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Definition

dropshipping

Contributor(s): Wesley Chai

Dropshipping is an e-commerce retail model that allows stores to sell products without keeping any physical inventory. In dropshipping, the retailer sells the product to the customer, then passes on the sales order to a third-party supplier, who then ships the order directly to the customer on behalf of the retailer. Dropshipping sellers do not need to invest in any product inventory, warehouse or storage space, and do not handle the fulfillment process.

Due to the low overhead entry costs and simplicity of starting a dropshipping business, it has become a popular and convenient business model for e-commerce retailers, who can run profitable stores with easy setup and very little risk. Dropshipping has been a contributor to the ubiquity of e-commerce, as it allowed many players to saturate markets with niche offerings.  

Retailers that use dropshipping forfeit some control over the customer experience; therefore, having exceptional customer support is critical for buyer retention.

How does dropshipping work?

Dropshipping works through third-party suppliers, who manufacture products on a just-in-time (JIT) basis for each order. When the retailer receives a sales order, they pass the specifications along to the supplier -- who creates the product.

Though many e-commerce retailers use dropshipping as the foundation of their business operations, dropshipping can be effectively used to supplement traditional, inventory-stocking retail models. Since dropshipping does not produce any leftover excess inventory, it can be used for research purposes -- such as testing the waters, before committing to selling in a market.

To set up a dropshipping agreement with a supplier, a formal dropshipping contract should be drafted. The contract should clearly state the terms of the agreement, with respect to:

  • Definitions
  • Term cancellation
  • Vendor's role
  • Supplier's role
  • Shipment problems
  • Right to modify
  • Responsibility
  • Nonpayment terms
  • Severability
  • Effectiveness
  • Products provided
  • Services provided
  • Billing
  • Sales and tax
  • Return policy

Pros and cons of dropshipping

Some pros to using dropshipping include:

  • Easy to start. Once a supplier is found and a website is created, dropshipping businesses can start selling.
  • Avoid high overhead investment. As there is no need to purchase inventory, product inventory and warehouse/storage costs can be avoided.
  • Low risk. Dropshippers won't lose money on unsold inventory. Can be used to test out the waters, as market research. For businesses that do not use dropshipping as their primary retail model, having a dropshipping supplier as a backup option can provide insurance from overselling.
  • Product variety. Dropshipping suppliers exist for almost every type of product, so retailers can expand their product offerings to include a diverse offering.
  • Avoid storage and shipping complications. Suppliers anywhere can be contracted. Dropshipping can be a worthwhile option for retailers seeking profitable sales in geographic areas far from warehouses, to avoid incurring long-distance shipping costs. Also, inventory issues from high-maintenance specialty products and other storage/shipping liabilities (such as large, heavy, valuable, fragile or frozen products) can be avoided.

On the other end, some cons to using dropshipping include:

  • Lower profits. Less overhead costs, but less returns. Dropshipping suppliers typically charge more for JIT manufacturing.
  • High competition. Since dropshipping has few barriers to entry, there are many players in the space. Sometimes, the same products are even being sold by multiple retailers, since suppliers are unlikely to agree to any exclusive contracts.
  • Less control over brand and customer experience. Suppliers do not typically allow retailers to control details in the packaging and presentation of the product.
  • Cannot match low pricing of larger companies. Larger companies have more buying power, which can be used for wholesale discounts on inventory.
  • Less control over supply chain. When dropshipping, the retailer relinquishes responsibility for the timely and correct shipment of the product but is still held accountable for any product quality issues or supplier errors.

History of dropshipping

Though not explicitly referred to as "dropshipping," the practice began with mail order companies in the 1950s, that were selling direct-to-consumer (D2C) via phone order catalog. Large-scale retailers such as Sears were experiencing massive growth -- and despite moving toward in-house warehouse fulfillment centers, some orders were still outsourced to independent suppliers to keep up with demand.

When JIT manufacturing was introduced by Japanese suppliers, retailers were able to take preorders and payments on sales from consumers, and pass them on to suppliers -- who would manufacture the product and deliver straight to the customer, on the basis of each individual sale. As this production model grew more widespread, dropshipping retail shifted toward an increased reliance on JIT manufacturing.

Dropshipping assumed its modern-day definition with the rise of the internet and online shopping platforms -- which allowed retailers to create e-commerce websites, or use online communal marketplaces such as Amazon and eBay to take orders. Now, e-commerce platforms like Shopify and AliExpress have made dropshipping a widespread retail model among online sellers.

However, due to the appeal of starting a business with little to no overhead investment costs, scam artists began to sell fake dropshipping "programs" as get-rich-quick home business schemes. In these scams, victims were sold fake lists of dropshipping suppliers, who were in actuality middlemen whose own profit margins did not allow the victim to profit significantly. Furthermore, dropshippers in China have been linked to cases where customers received the wrong product, or did not receive any product altogether.  

This was last updated in March 2020

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