Understanding Drop shipments

‘ DROP SHIPMENTS’ or drop-shipping is something many businesses resort to. There are some distinct cost advantages. Before discussing pros and cons, let us understand what Drop-shipping means. In simple terms, in drop-shipping, a business fulfills the orders from its customers, not by procuring the goods from the manufacturer/importer, storing it, packing/repacking and then arranging logistics for delivering the goods to the customer. Instead, it merely procures the orders, in turn places orders on the manufacturers/ importers and asks them to pack and deliver the goods to its customers directly. The difference between the purchase price and the price it bills its customer is the profit margin.

The advantages are obvious — There is no need to have warehouses to receive and store the bought goods and the hassles in packing/re-packing and transporting to the buyer gets eliminated too. A huge savings in cost putting less strain on capital. The downside, especially in case of online sales is that the margins are thin. The orders we place on online marketplaces like Amazon are fulfilled directly by the actual seller who ships our orders to us although we make payment to the marketplace provider only.

Some brick-and-mortar businesses too which sell their goods through regular distribution channels to retailers or customers directly provide drop-shipping facilities to their retailers, though this may constitute a very small proportion of their total sales. It is while structuring the marine cargo policies of such businesses that one needs to be careful. Clear understanding of the logistics patterns and frank communication with the proposer on the extent of liability will be necessary. A claim involving drop-shipment into which I had a peek, will explain the need for clarity between all stakeholders to the transaction.

One of the top importers and distributors of mobile phones, laptops, tablets, desktops, servers and play-stations in India had purchased a marine cargo policy on Sales Turnover basis. The logistics flow and requirements of the insured were discussed in detail and elaborately described in the policy. Among other things, the insured sold goods to retailers on drop-shipping basis i.e. the goods would be shipped directly to the end-user/customer of the retailer. The policy extended cover to drop-shipments too. Still… Mr. Murphy was proved right — ‘Anything that can go wrong will go wrong’.

The insured, let us call them ‘ X’ had imported a server against a firm order from a retailer ( say ‘Y’) in Kolkata. The value of the server including customs duty was INR 90 million. When the server arrived at Mumbai airport, it was noticed that there were minor damages to the outer crate. Preliminary survey was arranged by the insured themselves though no intimation was given to the cargo insurer ABC. The survey report noted damages to the external packing. This server was to be sent as a drop-shipment to one of the government-owned banks office in Kolkata with whom ‘Y’ had a contract. Insured decided to send the server to Kolkata in the same packing as time was running out. The server was loaded on to a truck and sent to the bank’s office location. ‘X’ raised a sales invoice on ‘Y’ for INR 100 million. The truck after reaching Kolkata, 25-30 kilometers from the named destination had a breakdown. The server was transferred to a tempo using crude handling methods which resulted in the server toppling over and becoming a Total Loss. The bank did not accept the damaged server and ‘Y’ who had raised an invoice on the bank for INR 115 million was left facing the loss.

‘Y’ too had insured the server in transit from Mumbai to the bank’s premises in Kolkata for INR 115 million with insurer MMM. Claim was lodged with MMM and during investigation, the transporter in a bid to escape liability for the faulty handling during transfer of the server, pointed out that the server crate was already damaged when it landed in Mumbai. MMM declined the claim citing pre-existing damages. Now ‘Y’ turned to ‘X’ and demanded that they compensate them for the loss, as it was awesome drop-shipment and it was ‘X’s responsibility to deliver the server safely. Initially, ‘X’ thought that the claim will get settled by their insurer ABC but soon realized the shortcomings: 1) They had not informed the insurer about the damages noticed at Mumbai airport. Had they informed and loss, if any, admitted, settlement would have been on the basis of landed cost only. Customs duty too might have been contested and valuation based on something less than INR 90 million. 2) Even if the insurer ABC was to ignore that the claim was not reported in time, assuming no pre-existing loss to the server transported to Kolkata, claim settlement would have been based on ‘X’s’ invoice on ‘Y’ i.e. INR 100 million. This is because the sales figure reflected in the books of ‘X’ will be INR 100 million only. The claim however was for INR 115 million, the value of the invoice raised by ‘Y’ on the bank. Although drop-shipments were insured under the policy of ‘X’, they should have pointed out that claims, if any would be based only on the invoice raised by them on their buyer ( including 10% if agreed and declared) and not to the extent of the marked-up invoice raised by ‘Y’ on their buyer.

Whenever drop-shipments are to be included in the policy coverage, all stakeholders need to be clear on the valuation limitations.