The Value of Drop Shipping: The Calculation

A drop shipping business has the potential to increase a company's online sales by up to 300%. But how does it work? How do you calculate the value of a drop shipping business?

This post will cover the fundamentals of how a drop shipping company operates, and I'll break down the calculation step-by-step. By understanding this process, you'll be able to tell from day one if your new retail business idea is viable.

Why Drop Ship?

As the name implies, a drop shipper takes an initial inventory of products and then sells them to customers through regular retail stores. It's a great idea for online retailers because it offers the possibility of increased sales without building any expensive real estate or physical inventory.

By using drop shipping, a business can sell multiple times its initial inventory and profit. It's a virtual warehouse that allows you to build all your products right from the start. You'll be able to focus on selling, rather than stocking shelves or worrying about logistics and returns.

How It Works

Here's an example:

A drop shipping company has an initial inventory of 100 products. It also sets up a website, and some marketing copy and video on YouTube to help sell the product. The costs to start-up are zero. The sales page for each product is set up so that each visitor gets their own unique URL for the product, which can then be tracked.

Next, the company reaches out to potential vendors that sell the same products that they have listed on their website. They offer a commission deal in which they will take a percentage of each sale made through their website. If the vendor agrees, then the deal is set in stone.

Now that the agreement is made, customers begin to view the website and eventually buy products. The vendor gets paid a commission, and the drop shipper keeps the rest of the profit.

How To Determine The Value Of A Drop Shipping Business

Since a drop shipping business offers a more limited initial investment and higher margins per sale, it has more value than other business ideas. But how can you calculate it? I'll show you how to do so in four easy steps:

Step One: Start with Your Gross Margin Profit From Your Existing Product Sales

Let's say that you sell 1 item for every 25 sold. Your gross margin is 25%, and your cost of goods sold is 9% (i.e. the markup on each product you sell). Your markup is 15%, and your net profit is 7%.

Let's say that you sell products at $20 per piece. You'll need to sell five pieces to break even, and your net profit will then be about $60. Since this is a drop shipping business, we'll need to add on the costs of running the business – which we can say will be 4% of revenue –or $1 for every sale made. This means that our gross profit will be:

$6 + [($6 x 5) x (1-(1-0.05)] = $12.50

However, since the drop shipper will be taking a commission on each sale made, the cost of sales for the business will be about 80% of gross profit. We'll multiply the gross profit by 80% to get our sales value:

$12.50 x 0.80 = $10.00

Step Two: Calculate Your Fixed Expenses and Variable Costs

Some of your start-up costs from running a business may vary depending on where you live and what type of retail or warehouse space you use.

For example, if you live in New York and want to open your office at your local mall or in an old warehouse, your start-up costs may be lower than someone who wants to do it out of their house. That's because you may need a storefront with more space and electricity.

But the cost of running an online business is generally higher than the cost of running a physical shop. That's why you start by calculating your fixed expenses – those costs that don't change from month to month (such as rent, utilities, etc.) – and the variable expenses (costs that are dependent on sales, such as shipping fees).

For a drop shipper, the fixed expenses should be about 20% of sales. Here's how to calculate that number:

Fixed Expenses = 20% x Sales

You'll also need to ship your products, which will cost about 10% of your sales. Here's how to calculate that number:

Shipping Costs = $10 x Sales %

Step Three: Calculate Your Advertising and Marketing Costs

Next we'll need to estimate advertising and marketing costs. In other words, how much do you think it will cost for you to get potential customers onto your website? This number should be 3-5% of your first year sales. Here's how to calculate it:

Marketing Costs = $10 x Sales %

Again, this is a drop shipping business, so we have to adjust our numbers. Since the initial inventory is owned by the drop shipper and not the vendor, you should subtract out the initial investment from your sales number. The result of this calculation should be about 20% of sales – or about 4% of first year sales. Let's say you plan to start with $20,000 in sales and a $4,000 cost for products (the drop shipper will take off about 20% for each sale made). This means you'd have:

4% x 20% = $1,000 + $4,000 – $20,000 = -$14,000

Step Four: Calculate Your Gross Profit

To calculate your gross profit we need to subtract out the cost of goods sold (9%) from your sales value. This is how you'll find your gross margin.

Conclusion

In this guide, I gave you some tips and advice on how to calculate the value of a drop shipper. It's an important step in deciding whether or not it should be your business idea.

Disclaimer: I have no affiliation with any of the vendors mentioned in this article unless stated otherwise. The information as described is for informational purposes only and does not constitute professional financial advice or investment decisions. As always, consult a professional before making any investments.