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Manufacturers' Dilemma:
Managing A Growing Volume of Returned Merchandise

BY WILLIAM SHERRARD, MARK ROSENBAUM AND FRED RAFFAT

Intense competition in the retail industry is creating a new problem for manufacturers: how to deal with the plethora of returned merchandise that is the result of a dynamic liberalization of return policies.

Managing this mountain of merchandise has become a major challenge to manufacturers that must accept and process the products back into their distribution channels for purposes of refurbishing, remanufacturing, recycling or liquidating the items returned by end users. With the rising volume of material, a significant amount of a manufacturer's profitability may depend on its ability to manage the reverse flow of its goods.

Many retailers have established their return policies with the belief that the "customer is king" or stated otherwise, the customer is the "center of the universe." For example, Dayton-Hudson claims that all of its customers are "welcomed guests." Nordstrom has won international fanfare for the ease with which it readily accepts returns. The Rite-Aid pharmacy chain encourages customers to buy a stick of lipstick, try it out and bring it back if they don't like the color. Customer service seems to be tantamount to accepting unconditional returns or to at least maintain extremely liberal return policies.

The problem is not limited to established firms. Manufacturers whose goods are sold via the Internet or by direct mail also confront hefty customer returns. Direct marketers have always confronted slightly higher return rates than department stores even though they possess loyal customers. Lands End "allows customers to return any item at any time, in any condition, no questions asked, for a complete refund." In November 1997, L.L. Bean had to begin tightening its liberal customer return policy. Some shoppers began returning articles purchased at garage sales. One customer even tried to return work clothes dug out of the closet of a deceased relative.

The first function in the return process commences with the unsolicited request from the retailer/customer to return merchandise. At this point, the manufacturer must decide whether to accept the merchandise or to reject the request and whether to issue a cash-return or a credit-return for future purchases. The manufacturer must decide if rejecting the request will significantly impair future goodwill; how unhappy the customer will be if credit is offered instead of cash; and whether a happy customer is worth the additional paperwork involved.

Often merchandise comes back in crushed boxes, some past its sell-by date, some damaged, some without original packaging or instructions, but some in a good enough condition to be resold. Manufacturers often assign personnel to the receiving function thus incurring additional costs.

Once the return is processed and the customer is given cash or credit, the merchandise is transferred to the manufacturer's "stagnant" inventory. Items typically languish in unopened boxes in the factory warehouse for months as they pass their sell-by dates. This results in the overstatement of assets since the balance sheet indicates the transfer to inventory at the original price when, in reality, the returned goods may not be salable at the original value.

The retailer or manufacturer has the option of reselling the items by placing them back in inventory or to recycle them into reusable raw materials. The major decision at this stage is determining if the recycling costs exceed the value of the recovered materials. If the factory is backlogged with orders then recycling usually waits, thus reducing inventory turnover.

Each item must be carefully analyzed to determine the strategy for its "second life." If the returned merchandise is part of the current product assortment, it can be placed in the current line for resale. Manufacturers often feel that an item that has failed in the marketplace should not go back in inventory. When the disposition of items is not readily discernible, they pile up until someone takes notice.

Some retailers have begun shifting the cost associated with returned items to the manufacturer. Many others are demanding consignment terms and/or guarantees that the manufacturer's merchandise will sell. In order for consignment to work, the manufacturer must receive timely and accurate sales data from the retailer. When the manufacturer requests an accounting of consigned merchandise, the retailer may not be able to account for 100% of the inventory. Experience indicates that retailers are more careful with merchandise they own than with merchandise held on consignment.

Many large manufacturers utilize consignment/guaranteed sale programs as a competitive advantage. This places an extra burden on small manufacturers or new start-up companies that are not in a financial position to afford the costs associated with consignment programs.

A common practice among jewelry retailers is to require vendors to accept another manufacturers' products in exchange for a merchandise credit. For example, when a jewelry manufacturer receives another manufacturer's returned merchandise he gives the retailer a merchandise credit. The retailer requires the manufacturer to accept the merchandise in return for a relationship with his company. Although the practice is ethically questionable, many manufacturers regard it is as a necessity to maintain an entrenched relationship with a retailer. As the retail industry continues to consolidate, it is likely that major retailers will flex their channel power by requiring manufacturers to become heavily involved in liquidating other manufacturers' products.

One method for reducing losses of returned merchandise that would otherwise be destroyed is to donate it to charity. Gifts in Kind America, a nonprofit group based in Alexandria, Va., assists manufacturers and retailers in the donation of goods to various needy organizations. Gifts In Kind America produces all the necessary tax documentation for the donor and is active in public relations activities. Major manufacturers and retailers donating merchandise to the group include Hewlett Packard, Gillette, 3M, Microsoft, Adobe, Eastman Kodak, IBM, K-Mart, Disney Stores, Sears, Talbots, Clothestime, LensCrafters and Hechinger.

The charity works with each donor on working with specific charities, focusing on a certain region, or assisting victims of natural disasters. Also, Gifts in Kind guards against fraud by removing all tags from the merchandise and by embossing the products with a special emblem designating that the items have been given to charity.

Another solution is to outsource the processing of the returned merchandise to a third party. Currently, the leading U.S. company specializing in this field is Genco Distribution Systems, located in Pittsburgh, Penn. Genco operates return centers nationwide that serve 10,000 customers and process $3 billion in returned merchandise each year. One of Genco's primary reverse-logistics tactics is to centralize all of a manufacturer/retailer's returned items at a central distribution center. Genco personnel process the returns and dispose of the items in a manner that maximizes potential profits.

Some manufacturers are streamlining their in-house handling of returned merchandise. At Estee Lauder, a cosmetics manufacturer, returns now represent its third most-profitable product line. When boxes of returned merchandise arrive, each item has its barcode scanned to determine its expiration date. Depending on the condition and/or expiration date of the returned merchandise, it is either scrapped or sorted for resale to seconds stores or to retailers in less developed countries. The software the company developed is now available to other manufacturers and gives operators a straightforward choice at each stage of the process.

Manufacturer's Options Regarding Returned Merchandise:

  1. Reject the return. Return merchandise to retailer.
  2. Negotiate return policies with key retailers.
  3. Process, refurbish and place back in inventory.
  4. Process, refurbish and send to company retail outlet.
  5. Process and recycle parts for other products.
  6. Process and sell directly to a third party.
  7. Process, refurbish and sell to third party.
  8. Process and give to charity.
  9. Process and scrap.

In the first three options, the manufacturer has the potential of making a profit on the transaction. The next two options (4 and 5) give the manufacturer little potential for profit and will likely result at best in the recovery of material costs. The last four options (6 through 9) result in returns below material costs.

--Sherrard is a professor in the Information and Decision Systems Department of San Diego State University's College of Business Administration. Raafat is a professor of production and operations management at San Diego State. Rosenbaum is a Ph.D. candidate in the department. Sherrard can be reached at 619-594-4304.