Analysis of optimal defective allowance policies for reducing product returns under alternative modeling of consumer behavior

Motivated by the challenges of managing returns of products with cosmetic defects at a home appliances manufacturer, we investigate the establishment of a defective allowance policy as a strategy to encourage consumers to avoid returning defective products. By offering a discount to consumers, the manufacturer can achieve cost savings by avoiding replacement expenses, including those related to returns handling and transportation. To our knowledge, this study is the first to analytically determine the optimal discount rate that a manufacturer should offer is such cases. We explore various models of consumer response to discounts and analyze their impact on both the optimal decisions and the financial outcomes of the defective allowance policy. Our findings indicate that simplistic consumer behavior models may reduce policy's effectiveness and underestimate its benefits, potentially deterring manufacturers from adopting such policies. Additionally, we examine differences in the optimal discount policy across product categories that differ in manufacturing cost, remaining value, handling and transportation costs, and price. Our analysis indicates that the ratio of replacement cost to product price plays a critical role in determining the optimal discount. Also, we find that product price exerts a greater influence on the optimal discount rate, whereas the impact of replacement costs depends on the price level: for high-priced products, these costs have negligible effect on the discount, whereas for low-priced products, these costs affect the optimal discount rate. Additionally, for lower-priced products, improved financial benefits are observed. Our analysis further suggests that accurately modeling consumer behavior and precisely determining the optimal discount rate are essential for maximizing the benefits of a defective allowance policy.