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September 02, 2014
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Strategy

Turn your reverse supply chain into a profit center

Selecting the right disposition strategies and understanding their financial impact can help you turn the reverse supply chain into a revenue generator instead of a cost center.

Reverse logistics—the management of returned and recyclable goods—is a pervasive and important business activity. In the United States, for instance, roughly 20 percent of everything that is sold is returned to the manufacturer.1 It is more expensive than is commonly recognized, costing companies approximately US $100 billion per year in the United States alone.2 Costs associated with returned goods represent anywhere from 8 percent to 15 percent of a company's top line.3 In fact, the cost of processing a return can be two to three times that of handling the original outbound shipment.4

Product returns exact a toll not only on a company's financial performance but also on its image and sales. In 2007, for instance, about 60 percent of Americans avoided certain food brands because of a recall.5 This suggests that a large percentage of consumers may have a negative view of brands associated with returns.

Article Figures
[Figure 1] Profit and loss statement for reverse supply chain
[Figure 1] Profit and loss statement for reverse supply chain Enlarge this image

Meanwhile, governments around the globe increasingly are imposing regulations affecting reverse logistics functions. One example is the European Union's End of Life Vehicle (ELV) Directive 2005/293/EC, which mandates recovery and recycling targets of 95 percent by 2015 for vehicles that are no longer usable. Some current regulations, such as the United States' Bioterrorism Act of 2002 and the European Union's Waste Electrical and Electronic Equipment (WEEE) Directive, include disposal requirements for chemicals and hazardous waste. More such regulations are expected in the future as the Extended Producer Responsibility principle, which aims to protect the environment and human health, continues to gain acceptance worldwide.

Despite this and other evidence of the growing importance of reverse logistics—and, in a broader sense, the reverse supply chain—most executives choose to focus more of their attention on the forward supply chain because its impact on a company's bottom line is far more substantial. By doing so, however, they are missing opportunities to improve their companies' profits and performance.

For one thing, returns management provides an opportunity to improve business efficiency at a time when the marginal cost of improvement in forward supply chain operations has been rising. For another, returns management offers various sources of revenue from auctions, refurbishments, recycling, and more. The reverse supply chain, moreover, offers a wealth of actionable intelligence that can be employed to improve product design, process design, and operations.

Although, as noted above, product returns can have negative consequences, with proper handling they can sometimes actually improve a company's relationship with customers. For example, how a company manages its warranties, product recalls, and similar activities will have a substantial impact on its brand image. Indeed, some companies are using reverse logistics as a strategic tool to differentiate themselves from their competition.6

Clearly the reverse supply chain (which can include everything from defective and end-of-life products, to shipment overages and refused goods, to reusable mobile assets like pallets and containers) is rapidly growing in importance. And as we have seen, returns management and recycling can be very costly activities. How can companies manage this function without adding unsupportable costs? As this article will explain, it is possible to at least mitigate those costs, and even to make the reverse supply chain into a revenue or profit center.

The key is to focus on disposition strategies for returned products and materials, such as donating, auctioning, reselling, refurbishing, incinerating, and recycling, among others. Selection of one disposition strategy over another should be a function of the financial benefits to be gained as well as of nonfinancial implications, such as brand equity and regulatory compliance. Companies can develop a framework for choosing the best disposition strategy by examining financial transactions in the reverse supply chain as a profit and loss (P&L) and cash-flow statement, and complementing it with nonfinancial considerations. In addition, this type of framework can help to monitor the performance of the reverse supply chain and identify areas for improvement.

Key impact areas
In order to improve the efficiency of a reverse supply chain and address market and non-market drivers, a company has to understand which areas of its business are affected by returns and recycling, and where it should therefore be focusing its efforts. These include:

Disposition strategies and gate keeping. Depending on the type of product involved, there are several disposition options, such as auctions, donations, redistribution, repair, refurbishment, recycling, incineration, landfill disposal, and energy generation. By making wise disposition choices and routing the returns accordingly, the reverse supply chain can be transformed from a cost center to a revenue source. The gate-keeping choice (who handles returned goods, and in what manner) is dictated by both financial considerations and nonfinancial considerations like regulations and brand equity.

