The owner stopped, bent down and picked up the penny, then turned to my friend “if you aren’t the type of person picking up pennies in the parking lot, then you aren’t going to make it in this business.”
My friend is in PE and the owner was an owner of dozens of Burger King restaurants. But that story has always stuck with me and I believe that mindset is equally true for owners of ecomm brands. In both businesses, margins are tight and operational excellence is critical. Success is optimizing lots of little things to get the margins, cash flow and capital right.
As an ecomm leader, you know returns and refunds can be a margin killer. But do you fully appreciate the cascading impacts of returns on your margins and capital? And do you know how to improve it in your business?
In this post, I am going to:
- start by looking at the obvious and not so obvious ways returns impact margins, cash and planning.
- look at impact of returns on an example brand.
- look at the various types of return and refund behavior.
- give my recommendations on how to make improvements in your business.
- provide other resources I found helpful in thinking about returns.
The obvious impacts of returns on:
- Net Sales. We all look at this number over time.
- Shipping & Fulfillment. Another obvious impact as we have all seen 3PL invoices. Since it’s often not a line item on the P&L, the return shipping and re-stocking impact on the margin structure is easily overlooked.
- Cashflow. Accrual accounting lines up returns with their respective sales. But in real life, returns often come in the next month. January is the annual reminder of this as returns spike. And Shopify holds back more cash to offset the December returns while your sales go down dramatically in January just as you need more cash to pay your Q4 bills and start reloading inventory.
The not so obvious impacts of returns on:
- Opportunity cost of a missed sale. You have one less item to sell. If the returned item is unsellable, you missed out on that contribution profit. If the returned item is resellable, you now have…
- Cost of discounting. If you are seasonal or have expiring product, you have a limited amount of time to sell at full price. Let’s say you are a clothing brand and in May you are selling at full price, but in June you have an end of season sale. Your May returns are coming back to you in June and now you have to re-sell them at a discount. This reduction in contribution profit reduces your unit economics for those products. This brings up…
- Your P&L hides the impact of returns on your unit economics. As you get returns, you offset the sales to show a Net Sales amount, your Shipping & Fulfillment account increases and your unsellable product goes into an offset account like Loss on Damaged Goods. But all that is aggregated. We know that all returns are not equal and all products are not equal. So as we figure out our unit economics, are we factoring in the impact of returns?
- For example, if you bought 100 units for $10 each and sold all 100 units but had 10 returned which were unsellable, what should your COGS be? To truly understand your unit economics, your COGS should be $11.11.
- We discussed impact of discounting above. For the purposes of unit economics, I want to know the realized selling price which would include the returned items I had to sell at a discount.
- And for the increase in Sales & Fulfillment expenses, I would want to know this on a per product and unit basis so I see a true Contribution Profit per product unit.
- Your returns skew your customer support costs. Some products just cause more problems and returns. Looking at customer support tickets to see how they are spread across products is something I would like to see quarterly and especially if returns spiked. I want to understand which products are causing the most tickets and then allocate my CX costs to products. Doing this will likely add more to my Sales & Fulfillment expenses for that product and thus further decrease that product’s Contribution Profit per unit.
- Over buying. I often see sales inventory sales forecasts that do not include returns. If your sales velocities are not factoring in returns, you will end up buying too much inventory which means likely discounting to recoup cash and training customers to look for deals. For each period and SKU, I want to see:
- beginning balance
- less expected sales in period
- plus expected receipts of new units
- plus returned units I can resell
- ending balance
- In this way I can understand how close to stock outs we get but also avoid over buying. Just a few extra days inventory per SKU adds up quickly when replicated across the product catalog. This leads to…
- Too much inventory chewing up capital. The cash you have to spend to buy that inventory means less money to put towards customer acquisition. And usually the cash to buy that inventory was borrowed, so you are reducing profitability and free cash flow further. And if you are relying on short term lending or MCA, you then have…
- Higher borrowing needs on MCA’s. If you are using Shopify Capital or any form of daily pay MCA, your payments are based on gross sales less discounts. They do not deduct returns. If you model this correctly (see here) you won’t be surprised and will know your true cost. But have you factored in the impact from high return periods? For example, Q4 sales are great, but your return rate likely goes up and your return window has likely been extended for the holidays. That means you may pay down your MCA faster during this period (increasing your cost of capital), but then have less cash as returns hit and you need to re-stock, so your borrowing needs go back up.
