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March 2013

Does drop shipping work online?

First, for those who don't know, what is dropshipping?  Wikipedia offers a succinct definition:  

Drop shipping is a supply chain management technique in which the retailer does not keep goods in stock, but instead transfers customer orders and shipment details to either the manufacturer or a wholesaler, who then ships the goods directly to the customer.

On the surface, this is an entrepreneur's dream scenario:  no capital required to carry inventory, no warehouse needed, so you can work out of the spare bedroom, it makes it easy to create the appearance of scale by giving you the ability to offer a huge inventory of different products.  In reality, there are significant problems with this model and it almost never works.

The biggest issue is one of the simple economics of supply and demand and of the dynamics of perfect competition

What tends to happen with dropshipping is that a wholesaler will make a particular product available for drop shipping and dozens, hundreds, or even thousands of would-be merchants very quickly start promoting the item to get sales.  Because of the speed of communication via the internet, the market will very quickly approach the theoretical economic condition of 'perfect competition'. What this means in English is that the competition among sellers to sell this product will cause all of the profit margin to get squeezed out of the market. Since there will always be someone with no overhead, they will always undercut the lowest available price (at least until they get down to their cost to buy the product) so the marginal price (the price of the next unit sold) will become equal to the marginal cost (the cost for the seller to buy another unit).  Like most economic theory this is just that, theoretical, however, if you think about it practically, you will understand and appreciate the effect.

Because these little resellers are often small entrepreneurs working out of the spare bedroom just to make some extra money, they have zero overhead.  They have no employees to pay, no rent for a warehouse, no incremental expense to their normal daily life.  If they can price an item $1 above what they pay for it, they believe they are better off than they were yesterday.  This causes the market  price for the product to collapse (and with the help of the internet, this can happen with lightening speed).  The price will drop almost all the way down to the cost of the item (the dropshipping company's price).  If you are the poor shmuck who actually has overhead to cover, you will never be able to make the required gross profit on the item to do so.

A reseller who uses the dropshipping model really adds no value and thus cannot capture any value in the transaction.  While many dropshipping companies will have you believe they are offering an easy way to make a fortune fast, I recommend you steer clear.