You can choose to have images created in the same folder as the source folder (Next to Source), or specify a folder where images should be saved (by choosing Other… or dragging a folder onto the preferences window). If you specify a destination folder that’s contained by the source folder, DropDMG will revert to its default behavior of saving the image next to the source folder. The Ask Later option causes DropDMG to ask you, for each operation, where to save the image or archive.
The bottom portion of the pop-up menu lists recent folders and favorite folders. Recent folders are the last 10 folders that you’ve chosen. Favorite folders are always shown in the menu, even if you have not used them recently. To make a recent folder into a favorite folder, find the folder’s alias in ~/Library/Application Support/DropDMG/Recent Folders. Select the alias and open the Finder’s Get Info window. Then click the Locked checkbox.