- ROAS. Are you factoring expected returns into your ROAS calculation?
- First Purchase Profitability. My preference is to look at Contribution Profit post Marketing (ie CAC) on a per unit basis to truly understand first purchase profitability. If we aren’t factoring in returns as above, then we are overstating our first purchase profitability and spending ad dollars less efficiently.
How returns ripple through a business will vary by company. But you can see the compounding effects of how a half a point here, another point there of margin adds up and that return rate of 10% that you assumed was OK is really a 15% drag on margin.
Let’s take this out of theory and look at data from a small brand.
In a 12 month period, this brand had:
- 3,341 total customers
- 513 of whom have made a return (15% of customers)
- Total returns of $123K (4.6% of total gross sales)
- There were 193 returners (38% of all returners or 6% of all customers) whose refunds were 20% or more of their gross sales. This group was responsible for 52% of all refunds.
- The 193 returners contributed a measly $50,776 in gross margin which is just 3.5% of total gross margin.
- Of this group, 36 customers had refunds of over $500 (AOV is ~$100) with an average refund rate of 38% and totaled $26K in refunds.
- 1% of the customers are causing 21% of refunds.
Your return problem is focused on a small set of ‘bad’ customers.
What are the return and refund behaviors?
The finaloop blog has a good piece summarizing a ZigZag survey. Both are terrific resources. The survey groups returners into 4 buckets:
- Occasional returners – rarely return items unless they fail to meet expectations.
- Of course there are legitimate returns. The item didn’t fit, the color wasn’t what was expected, the quality wasn’t satisfactory. This group generates about 23% of the return volume, have a 15% average return rate and are 43% of the returning population.
- Efficient returners – promptly return items, typically only returning a small percentage.
- This group accounts for about 31% of returns
We have now accounted for 74% of returns. The ‘bad’ customers are equally split in the following two groups:
- Serial returners – frequently over-order with the intention of returning many items.
- Slow returners – tend to delay returns, sometimes for weeks.
Let’s look at their behaviors:
Bracketing and over-ordering. Most common in clothing and footwear where the customer orders an item in multiple sizes and returns the ones that don’t fit or ordering multiple items with the intention of checking them all out and then keeping some or none. This may be part of value prop (e.g. Zappos) or you may not want to discourage this, but it has a real cost.
Gaming your discounts. This group adds items to the cart in order to get free shipping or discounts with no intention of keeping the products. They sign up for the subscription to get the discounted price and then cancel or worse return what they never wanted anyway. They simply want your discount regardless of the rules you put in place.
Skimming cash back or points. This group is scamming their credit card company for points or cash back or scamming your loyalty program. They buy more to get the rewards knowing they are going to return the items.
Wardrobing. This group buys items in order to wear out and then returns them. This is fraud.
Staging. Many influencers pretend to have more money than they actually do. Their solution is to use your return policy so they buy your products, wear them in their staged shots and then return them. Similar to wardrobing above. They likely justify their fraud by claiming they are helping give your brand exposure. But are you actually getting any mentions, traffic or customers?
Lazy or slow returners. These returners are sometimes gaming their loyalty systems, so they wait out the statement periods before making returns. And some just don’t care so they sit on the return for a long time and then complain.
Gaming your return policy. This group knows you are likely to tell the customer to keep the item instead of asking them to send it back. Health and beauty especially suffers from this as they can’t resell their products once returned but are forced to destroy them. Clothing can suffer from this where the customer claims a defect and instead of having the customer send it back they let the customer keep it and issue a full or partial refund. This is simply stealing. And worse, these thieves will then resell your product online further damaging your brand.
