There are numerous costs involved in conducting a product recall. Many of these costs vary greatly depending on factors such as the type of product being recalled, the cost and price-point of the product, the number of units recalled, the geographic location of the companies involved and even the demographics of the end-user. This article attempts to look at large buckets of costs common to all recalls and discern whether the cost alone would give a manufacturer incentive to increase or decrease recall effectiveness. For the purpose of this article effectiveness is measured by the successful correction or capture of recalled product units. You can read a summary of this article by clicking here.
Direct Costs
Direct costs are fairly straightforward. First, there is
the cost of implementing the recall.
This includes such costs as administration, shipping items back from retailers and
consumers, and the cost of fixing or disposing and replacing the product. Each of these costs is positively correlated
with recall effectiveness. That is, the
more successful a recall is in locating items, the higher the cost to
manufacturers. This correlation means
that there is an incentive for manufacturers to slow, hide, or not fully
advertise a recall.
Second, there are inventory
costs. Depending on the cause of the
recall, work-in-progress and raw materials may be lost in addition to completed
inventory. Because manufacturers are
restricted by law from selling recalled products in the US, and we will assume
for now that they do not attempt to sell them overseas, something the 2008 Consumer
Product Safety Improvement Act (CPSIA) expressly prohibits, this cost neither increases
nor decreases with the effectiveness of a recall. What is in stock at the time of recall will
be the same whether or not the items that have already been sold are retrieved
from homes or not. Therefore, inventory
costs should not affect a manufacturer’s decision to implement a fully
effective recall. However, it is possible
that a company would have an incentive to stall a recall in order to sell
additional inventory with the expectation that most consumers will either not
find out about the recall or will not return the product.
Third is lost sales of the
recalled product. Manufactures lose the
margin on returned items, the sale of which must be reversed or otherwise
reflected in financial statements, as well as any projected sales of the recalled
product. The more product-units
returned, the lower the revenue recognized, which again creates an incentive
for companies to limit recall effectiveness.
Overall, the direct costs of a
recall increase with the effectiveness of the recall. In other words, companies incur higher costs the
more successful they are in recovering the defective products. Taking these costs alone, it is easy to see
why one would conclude that a company has little incentive to spend any more
time or money on a product recall than that which is required by law. However, these costs alone do not fully
explain the observed financial impact of recalls.
Indirect Costs
I define indirect costs as the
additional financial impacts beyond the direct costs of the recall that would
not have occurred but for the recall. One
such cost is government fines. As noted in
my blog post outlining the recall process,
the CPSC can now impose fines of $100,000 up to $15 million for failing to
report potential product safety violations or defects. While these amounts are significantly higher
than previous fines, for most large companies, all but the fines imposed for particularly
egregious violations will carry a relatively minor financial burden. While companies
have an incentive to avoid the fines, in the past they have neither carried
much financial weight, nor had a tremendous impact on recall effectiveness.
The second category of indirect
costs is related to product liability lawsuits.
These costs are relatively easy for companies to quantify, but are
difficult for others to analyze because settlements are often sealed. To the extent that the recalls are for
products belonging to public companies, and the companies report these costs in
their SEC filings, we can at least identify the claimed damage amounts. Yet, the actual cost of the suit, including
legal fees associated with defense of a particular product issue, are difficult
to discern. Using data in the CPSC
Revised Injury Cost Model, published by the Public Services Research Institute, US companies spend a combined total of more than $2
billion a year in defense of consumer-product related lawsuits. These costs do not include the cost of settlements or jury awards, which can average $600,000 to $800,000 each.
Exposure to potential legal
claims often increases the longer a product is in use, creating an incentive to get
defective products out of homes as quickly as possible. One possible
counterpoint is that, if the company believes customers are unlikely to be
hurt, it may be willing to bear the exposure risk in order to avoid the other costs
associated with widely communicating a recall - not the least of which could be
a fear of class-action lawsuits.
The third category of indirect
costs is lost future sales. Based on the research described in my paper, The Effect of Product Recalls on Stock Performance, I use reputation effects as a proxy
for how future sales will be impacted.
In the case of brand image, sales are lost due to a customer’s fear that
a particular brand is no longer safe. Sales
of the brand’s other, non-recalled products will also decrease as overall brand-image
declines. Given that how a company
handles a recall has a greater impact on reputation than does the recall itself, companies ought
to be incented to conduct a complete and thorough recall, taking the
opportunity to also discuss how they have fixed problems and will prevent them
in the future.
In reality, companies may not
know of or believe the studies’ findings to be true, and therefore may try to
prevent consumers from finding out about the recall at all. However, this strategy, especially in the
days of the internet, is likely to fail, causing greater strife than had the
company been forthright in the first place.
Again, the incentive ought to be complete communication for increased effectiveness.
Lastly, if the company is
perceived by the public as having acted irresponsibly by not doing everything
possible to ensure an effective recall, Corporate Social Responsibility (CSR) ratings
will decline, potentially adding to the negative financial impact of the recall. While there is some debate over the financial
effects of CSR, we will assume that if companies believe CSR to be correlated with financial performance, they will
have an incentive to act responsibly, or at least be perceived as having acted
responsibly.
The chart above summarizes recall
costs and whether each carries a positive or negative incentive for companies
to ensure the recall is effective. Although
quantifying these cost incentives is difficult and goes beyond the scope of
this paper, I do offer this small bit of analysis:
In the fall of 2007 Mattel faced
several recalls in a short period of time due to loose magnets and lead paint
violations. Even though the fraction of
Mattel’s products that were affected was very small, the company suffered
significant impact on its stock price.
Given that Mattel had $5.5 billion in annual sales at the time, and
that the then-current direct recall costs were only $69 million, something else
must have been driving the bulk of the impact. Shareholders and analysts were building in
expectations regarding the recalls’ impact on Mattel’s future sales, which are not captured
in direct costs.
Therefore, while it may seem
counterintuitive, when all costs are considered, companies have an incentive to
implement the most effective recalls possible; that incentive being improved
financial performance. It could be that companies that do
not go the extra mile to locate defective products and communicate with
consumers quickly and thoroughly are budget-constrained, but more likely,
they are too focused on direct costs.
Mattel 10-Q, September, 2007
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