at least, not without immense and expensive integration work).

And just to make everything more difficult, every retailer has a different file format, as a rule, wants different selections of products, and has different business rules. Traditional electronic data interchange (EDI) syntax has been too cumbersome to accommodate all those formats (see The Pain and Gain Of Integrated EDI). Undoubtedly, EDI has no concept of individual customized orders for a certain customer, let alone of the partial line shipment or event management (including non-events, such as those actions that do not happen, but should). The traditional drawbacks of EDI value-added networks (VANs) have thus been dropped orders and lack of order status visibility, where shippers would not promote the retailer's branded packing slip, barcode, and return material authorization (RMA) formats. Furthermore, with the Internet suddenly becoming a viable selling channel (and attracting retailers who had not sold this way directly), the sheer volume of orders that the Web can create has made fax, telephone, and other forms of manual communication even more inefficient.

A typical problem is illustrated by the general case of a customer calling the store (or the assigned call center number), two weeks or so after buying a product from the retailer's web site (which promised 48-hour delivery), and inquiring about the order's whereabouts, only to be greeted by a dismayed and clueless service representative who cannot identify the case, and who can only say "I will have to call you back." The clerk then calls the supplier, whose counterpart representative says that they have never received the order.

Another common problem occurs when retailers sell someone else's products from their own web sites, and allow the supplier to drop-ship directly to their customers. The problem stems from the inability of everyone to obtain timely inventory situation feeds, meaning that the retailers inadvertently wind up selling things the supplier is already out of. For example, video games and some hot DVD movie releases can sell out in as little as several minutes during the holiday season. If these items were on the shelves, one could physically see when they were gone. But if one is going to drop-ship these items from remote locations, additional information is required (they might be shown as "on hand" at the supplier portal, but some or all items may have already been allocated to another retailer's order).

Indeed, nothing has hurt the adoption of multichannel shopping more than orders which are delayed or even cancelled because of stock-outs. Many retailers are thus striving towards near real-time cross-channel inventory management and visibility to mitigate this conundrum, whereby sold-out items are automatically grayed-out on the screen, while the back-order functionality (if and where customers agree to a back order) proactively alerts customers when the product is available again.

Then again, there is the problem which occurs when a customer wants to return a Web-purchased item to the store—but if the packing slip is in the shipper's name, the clerk at the return desk has no idea what to do with the item, since it cannot be pegged to a particular order. Additionally, even if a wholesaler does include a packing slip branded with the retailer's name and corporate logo, some wholesalers might place coupons and special offers in their boxes (from third parties competing for the very same customers, or from themselves) that result in utter loss of repeat business for the retailer.

Dealing with the Complexity

All of the above problems arise owing to the complexity inherent in drop-shipping, as opposed to traditional bulk shipping. Namely, it is the difference between a buyer creating a single purchase order for thousands of pieces to be sent to a single warehouse or address, and shipping thousands of individual orders to thousands of different addresses. Integration and connectivity between the retailer and its suppliers becomes far more difficult and important, and it must be more than binary (as with an electrical switch that is either on or off). There can be any number of possible states, and one has to have pre-built rules to handle these. For instance, how many days can a supplier be late in acknowledging or fulfilling an order? If a supplier does not have a certain item in inventory, how long must it take for a supplier to replenish it? This is where trading partners need the connectivity platform, and the data and rules that go through it in both directions, to best govern multiple relationships. Once the retailer has designed its process to take advantage of the multichannel sales opportunities, it must build a strong infrastructure that supports on-time delivery of orders and handling of returns.

The highly publicized business-to-consumer (B2C) Internet retailing disasters of a few years ago were typically not driven by bad Web site design, but were caused by the inability of several prominent "e-tailers" to deliver the goods in a timely manner. It was often the link between the Web storefront and the companies' traditional back-office or enterprise resource planning (ERP) systems and the real-world distribution systems that caused the problems. Multichannel retailers must be able to flawlessly execute a full range of services to engage, transact, and fulfill Web-placed orders. Hence, most successful multichannel retailers of today either had to build a complete set of the above services in-house, or else outsource some or all of them.

Many retailers might have tried to address customer-service snafus by working around some of the complexity on an inventory policy level. For example, they have tried to institute single, one-size-fits-all standards for how soon all items must ship, or minimum safety stocks, or other criteria. However, for those retailers dealing with a wide variety of products, these standards are of little use, since furniture makers, food producers, and consumer electronics manufacturers have different processes, different product lifecycles, and different time windows, and they simply cannot all operate under the same umbrella rules.

Additionally, large or heavy items (such as furniture or fitness equipment), while lending themselves well to drop-shipping (in that the process absolves the retailer of inventory storage and space issues), their shipping can be a logistical predicament, since the likes of FedEx, DHL, and UPS will not ship such bulky items, and small independent haulers need to be hired instead. Dealing with such small shipping companies requires that all the rules be carefully laid out in advance. Otherwise, they are going to leave the package in the driveway or outside the front door, just to perplex and annoy the customer. But with the right contract in place, these shippers can offer a "white glove" service, meaning that they will properly unpack it, while being nice and almost non-disruptive to the customer, and they will remove the empty shipping and packaging material and rubbish. The key point in this is communicating any extra costs to the customer beforehand.

Drop-shipping is not necessarily the perfect solution for everybody. Smaller, specialty online retailers that carry fewer than two or three hundred small and mid-sized products may find it less costly to manage inventory and ship the goods themselves. Otherwise, many merchants might possibly want to consider using the middle approach of stocking crucial goods and drop-shipping the rest.