Chargeback fraud. These people deserve their own circle of hell. Instead of dealing with the company, they file a chargeback with the credit card company. Maybe it’s pure laziness. Maybe it’s simply theft. In either case, it’s stealing. And the credit card companies should join them in that hell circle for shifting this burden to merchants.
Pure stealing. This group is the most infuriating. You send them product. They request and receive a refund and then they either ship back an empty box, a box of garbage or an item they obviously damaged themselves.
What should you do?
Our goal is not zero returns and refunds. We know from the ZigZag survey that almost 75% returns are to be expected. So our goal is to identify the products and people that cause the most refunds and reduce those. I recommend a 4 part strategy.
- Improve your refund policy. Review your policy to make sure it is crystal clear and easy to communicate. Message the hell out of it. Make sure CX is messaging it and enforcing it. And add a KPI for refunds for Ops. At one client, the CEO made refunds an important metric and focused especially on enforcing the policy around time to return an item. That worked.
- Look into your data to find the products or bundles that are causing the issues. Is it the products? The way you are selling them? The descriptions or photos? Again KPI’s can help here.
- Ron Shah from Obvi had a good tweet about this:
- Get help. Tools like NoFraud can help identify and eliminate problematic orders.
- A friend who runs a skincare brand had a problem with chargebacks and found implementing NoFraud really helped reduce this loss.
- Fire some customers. The truth is you have customers who are stealing from you. Some know they are. And some rationalize their behavior as not a big deal or just your cost of doing business. Your job is to make money and these people are taking it from you.
- Like the person who cuts you off on the highway and then flips you off as they drive away, these bad customers are not going to be happy. But before you get weak kneed imagining their angry social posts, hear me out. Here’s what I would do:
- Slow returners
- enforce your policy
- message return policy in post purchase communications
- Frequent returners
- create a premium or VIP customer list based on cumulative contribution profit net of refunds and recency.
- create a maximum number of returns allowed per year.
- if any of your VIP’s are exceeding your limit, let them know that you are making an exception for them only because they are such an important customer.
- consider adding a re-stocking fee to your return policy or add a re-stocking fee to any returns that exceed your maximum allowed.
- Gaming discounts and/or loyalty.
- If they are gaming credit card programs, then they are slow returners and possibly frequent returners; see above
- If they are gaming your discount and loyalty programs, cut them off. I would just start rejecting their orders. If you feel bad about this, you can give them a personal warning. But I think you are simply dealing with a dishonest person so you are wasting your time.
- Wardrobers and Stagers
- I would first try to understand who is a wardrober and who is a stager or influencer.
- For the true influencers, I would reach out and either incorporate them into my program or offer them some discount in exchange for posts and mentions with the understanding that items cannot be returned or some other creative way to get them compliant and helping you.
- Wardrobers I would ruthlessly enforce the return policy and keep evidence. This behavior is infuriating because the bad customer is rationalizing their stealing of profit from you through ‘I am sending it back’ or ‘it’s perfectly fine to sell (as if they know that)’ or ‘everyone does it’
- I would also cut these customers off.
- Stealing through chargebacks, taking advantage of your ‘keep it’ policies, pure theft
- Cut them off
- Tell your side of the story in their angry posts, comments and reviews
- I would be tempted to reporting this for the most egregious cases
“Our fix: Started tracking returns by product combo and cohort. The deep dive revealed certain bundles had 3X higher return rates.
We changed our recommendations and cut the return rate by 40%.”
Some simple worksheets to measure impacts in your business
Great resources
The Wall Street Journal discussed the impact of stricter return policies on customers with some customers deciding to no longer shop at those retailers or changing their behavior to shopping only in store. They also discussed return fraud with some egregious examples of customers sending back empty boxes or cereal boxes to mom and pop stores trying to sell online.
WSJ also has a good article on porch piracy
The finaloop blog, referenced above, is worth checking out.
This ZigZag survey is a terrific resource full of stats which are particularly useful for building the case internally to take action.
Ron Shah, the CEO of Ovbi (@obviceo) has some great advice about identifying returns problems and the impact of fixing them in a longer X thread about improving margins.