What Is Dropshipping & How Does It Work?

In today’s hypercompetitive marketplace, retail and ecommerce companies must offer a wide variety of products that give shoppers choices. But most cannot afford to purchase and stock all those products across numerous categories, locations and selling channels.

Enter dropshipping, an order management model that allows retailers and ecommerce companies to separate sales from fulfillment. Using this model, the retailer sells the product, which is stocked and shipped to the customer by a third party, usually a wholesaler or manufacturer.

Dropshipping is a potentially cost-effective approach for ecommerce businesses. The global dropshipping market is expected to grow to $476 billion in 2026 from $129 billion in 2020, Statista reports.

What Is Dropshipping?

Dropshipping is a practice in which a retailer accepts customers’ orders but does not actually stock the goods in its warehouse or ship them to the buyer. Instead, the seller contracts with a third party — a manufacturer, wholesaler, larger retailer or fulfillment house — that maintains the inventory of products and sends them directly to customers after orders are placed. Businesses also use their own stores to drop ship orders to customers regionally.

The dropshipping model is attractive to smaller retailers and entrepreneurs because it requires relatively little capital investment and overhead. In addition to freeing a seller from managing fulfillment, dropshipping eliminates the seller’s costs for inventory, warehousing and logistics — potentially creating more profit.

Key Takeaways

• The dropshipping business model — in which retailers outsource warehousing and fulfillment — may make sense for small and midsize retailers that aren’t able to maintain warehouses and logistics infrastructures.
• Retailers that choose to fulfill orders through dropshipping minimize their capital investment and overhead costs.
• Sellers may also gain more flexibility in where they’re located and be better able to scale fulfillment processes as order volumes rise.
• Diligence in choosing products, partnerships and processes is a prerequisite to success with a dropshipping model.

Dropshipping Explained

The service standards of Amazon and Alibaba have created an expectation of fast gratification when people shop online. But the vast majority of ecommerce players lack the expansive logistics infrastructures that these digital giants have built over decades and the means to offer so many goods. With dropshipping, ecommerce sellers can market and sell a wide variety of items without having to warehouse products or manage deliveries. It’s a way to piggyback on other companies’ infrastructures and product catalogs.

Dropshipping has its roots in the retail catalog businesses of the 1960s and 1970s. Major retailers developed high-volume mail- and phone-order businesses. These retailers used fulfillment warehouses to speed up distribution and delivery. In the 2000s, Amazon began building its own network of optimized fulfillment warehouses in a more modern version of the earlier idea.

Dropshipping became accessible to more ecommerce retailers over the last decade, when lower-cost dropshipping services emerged. Since then, the dropshipping business model has taken off.

How Does Dropshipping Work?

Retailers that opt for dropshipping are basically outsourcing the order fulfillment processes — including procurement, storage and shipping — to an external provider. The specifics of the process will depend on the type of dropshipping partner — manufacturer, wholesaler, order fulfillment provider — and the agreements and processes that are in place. Typically, however, using the dropshipping business model would begin with a decision about which products to sell and which third parties to partner with.

Benefits of Dropshipping

Companies and entrepreneurs looking for a low-cost way to get started in retail may consider dropshipping. Among the upsides to using dropshipping:

1. Lower capital investment. Unlike the traditional retail model, which requires investments in product inventory, storage and labor, dropshipping enables individuals or organizations to start online retail businesses with minimal capital investment. They will pay these partners as items sell, but the upfront investment is far smaller.

2. Decreased overhead costs. Retailers that use dropshipping do not have to source, store, ship or directly handle returns of the products they sell. This can lower overall costs and the amount of work sellers are responsible for.

3. Scalability. By working with a variety of manufacturers, wholesalers or fulfillment centers, small and midsize retailers can more readily expand their businesses. As long as they can handle the additional work of payment processing and customer support, they can expand at a relatively low incremental cost.

4. Geographic flexibility. With a dropshipping business model, a retailer can operate from anywhere — including the owner’s home.

5. Multichannel opportunities. Retailers that implement a dropshipping business model can sell via any number of channels — their own website, social media channels or other online retailers and marketplaces — and use dropshipping on the back end to fulfill orders regardless of where they originate.

6. Lower-risk experimentation. Since dropshipping retailers don’t have to pay in advance for the products they sell, they can test out new items or market segments at a lower cost and with less risk. They’re not paying to store slow-moving inventory as it eventually becomes obsolete.

Disadvantages of Dropshipping

Despite the benefits mentioned above, dropshipping may not be the right choice for everyone. Even when it appears to be a good fit, dropshipping can present some challenges, including:

1. High levels of competition. Because of the low barrier to entry, a dropshipping retailer can expect to face a lot of competition. The fight for customers may be intense.

