Pricing and order decisions with option contracts in the presence of customer returns

Abstract

This paper develops a newsvendor model to examine the impact of customer returns on a firm's pricing and order decisions, in a case where the firm faces price-dependent stochastic demand and has the option of purchasing option contracts. The firm needs to decide the optimal initial order quantity, option order quantity, and retail price simultaneously. The firm's joint optimal decisions are derived for both single- and multi-periods. We examine the impact of two typical forms of customer returns: proportional to product sold, and increasing with selling price. We demonstrate that when customer returns increase with products sold, the firm will set a higher price and reduce both initial order quantity and option order quantity through the wholesale price contract and option contract, respectively, for the single-period problem. In the multi-period problem, when customer returns increase with products sold, the impact of customer returns depends strongly on the variation in product purchase costs (order costs and purchase costs of options) in each period. When customer returns increase with selling price, however, the firm will cut its price, and initially order more products with fewer options for both the single- and multi-period problems. Furthermore, numerical examples confirm that the presence of customer returns results in a significant decrease in the firm's profit. Option contract can be a tool to mitigate the negative impact of customer returns as with the option contract, the more the customer returns, the more the firm is motivated to provide a returns policy.