Returns and credits for goods are a fact of life in most product and service businesses. It is very rare that they can be totally eliminated. However, the extent of returns and credits is certainly manageable and this article will illustrate how most businesses do not adequately measure and understand the full cost of returns and therefore do not recognize the huge return to be gained by investing in quality control.
Let’s look at a business with a cost of sales of 70% resulting in a gross margin of 30% with returns relating to quality issues of approximately 5% of sales. The cost of remanufacturing or sourcing the replacement products amount to 3.5% of sales (70% cost of sales x 5% replacements). Another way of looking at it: If the product is returned for credit and not replaced, 3.7% of sales (30% gross margin – 26.3% gross margin remains after the return). If your business is similar to this scenario, you are absorbing a huge and largely unnecessary cost. In many businesses this cost is buried in the net cost of sales reported to senior management. In a $10,000,000 sales business this could be a cost of $350,000 at 3.5%. These are just the direct costs; the impact of indirect and/or additional costs appear later in this article.
Apply the concepts in the preceding paragraph to your business and consider what the cost of inadequate quality is to your business. Then consider the cost of improving quality and the extent to which you may be able to reduce those costs. For example, adding an (additional) person to the quality control function in the business above would have a payback of a few months, if that step achieved a halving of the credits/returns. Other factors that must be considered in this scenario, especially if the item must be replaced urgently, may include:
Higher than original sourcing costs to obtain raw materials/component parts, if they are not in inventory; and
Overtime for labour
The earlier in the businesses process that the intervention to ensure quality occurs, the better the outcome. This is obvious if one considers that the quality deficiency may exist in defective raw materials or component parts. Detecting the deficiency before you add value ensures that you do not waste these costs. Similarly, if you can introduce quality control at the supplier level (especially on imported materials), then less quality control will be required by you and you will avoid incurring unnecessary transportation and receiving costs. So, consider the value of investing in that quality control process by your supplier – it can save you a lot more in the end.
In assessing the cost of below standard shipping to customers, it is important to consider the numerous indirect costs incurred as well as the many intangible costs. These can be very difficult to quantify but are often very significant. Actual indirect costs would include:
Transportation costs for the return and re-shipping to the customer, especially if there is now a need for expedited and more expensive freight costs;
Cost of disposing of the returned goods, if they cannot be re-used;
Cost of penalties levied by your customer for late delivery;
Cost of penalties where your product is a component of something bigger produced by your customer;
Staff time for dealing with the return in all areas of the business; and
Management time for resolving major problems with the client.
Intangible costs would include many of:
Your reputation with the customer;
The possible loss of that customer
The impact on your reputation if that customer discusses their experience with other potential or current customers;
The reputational risk if that quality failure becomes public knowledge;
The sales and marketing costs of finding new customers to replace those lost;
The frustration and loss of motivation amongst your staff. “The more customers you lose, the harder it is on your staff. Morale suffers when customers leave and the new ones require more patience and more time.” (The Real Costs of Losing Customers by JoAnna Brandi in Drake Business Review, 2009);
Lawsuits over consequences due to failure of your product;
As a result it is clear that the inability to easily measure the cost of inadequate quality of actual indirect costs that are incurred, as well as the many intangible costs, should not mean that they are left out of the equation. Some businesses arbitrarily add a factor that accounts for these to the direct costs. One example is to double the direct costs and another is to triple them to account for the high intangible costs. Whichever way you factor in these costs, the value of a high standard of quality control reinforces the culture of the organization, for management and all employees involved in the process.
In these challenging economic times it is easy to focus on issues such as head count and/or cutting staff and to assume that non-productive labour is an expense that should be reduced. Be aware that cutting quality control resources can have a consequence far out of proportion to the cost being cut. I would argue that the reputation of your business as a quality aware supplier will be even more critical in tough times, when your competitors are desperate for business and therefore competing on price. It may be the key to your survival.
About the Author: James Phillipson, Principal, Mastermind Solutions Inc.
James Phillipson is a Chartered Accountant who provides strategic financial management skills to small and medium sized businesses (SMEs). For the last twenty-five years he has helped companies use financial systems and processes to grow their business. Often that includes coaching the Controller and Accounting department staff.
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