2. Differentiation challenges. It can be difficult for retailers to create a unique market position when the sourcing, management and delivery of a product are handled — and branded — by a third party. The products being sold and delivered may be indistinguishable from those offered by other dropshipping sellers.

3. Profit margin pressure. Due to the highly competitive nature of the model and the difficulty of carving out a unique niche, dropshipping retailers can find themselves competing solely on price. If businesses are forced to lower prices, that eats away at margins.

4. Less control. A retailer relying on third-party product fulfillment can’t directly control product quality, fulfillment speed or return processes. Also, that retailer may not learn about supply chain issues until it’s already resulted in unhappy customers. That lack of control over issues that affect customers is a challenge. A dropshipper may be able to have some influence on its partners if it does a lot of business with them, but to some extent the retailer is always at the mercy of its fulfillment partners.

5. Customer dissatisfaction. When things go wrong during order fulfillment, customers will blame the retailer from whom they made the initial purchase. The low visibility of problems and the longer time required for problem resolution can further degrade the customer experience.

Is Dropshipping Profitable?

Low margins are a risk in the dropshipping space. Because startup and overhead costs are low, competition is high. Some dropshipping retailers compete solely on price and invest little in customer service, creating pressure for other sellers to also cut their prices. Another threat to margins is a high product return rate.

On the other hand, there are situations where dropshipping can increase profitability. When products are difficult to procure, stock and ship, working with a third party decreases overhead.

In addition, traditional retailers that don’t usually choose dropshipping can use the model selectively to enter new product categories or markets. Dropshipping allows them to do so with less financial exposure — that is, without a sizable investment in inventory, warehousing or logistics.

Retailers that are able to develop profitable dropshipping businesses — whether they dropship exclusively or only in select situations — get there by completing due diligence. For example, they invest in tools that optimize their purchasing processes and customer support; among these tools are email automation, point-of-sale (POS) systems and customer relationship management (CRM) tools. With better marketing and better customer service, companies may be able to hold the line on prices and maintain expected levels of profitability.

Dropshipping Model

The dropshipping model enables retailers to run a low-risk, no-inventory business. There are three parties involved in the process: the customer, the retailer and the dropshipping supplier.

The retailer — also called the seller of record — contracts with a dropshipping supplier to sell the supplier’s products. The negotiated price between the retailer and dropshipping partner includes the partner’s warehousing and logistics costs. Then, when a customer places an order with the seller of record at the retail price they set, the retailer sends the order to the dropshipper to fulfill the order. The retailer keeps the difference between what its customer paid for the item and what it paid to its supplier. It’s important for the retailer to keep those numbers in mind to ensure profitability.

Working with a dropshipping partner does require some investment from the retailer, often in the form of an ecommerce and customer support platform. Retailers also incur costs for web hosting, domain names, marketing and payment processing fees.

Why Choose the Dropshipping Model

For many retailers, the benefits of dropshipping outweigh the potential drawbacks. Dropshipping can certainly be an attractive option for first-time online retailers. The dropshipping model is particularly helpful in the following three areas:

• Testing the market. Dropshipping offers a low-cost way to conduct market research. With dropshipping, retailers can try out new products or target new customers without the large investment that would otherwise be required.
• As a backup when things go awry. In retail, supply chain issues and changes in demand are everyday realities. In other words, they’re unavoidable. Having a dropshipping partner for backup order fulfillment can be very helpful in such situations, including when there are seasonal demand surges.
• Dealing with difficult products. Some items are simply harder to source, store and ship. This includes big, heavy, fragile, volatile, perishable or high-value items. Working with a skilled dropshipping partner can be a more profitable way to get these items to end customers.

Dropshipping Process

The dropshipping process is straightforward once the retailer has set up an online storefront and forged relationships with a dropshipping supplier. Here’s how it works: First, a customer buys an item from the retailer. The retailer alerts the partner, which packs and ships the item directly to the buyer. Having handled only the marketing, sales, and customer communication, the retailer’s job — ideally — is complete.

4 Steps to Setting Up a Dropshipping Retail Business

1. Find the right niche. Because dropshipping opens up the playing field for retail and lowers the barriers to entry, it’s crucial to find an opportunity with strong profit potential. Look for a product or category with high demand, few competitors or a unique value proposition.

2. Research suppliers. Reliability is the most important characteristic, but there are other factors to consider. For example, the location of a partner can have an impact on shipping speed and costs. A partner’s manufacturing capabilities, communication skills, transparency, and reputation for customer service are also important.

3. Focus on ease of use and a good customer experience. Making it easy for customers to provide feedback and offering personalized communications are standard parts of most ecommerce sites today. They are among a half dozen or so steps you can take to improve the experience that users have at your store.

