Drop Shipping Merchants Face Special Fraud Risks. Here’s How to Fight Back
Drop shipping is a growing trend in e-commerce. It’s driven by the rising cost of warehouse space and the freedom it gives small merchants from managing inventory, logistics and fulfillment. Merchants who manage their margins and supplier quality carefully can do well with drop shipping—if they also understand their fraud risks and take steps to reduce them.
CNP fraud plagues the entire e-commerce industry. Losses to retailers are projected to reach $130 billion for the period from 2018 to 2023. That’s not great news for any merchant. But those in drop shipping are at particular risk for incurring CNP fraud losses that can overwhelm their business.
Low margins, high chargeback risk
Why? Part of the reason is the way revenue and risk are distributed in the drop shipping model. Each customer order triggers a wholesale payment from the merchant to their supplier, who then ships the order to the customer. The merchant collects the difference between the retail price and the wholesale cost—but they’re also liable if the order turns out to be fraud.
Fraud-related costs can add up quickly. For example, if a customer places a large order with stolen credit card data, the order amount will be charged back to the merchant when the cardholder discovers the transaction. Then, the merchant is also responsible for chargeback fees from their merchant account provider, the cost of the order’s shipping and the wholesale cost of the order they paid their supplier.
There can be other costs, too. Disputing chargebacks involves looking up and providing order documentation to card companies within a relatively short window of time. This pulls the merchant’s focus and resources away from the core business—and the dispute may not be successful. If a merchant approves too many fraudulent orders, they can damage their reputation and even lose their merchant account. In that case, the only options are to pay more for high-risk payment processing services or go out of business.
And although organized fraudsters know that drop shippers make easy targets, especially for high-value transactions, professional criminals aren’t the only source of chargeback risk. Customers who pay with valid cards sometimes also file chargebacks—often because they forget they placed the order, don’t like the product or don’t recognize the merchant name on their credit card statement. Regardless of the reason for these chargebacks, merchants operating on thin margins bear the costs.
High decline rates, fewer return customers
Another fraud risk is the risk of false declines—rejecting orders that look like fraud but are valid. Like CNP fraud, false declines affect the entire e-commerce industry. As many as 30% of rejected orders are false declines. Based on my observations, drop shippers tend to have high false-decline rates, as they err on the side of caution to prevent costly fraud.
However, rejecting good orders costs merchants much more than fraud does. Estimates of CNP fraud put the annual worldwide cost between $25 and $40 billion. Estimates of the annual cost of false declines since 2014 have ranged from $118 to $331 billion in the U.S. alone.
Beyond the lost value of those rejected orders, false declines cost merchants in other ways. Rejected customers often take their business to a competitor and are unlikely to return. This reduces the lifetime value of each customer and raises the cost to acquire customers.
Fighting CNP fraud and false declines
Drop shippers have several options for fraud prevention, each with its own pros and cons. For example, the fraud filters built into many e-commerce platforms can offer a variety of ways to screen orders, such as by IP address and location, AVS verification, device fingerprinting and more. However, these filters often let merchants set such broad rules—like blocking all orders from abroad—that merchants lose out on potential good customers. And because fraudsters are always adapting their tactics, merchants must constantly revisit their rules.
Another option is fully automated fraud screening that doesn’t require any input or monitoring by the merchant. Orders are approved or rejected based entirely on the solution’s screening criteria. Often, the providers will assume liability for any fraud-related chargebacks that get past their screening. However, because these systems automatically reject all orders that are suspected of fraud, they can generate a high number of false declines, and the cost of the lost orders may surpass the savings on chargebacks.
A managed solution combines automated screening with manual review of flagged orders by human fraud analysts. This option, like fully automated solutions, usually guarantees that the merchant won’t have to pay for any fraud-related chargebacks. Unlike automated solutions, managed solutions prevent false declines by evaluating each flagged order carefully.
For example, what looks like fraud—a high-value order from a new customer outside the country, with express delivery—might truly be fraud. It could also be an order from a wealthy shopper who travels globally and needs items delivered quickly. A human analyst can identify the difference and help the merchant retain good customers while avoiding fraud.
With the right combination of good screening criteria, automated order screening and review of flagged orders, drop shippers can reduce their fraud costs, build strong customer relationships and make the most of their business model.