Choosing a Distribution Model: Drop Shipping vs Traditional Inventory

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Welcome back, retail enthusiasts!

One of the topics that consistently comes up in the retail world is the logistics of shipping. From the manufacturers, to the distributors, to your retail store – there are many factors and unexpected costs to consider during the shipping process that can be often overlooked.

As Robert Gilbreath, VP of Marketing at ShipStation, a web-based shipping solutions provider, puts it, “Compared to splashy marketing campaigns and new product features, shipping isn’t exactly the sexiest topic. However, efficient shipping operations directly affect revenue and future growth, and companies that don’t adhere to best practices run the risk of having increasing sales without raking in enough profits.”

There are many facets of shipping that every merchant will need to understand in order to be successful, but we start with one of the fundamentals: choosing a supply distribution model. The following is an analysis of two major distribution models, drop shipping and traditional inventory.

Drop Shipping Model

Drop shipping is where a retailer markets a product, collects payment from the customer, and then orders the item from a supplier/wholesaler. The supplier then ships the product straight to the customer. But of course, there is a large logistical operation that goes on behind the scenes. Everything is vital to the operation, even having a strong and durable packing tape like the st36 is vital.

Drop shipping can be a preferable alternative to having your own inventory on hand for a few reasons.

The retailer does not hold the inventory

The biggest reason many retailers opt for a drop shipping model is because there are no direct inventory costs. By not holding the inventory, retailers forgo the inventory carrying cost, which includes: the cost of a storage facility, labor costs, investment risk costs, the up-front capital investment, and more.

Not holding stock also means the retailer can’t lose it, break it, or have it stolen, and does not need to worry about keeping track of inventory on hand.

The retailer is not involved with the shipping process

The drop ship model ships products straight from the wholesaler to the customer, nixing the headache of shipping all together for the retailer.

Some products may be too difficult to stock and ship

If you sell heavy, over-sized products, the stocking and shipping logistics can get very expensive and cumbersome. For example, if you sell refrigerators a drop shipping model might work well for your business by using showroom models and then filling orders by distribution directly from the wholesaler.

Customers pay before you ship

Drop shipping doesn’t require you to pay for the inventory upfront, which is great for businesses with a low cash flow. Removing the burden of investing in inventory up front also allows merchants to offer a broader range of products without substantial financial risk.

Despite these advantages, drop shipping may not be for every business. There are some disadvantages to opting for a drop shipping process

The fees are hefty

Wholesalers charge an additional membership fee for drop shipping services. Dr. Ralph F. Wilson, editor of Web Marketing Today, warns retailers utilizing a drop ship supply chain of potentially lower margins.

“While the manufacturer may be willing to sell you product for 30% to 40% of suggested retail, if you want drop-shipping services expect to see another 10% or so off your margins,” says Wilson.

You will need to do a thorough vetting process of any supplier you decide to take on and clarify all shipping and membership charges. See our blog post, “Creating a Vending Partnership” for more insight on vetting potential suppliers.

Shipping costs can add up

Shipping charges are greater with drop shipping, regardless of supplier fees, because products come from different wholesalers and ship separately. For example, a customer may order three products that come from three different wholesalers. Rather than the products being shipped together in one package from one location, each one must be distributed individually. This process therefore incurs shipping costs on three separate packages, essentially tripling your total cost of shipping for the order.

Mistakes may take longer to rectify

Not having inventory in-house means the process of dealing with back-orders, lost shipments, and returns can be troublesome. Make sure you and your supplier are clear on the expectations, policies, and communication structures regarding all potential shipping mishaps.

Order forms and paperwork can get messy

Armando Roggio, of Practical eCommerce, explains that order processing can become a huge burden with drop shipping, because with each order the retailer must “create a purchase order, submit that order to the vendor, wait for a reply to confirm that the product is still available, wait longer to get the tracking number from the vendor once the product has shipping, and then relay that shipment tracking information to the customer.”

Roggio warns that if a retailer “cannot automate the order management process, there is no opportunity to scale and grow with drop shipping.”

Drop shipping lacks security of supply

Many wholesalers do not report inventory in real-time which can create problems for retailers when a stock-out occurs.

Nate Gilmore, the VP of Marketing at Shipwire, Inc., an online order fulfillment service, defines a stock-out as the sale of an out-of-stock product by a retailer, due to infrequent product level reporting by the supplier. According to Gilmore, “One of the dirty secrets of drop shipping is that suppliers often don’t inform their drop shippers when inventory levels are low. Sometimes the retailer will sell the product to the buyer only to discover the supplier no longer has the item.”

The sale of an out-of-stock product can lead to angry customers, a bad reputation, and even lawsuits.

