Impact of Returns on

Supply Chain Coordination

Ana Muriel
Department of Mechanical and Industrial
Engineering, University of Massachusetts
In collaboration with Rocio Ruiz-Benitez
 Outline
Motivation
Model
Analysis
Computational Study
Conclusions
 Motivation
The value of commercial product returns now
exceeds $100 billion annually in the US (Stock,
Speck and Shear (2002))
Commercial product returns: Products returned for any
reason within 90 days of purchase.
Hewlett Packard recently estimated the cost of
consumer returns for North America exceeded 2% of
their total outbound sales revenue.
Reason % of returns
Returns ~ 6% of sales
Defective 20%
Could not 27.5%
install
Performance 40%
Convenience 12.5%
Ferguson, Guide and Souza (2005)
 Motivation
Policy of most US retailers:
Full returns no question asked!!
Return rates: 6% to 15% (Dekker and Van der Laan
(2003))
Mail order companies and e-tailers: as high as
35%
Largely ignored in supply chain coordination and
contracts literature
Most research on consumer returns concerns
inventory policies, production planning and reverse
logistics (Fleischmann and Kuik (2003), Kiesmuller (2003))
 Literature Review
Wood (2001), Remote Purchase Environments: The influence of Return
Policy Leniency on Two-Stage Decision Processes, Journal of Marketing
Research 38, 157-169.
Dekker and Van der Laan (2003), Inventory control in reverse logistics,
chapter in Business Aspects of Closed-Loop Supply Chains, V.D. Guide Jr., L.N.
Van Wassenhove, editors. Carnegie Mellon University Press, Pittsburgh, PA
Fleischmann M. and Kuik R. (2003), On optimal inventory control with
independent stochastic items returns, European Journal of Operational
Research 151, 25-37
Kiesmuller, G.P. (2003), Optimal control of a one product recovery system
with leadtimes, International journal of Production Economics 81-82, 333-
340
Ferguson, Guide and Souza (2005), Supply Chain Coordination for False
Failure Returns, working paper. Georgia Institute of Technology.
Souza, Guide, van Wassenhove and Blackburn (2005), Time Value of
Commercial Product Returns, working paper. University of Maryland.
 Research Questions:
What is the profit impact of incorporating consumer
returns in our decision models?
Centralized system
Decentralized system
How does it affect retail prices and quantities
ordered?
How does this depend on
the magnitude of logistics costs?
the relative share between retailer and manufacturer?
the proportion of product that is returned?
 Classical Model
Two-echelon supply chain
Sales S = min(y,Q)

cQ wQ rS
Manufacturer Retailer
s(Q-S)
Stochastic and price dependent demand y
Manufacturers decision variables: wholesale price w
repurchase price s
Retailers decision variables: order quantity Q
selling price r
Single replenishment opportunity
 Returns Model
vR l1R l2R

wQ rS
cQ
Manufacturer s(Q-S) Retailer
wR R = S
A percentage of sales is returned Returns rR
Manufacturers returns logistics cost: l1
Retailers returns handling cost: l2
This costs include inspection, shipping, sorting, repackaging, remanufacturing, disposal
Average salvage value of returned item v
 Costs Associated with
Returns
System costs: =r-v+l

Manufacturer costs 1 = w - v + l 1

Retailer costs 2 = r w + l 2
 Demand Distribution
y = stochastic and price dependent demand
faced by the retailer:
y=xD(r)
x= positive r. v. with mean 1 and density
function f()
D(r) = expected demand quantity, decreasing
in retail price
Demand density function
1 y
g ( y; r ) f
D(r ) D(r )
 Profit Functions and Optimal
Decision Variables:
Centralized System Decentralized System

C = rS cQ R T = R + M

Retailer
r c
1 R = rS +s(Q-S) wQ 2R
Q D(r ) F
*
r 2 w

C
r
1
Q D (r ) F
*
D
r 2 s
Manufacturer
M = (w-c)Q s(Q-S) 1R
 Analysis
Objective: Compare the following decision
rules
Policy IR: Policy CR:
Ignores customer Considers customer
returns when returns when
optimizing optimizing
QIR, rIR, wIR, sIR QCR, rCR, wCR, sCR
Customer returns
considered a
posteriori, to calculate
respective profits
Expected profit: IR

Expected profit: CR
 Analysis: Centralized
System
Proposition: Under deterministic and
price dependent demand, the optimal
retail price increases and the order
quantity decreases when considering
consumer returns. That is,
QCR< QIR and rCR> rIR