Company finances. The way in which returns are managed can have a significant impact on revenues and profits. A long "return-to-credit" cycle, for instance, can harm a company's relations with its customers, retailers, and distributors. Returns-related taxation also deserves attention. Value-added taxes (VAT) paid out in the course of managing returns often go unclaimed because the accounting function does not receive timely information, and there may be opportunities to minimize customs duties and other trade-related taxes paid against returned goods.

Performance measurements. It is valuable to develop a set of key performance indicators (KPIs) that are specifically related to the reverse supply chain. Examples include returned goods as a percentage of sales; the ratio of reverse supply chain revenues (savings) to costs; the asset-utilization rate; year-over-year growth or decline of returns; and the percentage of returns that are fraudulent.

Traceability. This typically is well managed in the forward supply chain but often breaks down when returns are involved. Proper tracking using bar codes, radio frequency identification (RFID), and/or global positioning systems (GPS) prevents mix-ups of returns with forward-flowing items. It also helps to prevent returned goods ending up at unintended locations that may pose legal risks to the company. In addition, many companies do not trace mobile returnable assets like containers and pallets, but doing so would enable efficient management of these assets and free up the capital locked in excess buffers.

Causes of returns. To truly understand the implications for their business of their reverse logistics processes, companies should undertake a root-cause analysis of the items being returned. The National Retail Federation (NRF) has estimated that fraudulent returns cost U.S. companies up to US $3.68 billion in 2010.7 Nine in 10 retailers say that they have experienced the return of stolen merchandise and fraudulent returns involving employees.8 By collecting and analyzing the claims data, companies can identify the claim patterns, fraudulent claims, and the loopholes that enable fraudulent returns.

For legitimate claims, such research can identify product and design flaws. And in cases of returns due to delivery of excess items, shortages, or in-transit damages, conducting a collaborative root-cause analysis with logistics and transportation service providers and distributors can help to reduce such incidents. In short, companies can leverage the reverse supply chain's actionable intelligence in order to improve product and process design and also reduce the quantity of goods in the reverse supply chain.

Recalls, warranties, and repairs. A product recall is one of the most undesirable situations a company can face. Recalls carry much risk to a company's image and hence should be handled with care. In the case of food recalls, regulations also come into play, and companies will be required to generate and maintain compliance reports.

Warranties and repairs are another sensitive area for customers, and providing the necessary information and regular updates to customers will go a long way toward assuaging their concerns. A company's website should be the first source of information about returned material authorizations (RMAs), followed by helpdesk support.

Logistics optimization. Working closely with third-party logistics service providers (3PLs) and using transport optimization techniques can make the reverse supply chain more efficient. Some 3PLs have recognized the need for this type of improvement and are differentiating themselves from other providers by providing reverse logistics capabilities.

The profit center view
Companies can make positive strides in the above areas of their business by taking a "profit center" view of their reverse supply chain. An examination in detail of the various disposition strategies in the context of both financial and nonfinancial considerations makes it possible to develop a framework for such a profit center approach, as well as develop a set of performance indicators for the reverse supply chain.

Disposition strategies
Several options exist today for disposing of returned goods. The choice of one or more options should be governed not only by financial concerns (a cost-benefit analysis) but also by nonfinancial concerns like brand image, customer satisfaction, and regulatory compliance.

Option 1: Refurbish/repair/remanufacture. (Note: Refurbishing, repairing, and remanufacturing, in which the original identity of the item is not completely lost, have been considered together in this analysis.)

In this disposition option, damaged or discontinued returns are repaired or refurbished and sold again. The financial driver for this option is the comparison between the cost of repair and refurbishment plus the cost of transportation and handling versus the market price of the repaired/refurbished/remanufactured item.

However, nonfinancial concerns are equally relevant. It's important that companies identify refurbished/repaired/remanufactured parts separately to avoid any risk to brand image due to product failures in the field. Also, consumers tend to consider such parts and products as inferior. However, a company can highlight this practice as a sustainability initiative and give it a more positive image.

