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The Economics of Dropshipping

This week we had the pleasure of chatting with Andreas Koenig and Alexander Pecka from PA & KA Commercial Trade GmbH. (www.paka-trade.com) They are one of the leading e-commerce merchants in dog accessories.

In the past two years, they've grown a simple idea from a few orders a day to over $10M in sales over the last 20 months, all using a simple premise called dropshipping. If you are already familiar with this concept, feel free to skip to the next section.

What is Dropshipping?

The reason this practice is called Dropshipping is because products are "dropped" from the manufacturer directly to the customer, bypassing the merchant.

Three trends: increased globalization, ubiquitous internet connectivity, and cheap international shipping rates1 have led to a rise in merchants dropshipping. Once popularized by Tim Ferris in his book 4-hour workweek, dropshipping has enabled merchants of all sizes to bring delightful products to consumers all over the world, from small operations such as the A&A's store, to massive enterprises such as Wish.com, which is going public next week.

Dropshipping is characterized by the merchant focusing almost entirely on product marketing and customer acquisition, delegating the other functions to overseas partners. In some cases, merchants do not even need to design their own products.

Overview of a Dropshipping Business

You too can become a dropshipping merchant in 3 easy steps!

  1. The merchant will research and test to find a category of trending products that can be shipped inexpensively from the manufacturer to their intended customer segment.
  2. Next, the merchant will establish a partnership with a relevant manufacturer in order to send product order data to the manufacturer, in order to ship their products directly to the consumer
  3. Finally, the merchant will start marketing the manufacturer's products, usually through online channels such as Facebook, Instagram, Tiktok. The manufacturer continues to tweak the marketing such that the cost of acquiring a customer is lower than the average profit from each customer.

The manufacturers mutually benefit because they gain from increased marketing (and therefore sales) with almost no investment, especially in regions and channels where they might not have capabilities.

Benefits of Dropshipping

  1. Easier to get started: all you need is a laptop and an internet connection, since you don't have to warehouse any goods
  2. Lower working capital requirements: you don't have to pay for any inventory. In addition, you usually received cash from customers before you have to pay your suppliers, which means your customers finance your business. The larger you grow the more free cash flow you have
  3. Wide selection of products: you can source products from anywhere around the world
  4. Low overhead, scales easily: you don't have to hire warehouse employees, or managers for those employees

Drawbacks of Dropshipping

  1. Highly competitive, low margins: The other side of the coin of having low barrier to entry is that the field is highly competitive. Each product category has many merchants all vying for consumer's attention on each channel.
  2. Shipping and return issues: Manufacturers often ship from far away, meaning shipping times for consumers are much longer than if the merchant had a warehouse full of inventory close by. In addition, when the customer wants to return the product, the manufacturer is not set up to process the return.
  3. Lack of quality control: There's no way for the merchant to inspect the products before they go out, which leads to more complaints and higher return rate.

How to Innovatively Manage these Drawbacks

Andreas and Alexander uses several tactics to alleviate some of these issues while leaning on the benefits of the model to scale up rapidly

Back Office Automation

First off, these entrepreneurs establishes strong relationships with each of their manufacturer partners so they automate data exchange and minimize errors in communication. One of their manufacturers set up a system for them to automatically transfer orders along with customer information, and is integrated directly with Shopify. Therefore, when a customer places an order, Doggykingdom's website simply acts as a conduit into the manufacturers ERP system, minimizing any mistakes in receiving the order.

Risks

One risk here however is the manufacturer may one day decide to take the customer data and market other products directly to those customers, since there is little customer equity created by the merchant beyond the order information.

Personalization as a Strategic Advantage

The merchant also made an important strategic decision to specialize on personalized products. They worked with their manufacturer to design an order information interchange system that would allow them to pass in a customer's personalized information. This way the product feels more personal, as well as more differentiated compared to standard products.

Most importantly, the merchant does not allow returns on any personalized products. This means that they eliminate the need to deal with a large portion of returns, which saves a lot of overhead time and resources. As a result, they were able to scale rapidly without worrying about expanding their capacity to process returns.

Challenges Created

Because it's not immediately clear to a customer they can't return a personalized item, one obvious challenge is irate customers might leave bad reviews when they try to return it. This in turn may create more pressure for the customer service team.

One way the merchant is looking to mitigate this challenge is by automating their customer service as well. They recently started piloting a robotic customer service call center, similar to Google Duplex, in order to answer customer's common questions on the phone.

Andreas and Alexander have taken the tried and true dropshipping model and innovated to stake out a strategically advantageous position. It will be exciting to see where the business goes in the new year.

Additional Resources

  1. https://www.shopify.com/blog/epacket-delivery-explained-everything-you-need-to-know-about-epacket-shipping
  2. https://www.shopify.com/blog/what-is-dropshipping

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