Intuitive since the profit margin is

reduced by consumer returns.
 Analysis: Centralized
System
Theorem: Under stochastic and price
dependent demand we have that
1. For fixed r, QCR(r)< QIR(r)
2. For fixed Q, rCR(Q)> rIR(Q)

3. Under mild conditions,

QCR< QIR and rCR> rIR

C1: For all r> rIR, QIR(r) QIR(rIR)

C2: For all Q<QIR, rIR(Q) rIR(QIR)
 Analysis:
Decentralized System
Corollary: Given w, the retailers
optimal decisions satisfy:
1. For fixed r, QCR(r)< QIR(r)
2. For fixed Q, rCR(Q)> rIR(Q)

3. Under mild conditions,

QCR< QIR and rCR> rIR

C1: For all r> rIR, QIR(r) QIR(rIR)

C2: For all Q<QIR, rIR(Q) rIR(QIR)
 Question
Will consumer returns always
result in higher prices and lower
quantities in a decentralized
supply chain?
 Analysis: System
Coordination
Under Buy-Back Contracts
Theorem: Under consumer returns, a
policy that allows for unlimited returns at
a partial credit s will lead to supply chain
coordination for appropriate values of s

and w. In particular,
s (c l1 )
1
Allowing no returns is system suboptimal
Extension of Pasternack(1985), demand is not price dependent
 Computational Study
Assumptions:
f(x) ~ uniform distribution in [0,2]
Linear demand model
D(r)=b(r-k)

where b<0 and k>0 constants

b=-3, k=5
(Emmons and Gilbert (1998))
 Centralized System
Sensitivity Analysis with respect to

8 l=1 CR
l=2 IR
6 l=3

0
6% 10% 15% 20% 25% 30% 35%
-2

-4

We observe: QCR < QIR and rCR > rIR

QCR decreases as l increases
Profit difference increases with l and
8
Optimal r and Q
Q*
r*
CR
IR
Decentralized System
We observe:
7
6
5
4
3 QCR < QIR
2
1 rCR > rIR
0
1 1.4 1.8 2.2 2.6 3 3.4 3.8 4.2 4.6

w
For fixed value of w,
Profit functions

8
Manuf.
Retail. RCR > RIR
Total
6

But for optimal w,

2

-2 1 1.2 1.4 1.6 1.8 2 2.2 2.4 2.6 2.8 3 3.2 3.4 3.6 3.8 4 4.2 4.4 4.6 4.8

-4
RIR > RCR
w
 Profit Functions at optimal w
Profit Functions Manuf. CR
Retail.
Total IR

6
5
4
3
2
1
0
6% 10% 15% 20% 25% 30% 35%

Percent Savings
Manufacturer: up to 10%
Retailer: 9% to 66%
Total: 6% to 37%
 Sensitivity Analysis
With respect to:

1) Share of logistic cost faced by

retailer ()

2) Percentage of consumer returns

()
 Optimal Q, r and w Q* CR
r* IR
w*
4.5
4
Under policy IR
3.5 QIR, rIR and wIR constant
3 logistics costs do not intervene in the
2.5 decision making process
2
1.5
1
Under policy CR
0.5 QCR and rCR increase with ;
0
5% 25% 50% 75% 95% Manufacturer decreases wCR
as incentive for retailer to increase order
quantity
Profit functions Manuf. Ends up bearing all logistics cost
Retail.
Total
3.5
3
2.5
2
If > 70% => RIR* < RCR*
1.5
1
0.5
0
5% 25% 50% 75% 95%

 Manufacturer's Profits Retailer's profits

3.5 2.5

3 2
2.5
1.5
2
1.5 1

1 0.5
0.5
0
0
5% 25% 50% 75% 95%
5% 25% 50% 75% 95% -0.5

-1

Total Profits

=.06 6
=.2 5

=.35 4
3
2
CR 1
IR 0
5% 25% 50% 75% 95%

 Conclusions
When considering returns
Centralized system:
1) Lower quantities and higher retail prices
2) Significant profit increase

Decentralized system:
1) Lower quantities and higher retail prices
2) Poor coordination of the supply chain
All members worse off in general
Ignoring returns reduces double marginalization
3) The manufacturer bears the returns logistics costs:
Higher percentage manufacturer decreases
incurred by retailer wholesale price to compensate