In some industry sectors, this disposition option has become a huge market in itself. For instance, the automobile industry sells a wide range of remanufactured automotive components, including engines, clutches, gearboxes, fuel injectors, and other products, in the automotive aftermarket. A remanufactured part may sell for around 50-75 percent of a comparable new one and carries the same warranty. However, the remanufactured parts must be labeled as "rebuilt" and be priced lower than the original part.9 For some companies, rebuilding is an integral part of their business strategy. Xerox, for example, leases its copiers; at the end of the lease period, Xerox rebuilds and resells them.10

Option 2: Auction or discount sale. Auctioning generally involves contracting with auction agencies that deal in a particular type of product or service. Discount sales involve offering returned goods at a heavy discount. A number of companies specialize in auctions and discount sales, providing online marketplaces to sell surplus, salvaged, and returned goods. Returned goods can also be sold to specialized firms in the secondary market after removing any telltale signs of the original brand.

Care must be taken that discount sales and auctioning do not have an adverse impact on the brand perception of the products. For instance, the existence of an alternate, cheaper way of buying a luxury brand could damage consumers' perception of it as a premium product.

The financial motive for selecting this disposal strategy would largely rest on the revenues to be gained from auction and discount sales. However, companies should also consider the associated costs, such as handling, transportation, and administration. Those that handle discount sales through factory outlet stores, of course, must also consider the total cost of operating those stores.

There are several nonfinancial implications of this route. Existing customers may feel let down when they find that others have paid less for the same product. If discount sales are frequent, then customers may wait for a discount sale to buy the product. Also, brand reputation and market positioning will suffer if discount sales are conducted through the primary ("A") channel retail outlets.

Option 3: Disassemble and recycle. (Note: The term "recycling" here includes all activities where the original identity of the item is completely lost.)

Recycling returned goods helps to extract and recover raw materials and parts for use in the production of new parts or products. A strong push for recycling comes from regulations like the previously mentioned European Union's WEEE directive. The need to comply with regulations like WEEE and the Restriction of the Use of Certain Hazardous Substances in Electrical and Electronic Equipment (RoHS) has made recycling the preferred disposition option for many product categories.

Financial considerations for recycling would comprise the costs of the recycling process, including transportation, handling, and administrative costs as well as the value that can be reclaimed from the recycled material. Recycling electronic products, for instance, makes economic sense because the cost of extraction of rare earth metals from electronic waste is less than that for mining.

Nonfinancial considerations would include branding and regulations. If branding as "recycled" gives a product a premium image, then a company should strongly consider recycling.

Option 4: Redistribute. Sometimes goods are returned due to delivery overages, or they may be unsold or discontinued items. In such cases, it makes sense to redirect the shipments to other geographical areas where they might be consumed.

For assets like containers, pallets, and packaging materials, redistributing—that is, introducing them to the forward supply chain—leads to better asset utilization. Another consideration is that the cost of disposal for these assets can be as high as their purchase price. Research has shown that reusable assets are more economical in the long run even though the purchase price is initially higher than that for one-way counterparts.11

There are several financial considerations that influence the feasibility of this option. To begin with, the ability to resell goods at the original prices without a deep discount is important. Second, redistribution may incur some costs, such as for transportation beyond state or national boundaries.

These must be accounted for, along with customs duties and other taxes. Companies should also add in any costs incurred in making changes to the products and packaging before redirecting them, especially to other countries. Examples include changing the language on products and packaging, and adding new product labels and certifications required by the new destination's regulations. For transport packaging materials, the value of assets that can be recovered and reused in the forward supply chain with minimal expenditure is the important criterion.

With regard to nonfinancial considerations, the shelf-life of the goods is an important factor, especially in the case of food items. Various countries' import regulations mandate a minimum remaining shelf-life at the time of entry. In addition, certain types of goods may be subject to antidumping laws by the destination countries if those governments believe the goods are being sold at less than the cost of production. There also are risks to the brand image if only discontinued or older models or versions of a product are available, or if customers find out that that the company sells returned products as new.

