Reverse Logistics Financial Model

by John Mehrmann, DEX

Reverse Logistics Magazine, Jan/Feb 2008

It has been said that a boat is a hole in the water in which to pour money. The same may be said of some Reverse Logistics financial models. Failure to track the true costs and chart a safe course may result in titanic losses. Far too often the most reported metrics only reflect the tip of the iceberg. It is only by looking below the surface, planning for changes in currents beyond the horizon, and planning a blue ocean strategy, that executives can chart a safe course. Let's take a look below deck on the HMS Reverse Logistics.

In measuring the cost effectiveness of processing returns, it is common practice to compare the cost of refurbishment in contrast to the potential resale value of the product. This is not only common practice, but it is also common sense. However, measuring the cost of returns and refurbishment is anything but common. The methods of measurement are as unique as they are diverse, and the contributing factors are as complex as the intricate links in the supply chain.

To measure the full impact of returns, it is necessary to begin with an understanding of the real value of the product. From the very beginning of the financial model, it is important to recognize that product value can be measured as a single unit, and also as a sum of the individual parts. Typically, the rate of price erosion for a whole unit is at a much more rapid pace than the depreciation of the parts. This is especially true when mass manufacturing is complete, and as customer service drives demand for replacement spare parts. A complete complex financial model tracks trends and adjusts refurbishment, repair, and parts harvesting accordingly with the passage of time.

All product and all sales channels are not created equal. When measuring the overall financial impact of returns, it is important to recognize that some sales channels or specific partners have significantly lower rates of returns than the average. Some sales partners have programs to discourage returns, or remarketing solutions that significantly reduce the quantity and expense of returns. Sales to enterprise customers and business-to-business (B2B) typically have very different results than business-to-consumer (B2C) and end-user retail channel returns. Marketing discretionary funds to support sales efforts may also be significantly different for each channel or partner. Manufacturers should track and compare these costs, just as retail and sales channel partners should track the return ratio by product. Of course, there are sales strategies, relationships, and profits to protect when making overall business decisions. The first step in avoiding non-value-added cost is to recognize it.

The next step in the financial model is to measure the cost of returns and refurbishment. Many years ago, it was sufficient to compare vendors based exclusively on labor rates. As we have become more sophisticated in analyzing the supply chain, we realize that labor is only the tip of the iceberg. Typically 1/8 of an iceberg is visible, and 7/8 is submerged below the surface. While it is very easy to see that portion on the surface, it is the bigger mass that lies beneath the waterline that could sink the ship.

What contributing factors impact labor? Location – location – location, labor rate is often a result of the geographic location. The cost of labor may vary dramatically from one region to another. While this may be very appealing on the surface, it is necessary to investigate the rest of the iceberg. Take time to investigate the historical trend of quality as it relates to the lower cost of manpower. Does the transfer to another geographic region also require an investment in freight and fuel surcharges? Far too often the proposed benefits of lower labor rates in other regions are consumed with the burden of freight, import or export, duties, and taxes. To add insult to injury, crossing borders may also result in delays for customs, paperwork, or even different holidays and work schedules. Be prepared to measure and document all of these hidden costs when developing a financial model.

But wait, there's more—if you are planning to process returns and refurbishment in another geographic region, consider the impact of accumulating product and the freight method. Accumulating and consolidating product can reduce freight carrier expense, but the product is also depreciating while it waits on dock. Cargo and rail options may be less costly than truck and air, but once again there is rapid erosion of the product resale value while it remains in a transport container. There is no single right or wrong answer to this dilemma, the proper answer is to diligently investigate your own costs and act accordingly.

It is also important to consider changes in the regional economic conditions, and the potential for dramatic changes. Labor rates in a geographic region may be desirable at the time of negotiation, but what happens if the currency exchange rate changes, or cost of living increase? It may have seemed inconsequential several years ago, but competition for employment in a region, median income levels, and the currency exchange rate, have all impacted business decisions and strategies. These are important factors to monitor and evaluate regularly.

Moving beyond the focus on labor, a growing concern that no longer lurks beneath the surface is the cost of freight. There is a potential for many legs of freight in the complete reverse logistics cycle. Each leg of freight also has an inherent risk of the dynamic application of fuel surcharges. The amazing and adjustable fuel surcharges are typically overlooked in budget planning processes, much to the dismay of executives who must find a place to absorb the expense later on.

The question remains, "who pays the freight?" At first, you might be tempted to respond with the simple answer of freight related to a product return. However, if the product is accumulated and shipped to another location for refurbishment, then that is another leg of freight and possible fuel surcharge. If the product must be forwarded to a location for distribution after completion of refurbishment, then that is yet another cost of freight. If spare parts or accessories need to be moved from a separate inventory position, this introduces even more risk for freight related expense. To avoid potential for wasted freight costs, all units should be received, processed, refurbished, and shipped, all from under one roof. Parts and accessories should be in the same facility as the product. Any unnecessary movement of parts or product is an exposure to non-value added cost.

Is there a warranty on the product or on key components? Are you leveraging the warranty that you paid for? Can you get credit? These are also critical questions that can impact the financial model. When calculating the value of returning product or parts for credit or warranty work, it is important to minimize freight and maximize the warranty coverage. If there is only a small percentage that is actually covered as a result of defect in material or workmanship, then it may be more expensive to implement process delays and freight to take advantage of the warranty. As with all of these examples, identify the frequency and the severity of the costs to make good business decisions.

