Returns Policies: Make Money by Making Good

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A returns policy for excess inventory is a commitment by a manufacturer, service provider, or distributor upstream to accept products from a downstream channel member. The format of returns policies varies in and across industries. The most generous policy promises to refund the full wholesale price for all returned products, while less generous policies offer credits against future orders. A partial returns policy gives only partial credit or refund. Manufacturers and distributors of a wide range of products have long allowed retailers to return excess inventory. In 1932, Viking Press became the first book publisher to accept returns. By then, magazines already had returns policies.

In the early 1980s, Parker Brothers, which was so successful with its “Monopoly’’ board game, attempted to enter the market for children’s books. The project failed, partly because Parker Brothers refused to accept returns from retailers.1 Currently, college bookstores return about 40 percent of all new textbooks, a proportion that has grown steadily over time.2 Consequently, the cost of returns to publishers has been rising, leading them to tighten their returns policies.3 The National Association of College Stores has formed a Returns Issue Taskforce to address the issue of returns policies. Despite their use in many industries for years, returns policies continue to be controversial.

Today, returns policies are common in the distribution of books, magazines, and newspapers, recorded music, computer hardware and software, greeting cards, and pharmaceuticals. Returns policies are more widespread in Japan than in the United States, a fact worth noting as international businesses step up efforts to penetrate that market. Japanese manufacturers accept returns of apparel, cosmetics, and electrical appliances in addition to the products commonly covered by returns policies in the United States and Europe.4

Returns policies are also a controversial issue in the computer industry. When IBM cut the price of its PC Junior in the early 1980s, it provoked a bitter response from distributors that had bought large inventories at higher prices and could not return excess stock. More recently, a vice president at IBM admitted, “We are not the best in the terms and conditions regarding returns policies.’’5 Returns can also undermine profitability; according to Borland, Inc.’s annual report, “Gross margins can be strongly affected in particular periods by aggressive pricing strategies and return privileges associated with new product introductions and upgrades.&

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1. “General Mills: Toys Just Aren’t Us,” Business Week, 16 September 1985, pp. 106–108.

2. Based on conversation with Merilee Henner, Richard D. Irwin, Inc., and Roger Reynolds, Stanford University Bookstore, 19 October 1992.

3. Recent changes in the terms of returns policies by McGraw-Hill and Irwin reflect this trend.

4. H. Ejiri, “This Strange Japanese Business Practice: The Returns System,’’ Nihon Keizai Shinbunsha (Tokyo: 1979);

D. Flath and T. Nariu, “Returns Policy in the Japanese Marketing System,” Journal of the Japanese and International Economies 3 (1989): 49–63; and

“Business Customs and the Marketing of Imports’’ (Japan: Price Level Policy Section, Price Level Division, Economic Planning Agency, Keizai Kikakucho, 1986).

5. David Boucher, vice president of channel management, IBM Personal Computer Co., quoted in Computer Reseller News, 20 June 1994, p. 1.

6. Borland, Inc., Annual Report (Scotts Valley, California, 1992), p. 12.

7. By contrast, Marvel and Peck point to differences in the nature of demand uncertainty as explaining the sharp difference in the acceptance of returns between Japan and North America. See:

H.P. Marvel and J. Peck, “Demand Uncertainty and Returns Policies’’ (Columbus, Ohio: Department of Economics, Ohio State University, working paper, 1992).

8. Based on conversation with Frank Connor, president, services merchandising division, McKesson Corp.

9. The arguments concerning correlation in demand are based on Lin. See:

Y.J. Lin, “Retail Arrangements: Secured Sales vs. Consignment’’ (Riverside, California: Graduate School of Management, University of California-Riverside, working paper, 1993).

10. For an end-user-based informational argument for money-back guarantees, see:

K.S. Moorthy and K. Srinivasan, “Money Back Guarantee” (Pittsburgh, Pennsylvania: Carnegie Mellon University, working paper, 1995).

This theory would support a pull (i.e., manufacturer-driven) argument for returns policies in the face of end-user uncertainty about product quality.

11. The lengthy marketing literature on perceived risk underscores the importance of this factor in consumer behavior. See:

R.A. Bauer, “Consumer Behavior as Risk Taking,” in Dynamic Marketing for a Changing World, ed. R. Hancock (Chicago: American Marketing Association, 1960); and

J. Bettman, “Perceived Risk and Its Components,” Journal of Marketing Research 10 (1973): 184–189.

12. P. Nelson, “Information and Consumer Behavior,” Journal of Political Economy 78 (1970): 311–329.

13. G. Heal, “Guarantees and Risk Sharing,” Review of Economic Studies 44 (1977): 549–560; and

V. Padmanabhan and R.C. Rao, “Warranty Policy and Extended Service Contracts: Theory and an Application to Automobiles,’’ Marketing Science 12 (1993): 230–247.

14. New Product Management for the 1980’s (New York: Booz, Allen & Hamilton, 1982);

New Product Success Ratios (Chicago: Nielsen Researcher, 1979); and “Marketing in Japan,” The Economist, 24 April 1993, p. 70.

15. W. Chu, “Demand Signaling and Screening in Channels of Distribution,’’ Marketing Science 11 (1993): 327–347.

16. For a similar incentive motivation to explain the structure of franchise contracts, see:

F. LaFontaine, “Agency Theory and Franchising: Some Empirical Results,’’ Rand Journal of Economics 23 (1992): 263–283; and

R. Lal, “Improving Channel Coordination through Franchising,’’ Marketing Science 9 (1990): 299–218.

17. One factor that we have not addressed here is the balance of bargaining power between retailer and manufacturer. Slotting allowances may simply reflect retailers’ power over manufacturers rather than a sophisticated signaling strategy.

18. V. Padmanabhan and I.P.L. Png, “The Effect of Returns Policies on the Pricing of Services and Perishable Goods’’ (Stanford, California: Graduate School of Business, Stanford University, working paper, 1993).

19. L. Pellegrini, “Sale or Return Agreements vs. Outright Sales,’’ in Marketing Channels, ed. L. Pellegrini and S. Reddy (New York: Lexington Books, 1986), pp. 59–72.

20. According to Roger Reynolds, Stanford University Bookstore, 7 August 1992.

21. V. Padmanabhan and I.P.L. Png, “Manufacturer’s Returns Policies and Retail Competition” (Stanford, California: Graduate School of Business, Stanford University, working paper, 1995).

22. Cooper and Ross discuss similar issues that arise with product warranties. See:

R. Cooper and T. Ross, “Product Warranties and Double Moral Hazard,’’ Rand Journal of Economics 2 (1985): 103–113.

23. Based on conversation with Merilee Henner, Richard D. Irwin, Inc., 19 October 1992.

24. B.A. Pasternack, “Optimal Pricing and Return Policies for Perishable Commodities,’’ Marketing Science 4 (1985): 166–176.

25. A.O. Hirschman, Exit, Voice, and Loyalty: Responses to Declines of Firms, Organizations, and States (Cambridge, Massachusetts: Harvard University Press, 1970); and

J.A. Goodman and A.R. Malech, “Using Complaints for Quality Assurance Decisions” (Washington D.C.: Technical Assistance Research Providers Institute, working paper, 1985).

26. Lal and Staelin suggest a similar idea for motivating a heterogeneous salesforce — let the salespersons choose from a menu of compensation schemes. See:

R. Lal and R. Staelin, “Salesforce Compensation Plans in Environments with Asymmetric Information,” Marketing Science 5 (1986): 179–198.

27. Based on conversations with Merilee Henner, Richard D. Irwin, Inc., and Roger Reynolds, Stanford University Bookstore, 19 October 1992.

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