Option 5: Donate. Donating returned goods can be appropriate when the handling and transportation costs for other disposal methods will be high and no value will be derived from the sale of the goods. The potential tax savings to be obtained from government and local authorities may also make it an attractive option. There are a number of organizations that facilitate charitable donations and assist in obtaining tax breaks; just one example is the U.S.-based group Waste to Charity (wastetocharity.org).

Option 6: Energy generation from waste. Refurbishing and recycling, of course, is not a viable option for food products. A more practical option for disposition of food items is energy generation. Organic waste can be converted to renewable energy through a process called anaerobic digestion. This method of decomposition is a good way to dispose of returned, expired, and recalled food products.

The financial driver for selecting this option would be the monetary value of energy generated or the utility costs that can be offset compared with the cost of transportation, handling, administration, and running the waste-to-energy plant. Nonfinancial drivers for adopting this disposition route would include compliance with food disposal norms and regulations and the positive image that a company can build by highlighting it as a sustainability initiative. Food and beverage companies are increasingly following this route.12

Option 7: "Zero returns" policy. Under this unusual policy, a manufacturer does not accept returned goods. Instead, it incentivizes retailers and distributors with a "return allowance" and provides guidelines for disposition.

The financial benefit from such a policy is derived when the cost of handling the returns and disposition exceeds the return allowance. However, because there is no universally accepted, objective formula for establishing return allowances, big retailers may use their buying power to push for higher allowances and thus reduce or eliminate this cost advantage.

There are some potential nonfinancial pitfalls associated with this option. Retailers might sell returned goods through the "A" channel, diluting the products' brand image. In addition, under the increasingly widely accepted Extended Producer Responsibility principle, the manufacturer may incur some legal liability if the retailer improperly disposes of the product.

Option 8: Landfill/incinerate. Landfill disposal is the simplest option of all but it should be the last resort. Governments around the world have been discouraging landfill disposal for a long time. In Europe, certain types of waste are strictly prohibited in landfills, and companies have to either find alternate means of disposition or treat them before disposal. For food items, landfill disposition is allowed subject to regulatory compliance. Incineration also typically is subject to regulation.

Since this type of disposal is a last resort, the financial drivers are immaterial. However, regulatory restrictions represent a strong nonfinancial driver that discourages companies from taking the landfill or incineration route for their returns.

Financial framework
A formal financial framework is imperative if companies are to make the right choices in the reverse supply chain, identify areas of improvement, and monitor performance. But more importantly, a financial analysis that communicates the performance and benefits of reverse supply chain initiatives is bound to attract the attention and support of top management.

In order to treat the reverse supply chain as a "profit center" in accounting terms, it is necessary to identify the relevant revenue and cost drivers. These are discussed below.

Revenue drivers
Most of the disposition options mentioned earlier have revenue or savings attached to them, which can be treated as revenue sources in a P&L statement.

"Refurbish/repair/remanufacture" provides a direct revenue source in terms of market value or proceeds from selling repaired, refurbished, or remanufactured parts and products. If parts are not sold but instead are used within the company, then their market value can be considered as revenues. This can amount to a substantial amount of money.

In the case of the "auction or discount sale" option, the proceeds can be directly considered as revenues. The "disassemble and recycle" option generally is handled by third-party scrap dealers and recycling plants, which pay a nominal fee for acquiring the scrap. The proceeds from selling the scrap to these third parties constitute revenues from the reverse supply chain.

For the "redistribute" option, there are two possible revenue sources. One is the proceeds from products sold at different locations after passing through the reverse supply chain. The other is the "net asset value" of recovered assets over a specified minimum percentage. When shifted to the forward supply chain in usable condition, containers, racks, pallets, and the like can be classified as recovered assets. The net asset value at year end of such recovered assets above a specified threshold may be considered as revenues. The logic being that if those assets had not been recovered, then their net asset value would have been written off in the P&L statement. Avoiding the write-off generated savings by eliminating the cost of replacing those assets. Historical average values for recovered assets can be used to fix the threshold percentage for minimum asset recovery; any improved performance over the historical recovery rate counts as revenues.