How many times is the product being touched along the way? Every time that someone handles the product, it adds cost to the entire chain, and that cost is put back into future product. Every time that someone handles the product, it is risk for damage and it is a delay to complete the return to resale. Collaboration and honest discussions are necessary between retail, sales channel partners, manufacturers, and vendors. Steps in the process must be measured, assigned cost and time metrics, evaluated, consolidated, or removed. Boxes should be opened one time only. Product should be inspected, tested, and processed one time only. Every extra step in the supply chain places you one step behind your competition in time and costs. Remove unnecessary steps and handling. You can build a reverse logistics model that is better, faster, and stronger.

Make a determination immediately as product enters this reverse pipeline, "how much time and expense to process it. What will it sell for when it is done?" Is the resale value of the product still more than the value of the sum of the parts? Can you use the product to exchange for a customer? Can you harvest parts to satisfy customer demands elsewhere? Does the resale value of the product exceed the purchase price of the sum of the spare parts? When considering this option, it is very important to understand the language of the original limited warranty, and the classification of the product. Refurbished parts can not be used to repair New Class A grade product. Use of refurbished parts to repair used or B Class products must be explicitly cited in the limited warranty terms and conditions. This article is not intended to provide legal advice, just a friendly reminder that you should seek legal advice before embarking on this cost saving course.

Do you really have duplicate inventory? Are you holding spare parts to support field service and also holding parts for refurbishing activities? Do you have more than one inventory of spare parts? Can whole units be used for parts harvesting? Are you tracking the value of the parts recovered in comparison to the value of the product that is disposed? Are you doing all of this under one roof, or are you also paying for shipping charges to get your parts to and from the units for refurbishment or repair? Freight on moving parts is a common hidden cost, but it is a cost nonetheless.

As you evaluate your expenses for refurbishment and repair of return products, consider the recovery or replacement costs of accessories, boxes, manuals, cables, etc. These costs may be minimal in comparison to the potential value of the product, but there are many pennies to be saved by careful management of these seemingly small costs. Every penny saved is a penny earned.

Are the resale value and volume as robust as the refurbishment? Warehouse and storage costs apply for the space to receive, process, and warehouse, the product. Sometimes this cost is a clearly defined line item on the vendor invoice, and sometimes the real cost for warehouse management or storage is buried inside an aggregate rate. Regardless if the cost is clearly itemized or buried in a total rate, the cost is passed on from vendor to client, and eventually back through the entire supply chain to future products. By working together, all parties can identify true cost, eliminate the handling, and reduce the rent on slow moving processes or products. It is all about velocity.

A new and rapidly growing area of cost consciousness is recycling and e-waste disposal. The industry will either drive change or be driven by it when it comes to restrictions, regulations, fines, and compliance. Regions that have adopted compliance and regulations have also introduced a small variety of new charges, and in some cases new revenue, associated with recycling and e-waste management. Costs or revenue streams must be accurately documented and archived for cost analysis and for applicable compliance. There is enormous opportunity to work together for cost effective tracking of part and product compliance in cost effective managements systems, and it begins with each organization recognizing both responsibility and expense.

There are other forgotten costs to manage reverse logistics. How many people in your organization are required to manage this process? How many to administer the credits, logistics, accounting, and IT? Are you systematically tracking your inventory, receipts, shipments, and your true costs as they occur? Can you rapidly identify anomalies before they get out of control? It may be that only a portion of the time is devoted to these activities, or it could be many full time personnel. When looking for ways to reduce costs and eliminate steps in the process, be careful not to achieve this goal by accidentally transferring the burden to internal personnel as an accidental byproduct of an otherwise excellent strategy.

Time is money. Determine the fiscal value of depreciation as it applies to product and parts. Identify the rate of price erosion, the cost to procure replacement parts in comparison to back-orders and refund checks, and delays in the process due to extra handling steps. Identify the monetary value of depreciation as assigned to each day, and then measure the total time from RMA request to resale, recycle, parts harvest, or rent and disposal. This will illuminate the dark corners where hidden costs lurk in shadows and prey on your profits.

Take some time to build your financial model. Look for best practices and identify hidden costs by collaborating with partners and peers. The result is continuous contribution to the profitability of your organization, avoiding disastrous decisions with hidden costs, and charting a clear course for success. To get this exposure and interaction with partners and peers, you need look no further than the Reverse Logistics Trade Show and Expo at Planet Hollywood Resort and Casino, in Las Vegas, Nevada. Similar events are in Amsterdam in June and Singapore in October. These events provide an opportunity to meet, collaborate, and learn from peers in a friendly and non-competitive environment. We look forward to seeing you there.

John Mehrmann has more than 20 years of management experience that spans logistics, operations, e-commerce, finance, customer relations, marketing, training and consulting. John has served the business community as Regional Sales Director at Data Exchange Corp, and Director of Service Operations for Toshiba. John is co-author of The Trusted Advocate, a powerful and refreshing new book on relationship sales, it is full of entertaining and hard-hitting perspectives to accelerate sales with authenticity and integrity.

Reverse Logistics Magazine, Jan/Feb 2008