Outsourcing strategy in the presence of the customer returns

https://doi.org/10.1016/j.ijpe.2021.108217Get rights and content

Highlights

  • We study a manufacturer outsourcing strategy with customer returns.

  • We discuss optimal returns policies and their impacts on manufacturer's outsourcing strategy.

  • Manufacturer may outsource to the competing contractor who sets a higher wholesale price.

  • MBGs may lead to prisoner's dilemma if the manufacturer outsources to the competing contractor.

  • If manufacturer outsources to the competing contractor, both can be either better off or worse off.

Abstract

In this paper, we examine a manufacturer's choice of outsourcing contractor, either a competing contractor or a non-competing contractor. Both the manufacturer and the competing contractor (which also produces a product in its own brand) face customer returns. We find that the manufacturer's optimal outsourcing strategy depends strongly on two factors: the efficiency of production and sale of its brand relative to that of the competing contractor in its own brand, and the ratio of the qualities of the two brands. The competing contractor, on the other hand, always prefers to produce for the manufacturer. Interestingly, we find that when the manufacturer chooses to outsource to the non-competing contractor, both the wholesale and retail prices of the manufacturer's product decrease, while they increase if the competing contractor is chosen. In addition, the competing contractor may be chosen even if it charges a higher wholesale price than the non-competing contractor does. We find that the manufacturer and the competing contractor should offer money-back guarantees if they can efficiently recover value from any returns. We further show that when a non-competing contractor is chosen, money-back guarantees offered by the manufacturer and the competing contractor can benefit at least one firm and may even achieve a win-win situation. When the competing contractor is chosen, both the manufacturer and the competing contractor can either benefit (Pareto improvement) or suffer (prisoner's dilemma) from money-back guarantees. These results are different from those in existing studies in the literature.

Introduction

With the development of contract manufacturing, original equipment manufacturers (denoted as manufacturers in the following text), have increasingly transferred their manufacturing business from in-house production to outsourcing to contractors (such as Foxconn and Flextronics), who are known as manufacturing providers (Arruñada and Vázquez 2006; Amaral et al., 2006; Cheng et al., 2012). The manufacturer focuses on its core competencies, such as product design and product distribution management, and does not actually produce the product. Outsourced products range widely from apparel, toys, food, beverages, and electronics to automobiles and even pharmaceuticals (Wang et al., 2014; Li et al., 2020). Thus, for example, 97% of the garments sold in the United States are made overseas (Uranga 2017). In the electronics industry, companies such as Apple, Hewlett-Packard, LG, and Dell outsource most of their production to contractors in Asia (Moorhead 2019). The major reasons for outsourcing include cost reduction, improvements in efficiency and quality, and the freedom to focus on core competencies (Arruñada and Vázquez 2006; Wang et al., 2014; Li and Zhao 2021). Apple CEO Tim Cook has said that the number one reason that Apple chooses to make iPhones in China is the large quantity of skilled labor (Leibowitz 2017); contractors can efficiently produce products at the required level of quality.

Outsourcing to contractors has been extensively adopted and rapidly become standard practice. The electronic manufacturing services market was valued over $450 billion in 2017, and is estimated to more than $650 billion by 2024, with a growth rate of 5% per year (Wadhwani and Yadav 2018). Intense competition in the market, however, has imposed pressure on contractors to build up a wide range of capabilities, providing other services, such as product design, or producing their own brand products in addition to producing for others (Wang et al., 2014). Contractors for manufacturers are increasingly capable of developing and marketing products, and some have even established their own self-branded products, becoming the manufacturers' competitors in the consumer market, in addition to serving as suppliers. These contractors are referred to as competing contractors. In practice, non-competing contractors may become competing contractors when they develop the ability to design and produce their own low-end brand products. For example, Taiwan-based Asustek, formerly a non-competing contractor for Hewlett-Packard, Sony, Apple, and other companies, has produced own-brand products, and Acer, a Taiwan-based contractor for IBM and Apple, has become one of the world's largest computer manufacturers (Mitic 2019), producing lower-quality computers.

A manufacturer who wishes to outsource must therefore carefully evaluate its strategy, choosing between non-competing and competing contractors. When a manufacturer outsources its production to a non-competing contractor, a competing contractor brand can compete directly with the manufacturer brand as if it were another manufacturer. When the manufacturer outsources to a competing contractor, the competing contractor plays two roles simultaneously, producing and supplying to the manufacturer as an upstream supplier, and producing and selling its own brand as the manufacturer's downstream competitor. The competing contractor's revenue thus is generated both from selling its own-brand product and from manufacturing under contract for the manufacturer.