For the "donate" disposition option, the revenue source will be tax deductions. Next is "energy generation from waste." If the energy generated is sold, then it is a direct revenue source. If used in-house, then the utility costs that energy offsets can be considered as revenues.

Lastly, reclaimed VAT payouts represent another source of revenue or savings. In countries where a VAT is paid as part of a service fee to providers of reverse logistics services, the tax refund generally goes unclaimed. Accurately tracking and accounting for the VAT paid in relation to reverse logistics activities, and then passing timely information to the accounting department helps to reclaim the VAT and generate savings.

Cost drivers
The most obvious reverse logistics costs include warehousing for temporary storage at collection centers and transporting returned items to their final disposal location. In addition, there are traceability costs related to the use of bar codes, RFID, GPS, and similar technologies.

But the cost drivers associated with the reverse supply chain go beyond physical distribution and handling activities. There are customs duties when goods cross national boundaries, and the excise and VAT taxes paid to third-party remanufacturers, logistics companies, and other service providers. There might also be other taxes and/or penalties, such as landfill disposal fees.

Returns authorizations are a distinctive aspect of reverse supply chain costs. This includes order management costs, which are indirect costs related to the generation of RMAs, move orders, and so forth. In addition, there are transaction costs incurred in issuing credit advices or chargebacks to dealers, retailers, and vendors.

Gate-keeping costs include both labor and equipment costs. These can be broken down into two categories. The first is direct costs incurred during handling, disassembly, sorting, cleaning of returns, and changing product attributes for redistributing products to new geographies. The second is indirect costs, typically incurred in the examination of returns to determine whether or not they are defective as well as in the examination of disassembled parts.

Customer service linked to reverse supply chain activities will also have its associated costs. Consider, for example, the cost of maintaining a call center to guide retailers and customers with returns and recalled products. Some retailers bear the costs of maintaining factory outlet stores to sell returns at discount prices. Finally, there are warranty-processing costs, which can be considerable.

For a company following a "zero returns" policy, the major cost would be for return allowances, which can range from 3.5-4 percent of sales to retailers.13

Last but not least are costs incurred in maintaining in-house facilities for refurbishing, repairing, and remanufacturing. For instance, in the automotive industry, several manufacturers have their own remanufacturing facilities,14 while some outsource it to third-party providers. For companies that are operating in-house facilities for energy generation from waste, the cost incurred for operating such a facility should, of course, be counted in the reverse supply chain.

Figure 1 summarizes this financial framework, along with illustrative nonfinancial considerations.

Performance measurements
In addition to the factors affecting a P&L statement discussed above, the following measurements can help companies monitor the performance of the reverse supply chain. Each area will have some kind of financial consequence, either directly or indirectly.

Customer recovery cycle time. When customers return a product, they expect a recovery in the form of a repair, refund, or exchange. The length of the cycle time from "a customer applies for return authorization" to "the recovery reaches the hands of the customer" has a critical impact on customer satisfaction. This cycle time is a measure of after-sales service and a source of competitive advantage.

Dealer/retailer credit cycle time. When dealers and retailers return a product, the manufacturer sends a credit advice to them. This credit cycle time is important to both parties, and in conflicting ways. For the manufacturer, a long credit cycle time means more money in accounts payable and hence lower working capital. But for a dealer/retailer, a long cycle time increases its working capital. However, in the interest of long-term relationships with dealers and retailers, manufacturers are expected to keep the credit cycle time short.

Return-to-reuse cycle time. This is the time from when a return authorization is created to the point when repaired/refurbished/remanufactured parts are put on shelves in the secondary, or "B," channel. Because of short product lifecycles, it is imperative that returned goods that have been repaired/refurbished/remanufactured be sold as soon as possible in the "B" channel. Long cycle times will risk items becoming obsolete before reaching that channel.

Returned goods as a percentage of sales. This measurement can be benchmarked using industry standards. For food and grocery companies, for example, the industry standard would be 1.2 to 1.8 percent.15 However, if returns are a part of a company's business strategy (consider the case of Xerox, mentioned earlier), then the comparison would be misleading.

