Boxing Day: The $816bn problem of returned presents

The National Retail Federation expects US consumers to return about $816 billion of merchandise in 2022, and the post-holiday flood of returns is where retail margins go to die. After a peak season built on heavy discounting, the bill is arriving. Retailers have long treated returns as a cost of winning customers, but the economics of reverse logistics have turned toxic. With diesel dear, warehouse wages rising and stockrooms already overfull, processing a returned sweater or gadget often costs more than the item is still worth.

Reverse logistics is an operational headache. Outbound goods travel in bulk on pallets from central hubs to stores. Returns come back as scattered single parcels, each of which has to be inspected, repackaged, tested and restocked by hand.

How free returns spread

Generous return policies were a weapon in the fight to move shoppers online. Buying clothes without trying them on was a hard sell until online sellers promised that sending them back would cost nothing. The pandemic then pushed millions of new customers onto websites at once, and habits such as ordering the same item in three sizes and keeping one became normal. The business grew large enough to attract specialists: PayPal agreed to buy Happy Returns, a start-up that consolidates returned parcels, in 2021.

Those habits were formed when freight was cheap and money cost nothing. Both conditions have gone, and the policies have not yet caught up. American diesel prices hit record highs above $5 a gallon this year, and the big parcel carriers have announced further rate increases for next year, so every leg of a return trip costs more than it did when the policies were written.

Returns eat the profit

Industry estimates put the cost of processing a return at twenty to thirty per cent of the item's original price. Online return rates often exceed 25 per cent, against 8 per cent for physical stores, and at those rates the returns pipeline can wipe out the operating margin on the original sale.

The arithmetic is brutal for apparel. A dress sold online at full price carries a thin operating margin after shipping and marketing. If one in four comes back and each return costs a fifth or more of the price to handle, the retailer has spent the profit on the three that stayed before counting any markdown on the one that did not.

Retailers are caught in a prisoner's dilemma. Scrapping free returns or charging restocking fees drives away fussy shoppers who have got used to treating their living rooms as fitting rooms. Carrying on paying for return freight hurts cash flow just as debt service costs are climbing.

Refunds leave before stock returns

The cash timing makes things worse. A shopper who returns a parcel is usually refunded within days, while the item may sit in a processing queue for weeks before it can be sold again. In the busiest weeks of January, retailers are paying out cash for goods that are, in effect, in transit to nowhere in particular.

The accounting will expose any misjudgement quickly. Under current rules retailers record sales net of the returns they expect, booking a refund liability at the point of sale. If January returns run above those estimates, the difference comes straight out of fourth-quarter revenue and margins, which is why the first trading updates of the new year matter more than usual.

Sold for salvage

Worse, seasonal goods returned in January often come back too late to sell at full price. Merchants end up selling pallets to off-price salvage buyers for pennies on the dollar, or writing them off altogether.

That means the retail inventory overhang of 2022 will drag on well into the first half of 2023. The overhang is already large: Target and Walmart spent much of this year cutting prices to clear stock they had over-ordered, and returned Christmas goods land on top of that surplus.

Some businesses do well from the glut. Liquidators and off-price chains such as TJX and Ross Stores are the natural buyers of other retailers' surplus, and a market flooded with returned and excess stock lets them buy branded goods cheaply. Their gain is a transfer from the full-price sellers who over-ordered and over-promised.

Someone has to blink first

Some already have. Zara began charging British customers for returning online orders by post this year, and several other clothing retailers have introduced fees or shortened return windows. The argument against following them is serious. Free returns raise conversion rates, and a shopper who returns easily often buys again, so the true cost is partly a marketing expense that wins lifetime spending.

Large platforms with dense logistics networks can also process returns far more cheaply than a mid-sized chain, and may use generous policies to take market share from weaker rivals. That argument favours the biggest sellers and hurts everyone else. Mid-sized apparel and electronics retailers, without the scale to recycle returns cheaply, are the most exposed.

What to watch in January

The evidence will come in January trading updates and fourth-quarter results in February and March, where gross margins, inventory write-downs and any change to return policies will show who is absorbing the cost. A retailer that reports higher sales alongside falling gross margin is probably paying for its returns; one that shortens its return window or adds a fee is telling investors it has done the sums.

E-commerce was built on free and easy returns, and at today's costs, retailers that keep paying for shoppers' indecision will watch it eat their margins through the first half of 2023. Restocking fees and stingier return policies will probably spread to most mid-sized chains before next Christmas.