The manufacturer's choice of a supplier thus depends on the competition scenario it wishes to engage in. In practice, competition may relate not only to production and sales, but also to a variety of other factors, including post-sale interaction with customers in the form of customer returns. Customer returns present a rapidly increasing concern in the retailing industry. According to a National Retail Federation report (2019), customer returns in the United States accounted for $309 billion, averaging 8.1% of total sales in 2019. The returns rates can be up to 30%, and even as high as 50% for some expensive items during holiday season (Kenneally 2018). To manage customer returns, firms provide returns policies that range from “100% money back guarantees” (MBGs) to “no refunds.” (Office of Consumer Affairs 2018 (Canada); Better Business Bureau). MBGs are widely offered in practice (McWilliams 2012; Akçay et al., 2013; Chen et al., 2018), as they allow the customer to return an unsatisfactory product for a full refund. Studies have shown that an MBG can benefit firms by, for example, signaling the high quality of the product (Moorthy and Srinivasan 1995; Shieh 1996), reducing customers' risk of dissatisfaction (Davis et al., 1995; Chen and Chen 2017a), and increasing customers' willingness-to-pay (Suwelack et al., 2011).

Managing customer returns is, however, a significant obstacle for firms. In addition to the loss of sales, the costs associated with reverse logistics (shipping and handling costs) are high. In 2017, the total U.S. return delivery cost was expected to reach $550 billion by 2020 (Mazareanu 2020). To avoid costs related to customer returns, some firms implement restrictive returns policies (Su 2009; Hsiao and Chen 2015), including no refund. For example, the Camera Store does not accept any returns of printer in which ink has been installed (https://www.thecamerastore.com). Firms like Leon's, vanloshop.com, Kylie Cosmetics, and Factory Direct also do not allow customer returns.

Previous studies have examined various factors in outsourcing decisions, such as production cost and quality (Feng and Lu 2012; Xiao et al., 2014; Li et al., 2020), but those studies have focused on the coexistence of the manufacturer brand and the competing contractor brand in the market, neglecting the fact that the competing contractor may influence the decisions of the manufacturer even if it has no sales. In addition, customer returns are prevalent in the retailing industry, but previous studies in the outsourcing literature have not considered the impact of customer returns on manufacturer outsourcing decisions. How should the manufacturer choose its contractor in the presence of customer returns? How should the manufacturer and a competing contractor manage customer returns and what returns policies should be offered under the manufacturer's optimal outsourcing strategy? What are the interactions between returns policy and outsourcing decisions? Can MBGs benefit the manufacturer and the competing contractor? These questions are understudied in the literature.

To address the above questions, we develop a game theoretical model to study a manufacturer's outsourcing strategy when it sells a high-quality brand product with two outsourcing choices: either a non-competing contractor who only manufactures for the manufacturer, or a competing contractor who produces both the manufacturer's product and its own low-quality own-brand product. Both of the contractors are present in the system, although the manufacturer only contracts with one. Both the manufacturer and the competing contractor face customer returns, and thus need to decide returns policies (either no-refund or an MBG) and pricing decisions. Our study captures both price and post-sales service competition through a multi-stage game in different channel structures.

We find that the manufacturer's choice of contractor depends strongly on the efficiency of producing and selling the manufacturer's brand relative to the competing contractor's own brand, and the ratio of qualities of the two brands; the competing contractor always prefers to produce both the manufacturer's product and its own. Specifically, the manufacturer will outsource to a non-competing contractor only if the efficiency ratio is very low, or the efficiency ratio is moderately high and the quality ratio of the two brands is very high; otherwise, the manufacturer will outsource to the competing contractor. Interestingly, we find that, when the manufacturer outsources to the non-competing contractor, both the wholesale price and the retail price of the manufacturer's product decrease, resulting in an increase in the sales of the manufacturer's product (demand oriented outsourcing strategy). When the manufacturer outsources to the competing contractor, both the wholesale price and the retail price of the manufacturer's product increase, resulting in a decrease in sales of manufacturer's product (price oriented outsourcing strategy). Under certain conditions, the manufacturer should outsource to the competing contractor even if it charges a higher wholesale price than the non-competing contractor does.

