How Drop-Shipping Works for Retailers and Manufacturers

Retailers are interested in carrying our manufacturing firm's new products, which help infants and toddlers to stand and walk. However, many are asking for drop-shipping, which we worry will increase our costs and sales logistics. Should we require retailers to purchase product at full price and then provide a credit to compensate them and cover their profit after the sale has been finalized and the period for returns has expired? —M.M., Phoenix

Drop-shipping is the delivery system used by most online retailers and other companies that do not have the physical storage facilities to purchase and hold inventory, as traditional brick-and-mortar stores do.

When a customer orders a product online, or from a mail-order catalog, the retailer transmits the order to the manufacturer—or to a third-party fulfillment company. That company then packages, labels, and ships the item directly to the customer.

"The retailer never owns the inventory," explains Stewart Buskirk, vice-president for technology at One World Direct, an order-fulfillment company in Mobridge, S.D. Drop-shipping saves the online retailer or catalog firm in inventory, warehousing, and shipping costs. Buskirk says it is becoming increasingly popular in this economic climate, in which many small companies and startups cannot get financing to purchase inventory.

Wide Range of Merchandise"Some stores use a mix of drop-shipping and traditional warehousing. A retailer selling baby items knows that 10% to 20% of its items are pretty good sellers, and worth stocking. But it needs to offer a much wider range of merchandise to attract customers. Instead of tying up cash and space to experiment with new product lines, it arranges for drop-shipping with a manufacturer or distributor who has the inventory," Buskirk explains.

Bill Donohue, vice-president of Virginia's Philpott Manufacturing Extension Partnership, which provides business and technical assistance to the state's manufacturers, says drop-shipping allows retailers to refresh their product line offerings without having to dispose of leftovers through distress sales.

"The challenge for you is that you have to manage your inventory levels while still performing as expected by your retailers. You need sufficient working capital to keep the product flowing," he says. Lean manufacturing methods can allow you to produce short product runs economically, but the logistics get more complicated if you are designing your products and then having them produced overseas, he notes.

Providing drop-shipping, or outsourcing it to a freight shipping consolidator, may indeed increase a manufacturer's costs and logistics, but it is probably inevitable, Donohue says. "Even in today's recession, shipments to the home have increased 33% year over year. So my prediction is that the future is bright for those manufacturers who learn to be savvy with business-to-home logistics," he says. For a new company, where getting product out to customers is imperative, drop-shipping encourages retailers to take a chance on your products.

Respect the Retailers' TermsYour idea of charging full price to retailers and then balancing out their accounts in the future is not a good one, Buskirk says. "Retailers all have different policies on returns and warranties. You want to keep all that at arm's length and let the retailers handle that—not you," he says.

He and Donohue both recommend that you charge retailers on a "cost-plus" basis, meaning your wholesale price plus shipping and handling. The customer chooses her shipping method based on how soon she wants to receive the product, and you add a handling charge for the work you'll do picking, packing, and shipping the item. "If you go to a third-party firm like ours, we pick, pack, and ship on demand for about $1.50 per item," Buskirk says.

You can bill your retail customers as they sell product, set up an automatic debit at the time you ship, or ask for pre-payment from retailers. "The last method is the best from the manufacturers' point of view, but keep the payments small—maybe no more than for a week's sale volume," Buskirk says.

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