As many online merchants would agree, drop shipping is an e-tailer's best friend. While brick and mortar retailers have to stock every product color and size, many online merchants carry minimal inventory.

Instead, many Internet merchants fill orders as they receive them. They simply route customers order to a wholesaler, who drop ships directly to the customer (preferably with the merchants label on the box). No fuss, no muss. And, most importantly: no expensive inventory to hold.

Certainly, drop shipping has advantages. First, it allows an e-merchant to "have a very diverse portfolio, a really nice mix of goods," Craig notes. Additionally, because it requires no up-front investment, "If you don't sell anything, you're not out anything."

But on the other hand, the problems are just as clear. A merchant who relies on drop shipping "is putting no capital at risk, but it really does lead to a lesser margin," Craig notes. Many Internet retailers who use virtual inventory are forced to buy at MSRP (manufacturer's suggested retail price). In this case, there is precious little room for an e-tailer to mark it up.

Furthermore, "It's an open market," he notes. "You have to realize that there are several other sellers doing exactly the same thing, everybody could hook up to that vendor and sell — do you have enough volume, do you have a captured audience so that you can drive more and get more margin?"

Returning orders can be a special headache for those e-tailers with virtual inventory. Most wholesalers have a complete profit and loss structure (P+L) around shipping and handling. In short, they may accept a return, but they will not refund the customer's shipping and handling charge. Nor will they refund the shipping and handling charge to the merchant for returned items.

An e-tailer can even lose money with virtual inventory, if there are enough returns. "You need to make sure you're not losing money on the pick, pack and ship element," Craig cautions.

Is This Drop Shipper Trustworthy?
Many large e-tailers have their own vendor manual full of rules for their drop shippers. "It's a very thick document that your vendor has to comply with if they're going to be your drop ship vendor - if you're big enough, you can dictate those terms to them, within reason."

For those e-tailers who don't have such a manual, caution is required in partnering with drop shippers.

First, merchants must research that wholesaler to make sure they're legitimate, "that they're not going to be here this month and gone the next," Craig says.

Questions to ask include: What is their mis-ship rate? How often do they accidentally ship the wrong product? What is the quality of the merchandise? Many wholesalers will accept returns, which they then put back on the shelf for future sales - but do they do their quality control carefully enough to make sure it's not defective?

When looking for a wholesaler, it's a good idea to place a test order from them. This will determine, among other things, how the box is labeled when it shows up at the customer's door. "You would not want something shipped to your customer that has a Pier One or Wal-Mart tag on it," says Craig.

Additionally, a wholesaler needs to include a packing slip that is — hopefully — branded with the e-tailer's name. Some wholesalers place coupons and special offers in their boxes (from third parties, or from themselves) that can result in no repeat business for e-tailers.

A detail as small as the type of packing material can be important. For example, does the wholesaler use biodegradable packing peanuts? "If you're an REI or an outdoor gear retailer, maybe you don't want some biohazard packing material," Craig says.

Even after a vendor relationship is established, it's important to be "secret shopper," from time to time. "You might be shocked at what you get," Craig says. It's also a good idea for e-merchants to monitor their shoppers satisfaction. "If you're taking the brunt of your customer service calls, you can track an up tick of complaints against a vendor."

In short, a merchant needs to carefully manage their wholesale-customer loop.

"They are likely not just servicing you, they're servicing a plethora of other vendors who are doing the same thing you are and…they're going to make mistakes — they're only human," Craig adds.