We find that the optimal returns policy for each brand depends only on whether the firm can handle customer returns efficiently (that is, the net salvage value of the returned product is positive). When the manufacturer outsources to a non-competing contractor, MBGs can benefit at least one firm. When the manufacturer outsources to the competing contractor, both the manufacturer and the competing contractor can be either better off (Pareto improvement) or worse off (prisoner's dilemma).

We contribute to the literature in three ways. First, we extend the literature on manufacturer outsourcing by considering the impact of customer returns. Our study provides new insights into outsourcing and returns policies. Second, we examine the driving factors in the manufacturer's choice of outsourcing strategy in a competitive market. We show that outsourcing to the non-competing contractor is a demand-oriented strategy, while outsourcing to the competing contractor is a price-oriented strategy. Finally, we fill a gap in the outsourcing literature by considering the situation in which the competing contractor has no sales, and we find that the existence of the competing brand can influence the manufacturer's outsourcing and pricing decisions.

The rest of this paper is organized as follows. Section 2 reviews the related literature. Section 3 presents the model framework and description. Section 4 describes the customer's purchasing decisions and the manufacturer and contractors' pricing decisions; and analyses the optimal pricing and returns policies for the two brands. The manufacturer's optimal outsourcing strategy is also identified. Section 5 shows the impact of an MBG on the manufacturer's outsourcing strategy. Section 6 presents an extension in which the contractor offers a buyback contract to the manufacturer. Section 7 summarizes the conclusions and discusses future work. Proofs of all results are presented in Appendices A and B.

Section snippets

Literature review

This paper is related to two streams of literature, production outsourcing and customer returns policy.

The issue of outsourcing production to a contractor has been widely discussed in the operations management literature. Previous studies have mainly focused on the make-or-buy decisions of monopolistic or competing manufacturers with independent upstream suppliers. Studies have explored the impacts of various factors on firms' outsourcing decisions, including production cost (Gray et al. 2009a,

Framework

We consider a market in which a manufacturer (denoted with subscript m) sells a high-quality manufacturer brand product (αm) and outsources production under one of two strategies X={C,R}, to a competing (Strategy C) or a non-competing (Strategy R) contractor. The competing contractor (denoted with subscript s) competes with the manufacturer with a low quality own-brand product (αs) and can fill the manufacturer's outsourced order, where αs<αm. The non-competing contractor (denoted with

Optimal decisions

In this section, we derive the equilibriums for the manufacturer's two outsourcing strategies using backward induction. There are two outsourcing strategies for the manufacturer and four combinations of returns policies for the manufacturer and the competing contractor, which gives a total of eight cases. As the derivation for each combination of returns policy is similar, for convenience of exposition we show the detailed derivation for the case K=GN (the manufacturer offers an MBG and the

The impact of MBGs

We now discuss the impacts of an MBG under the manufacturer's optimal outsourcing strategy. Recall that we have shown that either the manufacturer or the competing contractor adopts an MBG if Ei0, where i=m,s (Proposition 1), and the manufacturer's optimal outsourcing strategy is X=R if and only if ρR<βK<ρ1 or ρ2<βK<ρ3, and X=C otherwise (Proposition 2). In this section, we will discuss the impacts of an MBG in the case in which both brands have sales and Em0 and Es0 under the

Extension

In this section, we extend our discussion to a case in which the manufacturer offers an MBG policy (K=Gks) and the contractor offers a buyback contract, with a buyback price to the manufacturer for each product returned from the customer. We denote this case with subscript b. The game sequence for K=Gks is the same as in the main model, except that in Stage 3, the contractor's decision is to set a pair of prices (wsbCGks,bsCGks)/(wnbRGks,bnRGks), where bsCGks and bnRGks are the buyback prices

Conclusions

In this paper, we examine the manufacturer's outsourcing strategy when the manufacturer chooses between a competing and a non-competing contractor, and when both the manufacturer and the competing contractor face customer returns, for two customer returns policies.

We find that the manufacturer's optimal outsourcing strategy depends strongly on the ratio of the two brands' efficiencies of producing and selling, and on the ratio of the qualities of the two brands, and we also find that the

Acknowledgements

The authors gratefully acknowledge financial support from the Natural Sciences and Engineering Research Council of Canada, the National Natural Science Foundation of China (Grant No. 71871184), and the Fundamental Research Funds for the Central Universities (China) (Grants Nos. JBK160501, JBK18JYT02, and JBK190504).

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