Manufacturer's Return Policies and Retail Competition

Abstract

Manufacturers' returns policies are a common feature in the distribution of many products. The obvious rationale for returns policies is insurance. Practitioners, not surprisingly, have a different perspective and view returns as a cost of doing business. In this paper, we study the strategic effect of returns policies on retail competition and highlight its profitability implications for a manufacturer. The setting for our research is the distribution of products with uncertain demand, limited shelf lives, and retail competition. Our objective is to provide a better understanding of when manufacturers should adopt returns policies. The insights are obtained with a model based on the economics of strategy and decision making under uncertainty. We show that when retailing is competitive and there is no uncertainty in demand, a returns policy subtly induces retailers to compete more intensely. The provision of a returns policy reduces retail prices without affecting wholesale prices, thereby reducing retailer margins and improving manufacturer profitability. The intuition is that with a returns policy, Cournot-like levels of retail stocks cannot be sustained. Each retailer will order stocks so that it will not be constrained by stocks, and so, intensifying retail competition. When, however, demand is uncertain and there is a single retailer, a returns policy encourages the retailer to over-stock, and so decreases (upstream) manufacturer profits. While the provision of a returns policy leads to lower retail margins, the optimality of returns policy depends on the overall uncertainty and marginal cost. A returns policy reduces the dispersion in retail prices between the high and low states of demand and the range of retail prices in the returns case is contained within the range of retail prices for the no-returns case. In the general setting, when there are competing retailers and demand is uncertain, there is a trade-off for the manufacturer between the benefits (more intense retail competition) and the costs (excessive stocking) of a returns policy. We find that a manufacturer should accept returns when the marginal production cost is sufficiently low and demand uncertainty is not too great. To validate the results of our theory, we conduct an empirical test with data from a major U.S. retailer. The tests confirm our prediction that a returns policy intensifies retail competition and reduces retailer margins. Our theory and empirical test should interest practitioners and researchers in distribution, especially those concerned with managing retail competition.