For some e-businesses, drop shipping has been a veritable gold mine; for others, it's led to their downfall. What do virtual fulfillment systems augur for the future of e-commerce?
"Drop ship for huge profits!" "Put a drop-shipping wholesale company to work for you!" "Drop shipping has opened the door to many e-commerce startups..." "Tap the power of drop shipping!" "A low-risk way to build direct marketing profits!" "No investment! No inventory!"
And the prospect is mouth-watering. Consider this scenario: You establish a Web site and advertise products on it--anything from sporting goods, books or bath and body products to astronomy equipment, software, home and garden decor, wedding supplies, lingerie or vitamins. When customers send in orders, you simply forward them to your wholesaler or distributor, who ships the orders directly to customers' homes with your company's label on them.
In this scenario, companies completely avoid the enormous costs and risks involved in inventory, warehousing, and fulfillment. It sounds too good to be true. Is it?
For some e-tailers, drop shipping has actually proved the goldmine it is touted to be. Forbes reported in February 2000 that the CD retailer Spun.com had avoided an $8 million investment in inventory by using the fulfillment capabilities of wholesale distributor Alliance Entertainment. Spun.com is still thriving, having recently sold the business to Idealab, a major Internet incubator, while retaining managerial control.
In contrast, Valley, the primary distributor for music e-tailer CD Now's CDs, has gone bankrupt. The authors say that currently 30 percent of Internet-only retailers use drop shipping as their primary order fulfillment mechanism, and the trend is growing.
But for others, drop shipping has contributed to their downfall: According to an August 2000 article in the now-defunct Industry Standard, when virtual retailer Value America declared bankruptcy, it cited in part an inability to fill customer orders from virtual stocks.
"If you look at all the Internet retailers that died, many of them blamed their (demise) on order fulfillment"
--Serguei Netessine, Wharton operations and information management professor
"If you look at all the Internet retailers that died, many of them blamed their (demise) on order fulfillment," says Netessine, adding that this has been the case whether a company used virtual or traditional fulfillment. While Value America may have lost too many customers because of drop shipping inadequacies, Webvan lost all its cash by spending millions on warehouses.
Is virtual fulfillment satisfying?
If switching to the new virtual fulfillment system doesn't work for everybody, who does it work for? The authors conducted interviews with, and did statistical analyses on, 54 publicly traded Internet retailers that sell a wide variety of consumer goods. They found that "if an Internet company chooses its supply chain type logically--if it's aligned with its strategy, products, and operating environment--it's highly correlated with success," says Netessine.
In fact, Netessine adds, it correlates much higher than other more commonly adopted measures of financial performance. The authors maintain that "firms making irrational supply-chain choices are twice as likely to go bankrupt than those making rational choices." They outline a set of measures that can help a company determine its optimal order fulfillment path.
Randall, Netessine, and Rudi first discuss the potential advantages of using the virtual setup. These include a greatly reduced investment in inventory and fulfillment; the ability to offer a wider product selection to customers; greater product availability; savings on product handling and warehousing (because the wholesaler can achieve economy of scale), and reduced transportation costs, as the cost of shipping the item to the retailer first is eliminated.
But they also point to pitfalls. A wholesaler performing the service of drop shipping may mark up products, adding between 10 percent and 15 percent of the regular wholesale price--which might be unacceptable for some retailers. The retailer may also experience problems with control and service quality. The authors give the example of a customer who ordered an expensive golf club via a virtual Internet retailer, attracted by the low price. But the retailer didn't know the fulfillment partner lacked the inventory to fill demand. The disgruntled customer ended up buying her golf club from a local shop at full price.
Using a virtual fulfillment system also makes a retailer more vulnerable to "rationing" by wholesalers. Typically, when wholesalers can't meet product demand, they parcel out products among retailers. While this can happen with both traditional and virtual order fulfillment, it becomes more risky for the retailer using the virtual structure because it holds no safety stock of its own.