Customer service is out of the retailer’s control

After the point of sale, the customer will be dealing with the supplier directly — which likely has customer service policies distinct from the retail staff. While safe-guards can be erected for errors in shipping (i.e. the product arrived late, was not what the customer ordered, was of poor quality), it’s not always possible to ensure quality customer assistance from the wholesaler’s end. Lapses in quality service could cost the retailer business.

A drop shipping model is best for online retailers who seek to offer a broader range of products and do not necessarily need to have a large investment in inventory. A 2009 study from the University of Maryland found that the average online retailer could earn over 5 percent more profit by utilizing drop shipping over traditional in-house inventory.

Traditional Inventory Model

The customary retail distribution method is the inventory model. According to Wilson, this “tried-and-true retail method is to order an item from the manufacturer or distributor and keep it in stock until you receive an order.”

This supply model is simply a retailer picking, packing, sourcing the 4×6 shipping labels and finally shipping the ordered inventory that it physically holds either in-store or in a warehouse. There are some advantages to keeping inventory on hand.

The retailer controls the supply process

From start to finish, retailers know exactly how much is in stock and what shipping and inventory costs will be. Unlike in drop shipping, surprise shipping charges are rare and inventory is monitored in real-time – avoiding the stock-out problem. Retailers will also control all customer complaints, so appropriate service can be ensured.

This inventory control is particularly important for order fulfillment accuracy, which can make or break a future sale. A 2013 study conducted by Webgistix, an online order fulfillment company, found that “29 percent of customers will never buy from an ecommerce merchant again if they receive even one incorrect order.”

Orders can be immediately filled

Where the drop ship model requires extensive communication, holding inventory allows you to fill the order as soon as it’s received. Webgistix reports that this short turnaround is critical to online sales. 42 percent of consumers studied reported abandoning an online sale due to slow delivery times.

In-house inventory has higher margins

Drop ship suppliers not only charge a membership fee and inherently have higher shipping costs, but they also place restrictions on partner retailers – forcing lower profit margins compared to retailers that own even a small amount of inventory bought at wholesale.

Nate Gilmore, the VP of Marketing at Shipwire, Inc., an online order fulfillment service, says that retailers looking to outsource their order fulfillment to a third-party need to investigate the terms thoroughly before they commit. “Many drop ship suppliers will apply conditions to retailers – minimum price controls, sales conditions, return conditions, etc.” says Gilmore.

There are also disadvantages to using the traditional inventory model.

The initial investment may be too great

Small to mid-sized retailers may not have the initial capital to invest in inventory, especially in new product lines where the demand market is not yet known. According to the University of Maryland study, broadening product offerings is much riskier for merchants utilizing the traditional inventory model.

Higher capital risks from excess inventory

Excess inventory occurs when a retailer incorrectly purchases more product than the market demands – often forcing the retailer to liquidate for pennies on the dollar.

Excess inventory also has a storage cost; shelf or storage space occupied by excess inventory leaves less space products that sell. This space also uses utilities, and the excess inventory requires employees to manage and organize it. These costs quickly add up and may deter businesses from making the initial investment, rather than risk owning inventory they cannot sell.

Storage space is a significant cost

In-house inventory requires a storage space, most typically a warehouse. The cost of storing inventory includes the cost of the physical location (either rent or mortgage), the cost of the utilities, shipping and handling costs as products move in and out of storage, the cost of maintaining the facility, and so on.

Storage costs also include the insurance premiums and taxes paid on the inventory. Many retailers outsource these warehouse functions to 3PL’s (Third-Party Logistics) to decrease the financial burden.

There are many general risks associated with holding inventory

Aside from the specified risks above, there are many other carrying costs associated with owning inventory in-house:

  • A new model makes the inventory obsolete
  • Items may depreciate in value the longer they sit in storage
  • Inventory could expire (perishable items)
  • Inventory could be damaged while in storage
  • Products could be stolen or tampered with

Choosing a Model

There is no definitive way to best choose a distribution model. In general, both supply chain systems examined here have significant benefits and challenges. Deciding between these two models will depend largely on the details of your specific business. Many retailers employ a mix of these supply strategies, as well as logistics from other distribution models. Home Depot, for example, employs a hybrid of traditional warehouse inventory distribution and Crossdock DCs — another distribution model where inbound shipments are moved directly to outbound vehicles, attempting to skip the store-front all together.

Though shipping supply procedures may never be as exciting as the other aspects of your business, it’s a fundamental component to a successful business. A good distribution strategy will allow you to reduce unit and total shipping costs, enjoy higher profit margins than your competitors, and limit the risks inherent with inventory.

What type of fulfillment model does your business use? Let us know on our Retail Blog, Facebook, Twitter, or LinkedIn. Have questions about this post or any of our services? Send us an email at info@retailbound.com or visit our website www.retailbound.com

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