Asset-utilization rates. Asset-utilization rates rise when the reverse supply chain is efficient in shifting assets like containers, cases, and pallets in usable condition to the forward supply chain.

Fraudulent warranty claims percentage. Since the reverse supply chain processes warranties, this functional area can play a crucial role in identifying and reducing fraudulent warranty claims.

Year-on-year percent growth/decline of returns. The reverse supply chain can indirectly contribute to a reduction in the volume of avoidable returns like damaged goods, failed products, excess delivery, and so forth. That is because the reverse supply chain has the information and intelligence about the root causes of such returns. By collaborating with product design, manufacturing, and the forward supply chain, the root cause of such avoidable returns can be addressed and the volume of returns can therefore be reduced.

Number of "B" channel products in the "A" channel. Due to the rise of secondary markets and increasing regulation of returns handling, company need to take care that a "B" channel product does not land on the shelves of an "A" channel outlet. This can not only lead to legal issues but also impact brand equity.

Recall cycle time. Recall cycle time is the time from "a targeted recall is declared" to "the replacements are on shelves or in customers' hands." The responsibility of executing a recall lies with the reverse supply chain. If not handled properly, recalls can spiral into a major embarrassment for a company.

Percentage (by weight) of returns disposed of in landfills. Landfill disposal is the least desirable option and comes with regulatory hurdles. The reverse supply chain must ensure that landfill disposal is kept to a minimum or eliminated altogether.

A competitive advantage
This paper identifies the key impact areas of the reverse supply chain for supply chain executives to focus upon, a brief guide to choosing the right disposition strategy, and a "profit center" framework for effectively monitoring the reverse supply chain's performance and communicating the benefits delivered. It should also help convince organizations that the reverse supply chain is indeed a profit center that can provide a competitive edge and hence deserves close attention. Indeed, with the Extended Producer Responsibility principle swiftly gaining ground worldwide, growing competition, and evolving business conditions, ignoring the reverse supply chain will no longer be an option in the near future. Companies that address the reverse supply chain in a holistic way will not only gain business efficiencies but also competitive advantages.

Notes:
1. Dale S. Rogers and Ronald S. Tibben-Lembke, Going Backwards: Reverse Logistics Trends and Practices. Reverse Logistics Executive Council, (1998) page 115, http://www.rlec.org/reverse.pdf.
2. C. Dwight Klappich, "Technology Support for Reverse Logistics is Minimal," Supply Chain Digest (June 5, 2008).
3. Aberdeen Group Inc., Revisiting Reverse Logistics in the Customer-Centric Service Chain (2006).
4. Shibesh Banerji, "Revisiting Returns," American Executive (March 1, 2011).
5. Lydia Saad, "Seven in Ten Americans Reacted to a Food Scare in the Past Year," Gallup Inc. (August 1, 2007).
6. Rogers and Tibben-Lembke, Going Backwards: Reverse Logistics Trends and Practices.
7. National Retail Federation, "Return Fraud Survey Results 2011" (2011)
8. Ibid.
9. Automotive Parts Remanufacturers Association, "What is Remanufacturing?"
10. Steve Elliot, "Environmentally Sustainable ICT: A Critical Topic for IS Research?" Pacific Asia Conference on Information Systems (2007).
11. Rogers and Tibben-Lembke, Going Backwards: Reverse Logistics Trends and Practices.
12. Food, Beverage & Agribusiness 2011 Special Issue. GE Capital Insights (2011).
13. Rogers and Tibben-Lembke, Going Backwards: Reverse Logistics Trends and Practices.
14. Ken Hoefling, "The Global Remanufacturing Industry," The Associated Chambers of Commerce and Industry of India (September 29, 2009).
15. April Terreri, "Reverse Logistics Moves Forward," Food Logistics (February 27, 2010).

Ashutosh Agrawal, a Senior Consultant at Infosys India, blogs on business and society at www.frontiers2explore.blogspot.com.

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