According to Forrester Research, drop shipping accounted for 23 percent, or $90B, of the $390B Americans spent online in 2018. That’s a lot of Benjamins. This post discusses how this fulfillment approach impacts five key retailing metrics.
Let’s take a look at each in turn.
Metric #1 – Gross Merchandise Value
Overall, drop shipping has a positive effect on Gross Merchandise Value (GMV). It increases GMV, or annual sales, in four strategic ways:
- Wider Assortment of Sizes/Colors – Retailers typically buy the most common sizes and colors from suppliers and stock them in their distribution centers for sale. Drop shipping, meanwhile, enables them to offer customers less productive colors and sizes because they are not constrained by space availability within the warehouse.
- Endless Aisle – Through drop shipping, retailers offer new brands and new assortments in categories they already do business in because they do not have to make additional inventory investments to serve their customers.
- Hypothesis Testing – Drop shipping allows retailers to test new merchandise before making larger financial commitments. When hypotheses prove correct, they negotiate new supplier relationships or expand current ones based on actual sales data. When wrong, they simply continue innovating by testing new ideas.
- Save-The-Sale – Finally, retailers avoid situations, online or instore, where their own inventory runs out by establishing alternative inventory sources within their supply chain. This form of drop shipping is often the most difficult because it involves complex systems integration, real-time inventory visibility, and distributed order management decisions. However, it enables retailers to capture more sales and improve the customer experience. This strategy can help retailers avoid their share of the $169B of annual sales that IHL estimates are lost every year due to out-of-stock inventory.
Metric #2 – Cost of Goods Sold
Unlike GMV, drop shipping has a negative effect on (i.e. it increases) Cost of Goods Sold (COGS). This is for three reasons:
- Inventory Holding Costs – Supplier inventory is locked up until the customer places an order on the retailer’s website or mobile app. This requires dedicated storage space, labor costs, and capital on the part of the supplier. These costs get reflected in higher prices passed on to the retailer and ultimately higher COGS.
- Liquidation Risk Premium – Suppliers who drop ship are taking a gamble that retail partners will be able to sell through their inventory to their end-customers. If a supplier’s drop ship inventory does not sell, however, it’s little skin off the retailer’s nose as the supplier is still responsible for finding a customer. This risk premium is passed on to the retailer in the form of higher prices and COGS.
- Inverse Economies of Scale – Finally, drop ship purchases are made by the retailer in real-time, on a purchase-order-by-purchase-order basis. Practical economies of scale do not exist as they do with traditional wholesale buying. For example, suppliers do not offer price discounts based on minimum order quantity thresholds in the drop ship model. Quite the opposite, suppliers often charge retailers handling fees to account for their higher labor costs involved with fulfilling direct-to-consumer (DTC) orders.
Metric #3 – Inventory Turns
Inventory turns, defined as the number of times inventory is sold or used in a given time period, improves as retailers shift GMV to drop shipping. Drop shipped inventory is essentially purchased from suppliers when customers place orders and click the check-out button. It is decremented when packages are shipped DTC and only exists on the balance sheet for a matter of hours or days.
Comparing this with replenishment-based fulfillment where inventory is bought and staged weeks or months in advance, the amount of inventory required to support drop shipping is very small. The more drop shipping a retailer does, the more favorable inventory turns become.
Metric #4 – Return on Assets
Return on Assets (ROA) is a measurement of how profitable a retailer’s assets are in generating revenue for the business. Drop shipping does not require traditional supply chain assets like warehouses and inventory. It also does not consume labor associated with operational activities such as sales forecasting, managing inbound logistics, or cycle counting the inventory. Fewer assets mean a retailer’s ROA improves as GMV moves to more drop shipping.
Metric #5 – Working Capital
Working capital, defined as capital a retailer uses in its day-to-day operations, is favorably impacted by drop shipping. By “collecting” money from customers at the point of check-out or shipment confirmation, and paying suppliers weeks later as governed by their standard agreements, operating liquidity increases with each drop ship order. Increases in working capital directly translate to the balance sheet and create shareholder value for the organization.
Why do retailers not drop ship their entire assortment? After all, doesn’t the strategy drive incremental GMV and improve inventory turns, ROA, and working capital? While it does do these things, drop shipping has two fundamental limitations. The first is profitability. As described in this blog, COGS are higher when compared to traditional fulfillment due to higher prices suppliers charge retailers. Second, drop shipping is operationally complex because retailers have to rely on 3rd parties – each with its own unique systems, business processes, and self-interests – to serve their customers. Maintaining high levels of customer satisfaction is therefore often difficult.
Despite these limitations, the strategy is key for retailers looking for GMV growth and has favorable impacts on key retailing metrics. It can also be an important part of a retailer’s overall omnichannel strategy, allowing it to offer more products to more customers in more locations through a greater variety of channels.