Encroachment on customers is a possibility, too, when retailers share specific order information with wholesalers. According to the authors, Allstate Insurance is engaged in a legal battle with its agents, based on its decision to use its accumulated customer information to bypass agents' services and sell directly to consumers.
Netessine, however, sees customer encroachment as a relatively low-level danger for most industries. He notes that a wholesaler who steals one retailer's customers risks being found out and boycotted by other retailers, forfeiting its entire network. "Plus, if you are a manufacturer, getting into retail isn't easy," says Netessine. "For instance, while Dell sells direct to customers, Compaq and IBM tried that but can't. For years they worked through retail channels, so they're kind of stuck."
The authors assert that drop shipping works best in situations of:
• High demand volatility: When demand is highly variable--as for example with "fashionable" items--retailers holding their own inventory are at a high risk. Using a wholesale fulfillment partner that serves multiple retailers out of the same stock can help smooth out demand fluctuations. Fingerhut, the well-known catalog retailer, provides this service for thousands of retail clients. • High product variety: Firms aiming to offer a wide range of products might want to choose the virtual inventory structure. A CD retailer who becomes a partner of Alliance Entertainment, for example (as Spun.com did), can make available to its customers Alliance's entire inventory of over 200,000 different CD titles.
On the other hand, the traditional structure is probably better if your business has:
• A high need for order consolidation: Imagine, say the authors, ordering groceries online, then having 35 different packages arrive at your door. Product categories such as grocery strain the limits of what drop shipping can handle. (The exception is unless you can find a shipper willing to consolidate orders from multiple drop shippers: UPS, for example, combines computers and monitors drop shipped from Dell and Sony into single orders for customers.) • A lack of small-order fulfillment capabilities among wholesalers: Some industries, such as the jewelry business, do not have many wholesalers who are equipped to ship individual customer orders.
"Younger companies that don't have the money to invest in fulfillment capabilities will try to outsource fulfillment"
--Serguei Netessine, Wharton operations and information management professor
"Younger companies that don't have the money to invest in fulfillment capabilities will try to outsource fulfillment, do drop shipping, and be a virtual storefront," says Netessine. "But as a company becomes older, bigger, and increases revenues, it might want to consider bringing fulfillment in-house to increase profit margin. You get products cheaper from the wholesaler."
Hybrid arrangements are a possibility. According to the authors, BlueLight.com stocks some of the most popular CD titles internally while drop shipping others. A company with a traditional supply chain can use drop shipping judiciously to enhance product selection, or as a backup for delayed orders.
Netessine and his colleagues hold that brick-and-mortar retailers can also benefit from virtual order fulfillment, if they too pay attention to what's right for their particular business. Currently only 5 percent of multichannel retailers use it as their primary fulfillment method.
But the authors see great potential for drop shipping in the case of particular products and environments. At airport boutiques, for example, where shelf space is extremely expensive and customers are reluctant to add weight to their baggage, the stock could be limited to display-only samples, and the customer's order subsequently drop-shipped to his or her home.
Another possibility, currently being explored by Staples and some other brick-and-mortar stores, is the dual strategy of holding inventory at the store and drop shipping out-of-stock items directly to customers. These retailers are installing in-store Internet kiosks that let customers place orders for items not in physical inventory.
As more manufacturers invest in drop shipping capabilities, the picture may continue to shift. "In the last five years, wholesalers are getting better at it," says Netessine. "There's a lot of learning going on."
He points out that Amazon, which successfully uses a traditional supply chain, began its business with drop shipping. The company quickly discovered that existing wholesalers could not meet its requirements for speed, transparency, and real-time order data, and decided to create its own fulfillment system. But today even Amazon--long famed for holding customer service close to its vest--is using drop shipping for cell phones, computers, and non-bestselling books. It plans to strike more drop shipment deals in the future.
Whichever way retailers choose to go, say the authors, opting for a virtual, traditional, or hybrid inventory structure "is and will continue to be a high-stakes decision where companies risk customer loyalty, large investments, and ultimately market success."
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