4. Invest in marketing. When it comes to launching a dropshipping business, even if you build it, they may not come. Marketing is the key to getting customers to your site. Social media advertisements and automated email campaigns can be cost-effective approaches to building and maintaining a customer base.

5 Dropshipping Tips & Best Practices

Dropshipping may seem like an easy way to enter the retail business, but doing dropshipping well — and profitably — takes effort, experimentation and patience. Following are some best practices for launching a dropshipping business and improving your chances of success.

1. Choose your partners wisely. It’s important to weigh multiple factors when selecting a company to fill your customers’ orders. Don’t emphasize cost at the expense of quality — an unreliable partner may cause customers to flee and never come back. For example, if you’re a home furnishings retailer, a lightbulb manufacturer that charges 25 cents more per bulb but has a stellar reputation may be more valuable in the long run than a mistake-prone partner.

2. Immerse yourself in the details of your agreements. Your dropshipping contracts will cover the negotiated wholesale price. But those contracts should also cover such items as service level agreements (SLAs) for shipping times; the terms of returns, refunds, chargebacks and handling fees; fees for missed SLAs; and sanctions for breach of contract. For that hypothetical home furnishings retailer, this would mean making sure the dropshipping partner understands what the contract says about the manufacturer’s liability should products take too long to ship, get damaged in transit or need to be returned.

3. Put experimentation and learning high on your agenda. Whether it’s a new product or a new marketing approach, take advantage of the low costs of dropshipping to learn what works and what doesn’t. Build on the successes and don’t repeat the failures. If selling lightbulbs to contractors isn’t working as you had hoped, you may want to de-emphasize that segment and shift your focus to a different set of customers — consumers, for instance.

4. Invest in automation. Technology and data are essential parts of developing a dropshipping business. If there are low-cost tools for targeting customers, offering services or managing finances, take advantage of them. One thing that should certainly be explored are autonomous chatbots. Automated chat sends an immediate signal to customers that online help is available at all times if they need it.

5. Have a plan for when problems arise. It’s inevitable: Your suppliers will occasionally deliver late, damaged or incorrect products. Have processes in place for managing dissatisfied customers should your partner’s performance falter. If those lightbulbs arrive in pieces, it won’t matter if the logistics provider ignored the label that said “fragile” or the supplier forgot to put it on; the customer will blame you and it will be your problem.

Dropshipping and Technology

Technology is integral to a successful dropshipping business, as there is a lot of coordination that must happen to pull this off. Here are the most important tools for retail dropshippers:

Email automation. When used effectively, email is one of the best forms of online advertising and can have an outsized impact on sales. Email automation based on customer behavior (such as an email to a customer who abandons a shopping cart before purchasing, or offering a discount on future orders to someone who has just completed an order) can deliver significant returns.

Point-of-sale (POS) systems. One part of the buying journey dropshipping retailers do control is the online shopping experience. That’s why these businesses will benefit from an integrated ecommerce platform, especially as they grow. Such platforms can connect to point-of-sale, order management, merchandising, marketing and customer service solutions to keep everyone on the same page. A good ecommerce platform will be connected to a company’s financial system so it’s easy to find the numbers and reports you need.

Customer relationship management (CRM) software. A CRM system stores information such as orders, billing and service requests so that dropshippers can analyze the data to better understand their customers. NetSuite’s CRM solution, can help retailers gather their customer data alongside other critical business information in a single place, where it can be accessed by the sales, marketing and customer support departments.

Dropshipping has considerable appeal for retailers because of its relatively low costs and low risks. Dropshippers often face intense price competition, however, and must be comfortable with a business model that leaves some things outside of their control. That said, the right partnerships, processes and technologies can counter many of these challenges, allowing the best dropshippers, and the retailers they work with, to prosper and grow.

Dropshipping FAQs

How do I start a dropshipping business?

There are several steps involved. First, start in the right place — a niche where you have a chance of winning. This could mean looking for products that are in high demand, face low competition or compete in an area where you have a unique strength. It’s also crucial to work with reputable partners. Finally, you’ll need to open an online store and find a way to attract customers.

Is dropshipping illegal?

No, dropshipping isn’t illegal. It is a legitimate order-fulfillment method for retailers, as long as they comply with the regulations of the regions in which they operate.

Why is dropshipping bad?

Dropshipping isn’t inherently good or bad. It is an order fulfillment model for online retailers in which fulfillment and delivery are handled by a third party and is a great option for many sellers.

How profitable is dropshipping?

Profitability varies. Dropshipping can be the best option when products are difficult to procure, stock and ship; for retailers in these situations, dropshipping may be the only way to turn a profit. On the other hand, crowded dropshipping segments may be buffeted by price competition. Product returns are another threat to a dropshipping retailer’s profitability. A certain amount of agility is needed to avoid dropshipping’s downsides and capitalize on its promise.