What role does your company’s inventory holding costs play in your restocking fees on product returns? Do you track your product’s average number of days held before it's sold, and then use your holding costs to determine your company’s fee for accepting a customer return? Perhaps you’ve not yet taken the time to define your company’s restocking fees, or are unsure of what criteria should be used.
While there are varying opinions on how to implement fees for returning product, I’m going to put forth the argument that restocking fees must be based on your company’s costs to hold inventory and ultimately, must provide some way to recoup those costs.
The Importance of Charging Restocking Fees
When thinking of your company’s inventory holding costs, think all those support costs associated with managing and holding inventory for extended periods. Think of inventory damage and obsolescence, the cost of money, the high costs of ruined inventory, your electricity and warehousing costs, your per-unit freight costs on incoming and outgoing shipments of materials, parts and finished products and ultimately, your costs of overtime to receive and ship out urgent customer orders. In essence, any cost that can directly be attributed to inventory, can be classified as a cost of inventory.
It’s the reason why the longer inventory is held, the more expensive it becomes. Therefore, if time plays a role in increasing your company’s holding costs of inventory, then these costs must play a role in your company’s restocking fees. In the end, it means you must account for the initial holding costs on the first sale and the holding costs once the product is returned. So, how is this done?
The Restocking Fee Calculation:
{(Inventory Holding Cost) + (Inventory Holding Cost)}* Company Overhead Percentage
1. Determine Number of Days Inventory Was Held Before it was Sold
It’s essential to track your average number of days inventory is held for every product sold by your company. Most know this as a product's inventory turnover rate. This forms the basis of being able to determine your inventory holding costs by product line, and ultimately, your restocking fees. Some products will have a high turnover rate and sell quickly, while others will take longer to sell and have a lower turnover rate. Segregate your product lines into categories based on these rates. Products that have high turnover will have a low restocking fee, and those products with a low turnover will have a higher restocking fee. This helps to reward customers for purchasing your fastest moving inventory while charging them a little more for those products that take longer to sell.
2. Apply 3% Monthly Inventory Holding Cost by Product Category
Most companies apply a standard 3% inventory holding cost for each month product is held and not sold. This 3% is made up of those aforementioned cost drivers of inventory obsolescence, damage, financing, etc. Multiply this 3% monthly inventory holding costs by the product line’s COGS (Cost of Goods Sold).
For example, let's assume a company has a product whose COGS are $2,500.00. Its monthly holding costs would be $75.00 ($2,500.00 x 3%), but in our example, the inventory is only held for 10 days before being sold. As such, the inventory holding costs are $25.00, or one third the monthly costs. However, this only takes care of the costs to hold the product before it was sold. It doesn't take care fo the costs of the product return. Again, once the product is returned, your company will hold the product for the same 10 days before selling it again. Therefore, we double the holding costs to $50.00.
3. Cover Freight & Overhead Costs
Your customer must be willing to cover the cost of freight to return the product. In addition, any costs pertaining to packaging, invoicing and customer service must also be captured. When thinking of these costs, think of your indirect costs of operations. Better yet, think of your company's overhead percentage.
Your overhead represents your costs that are above and beyond your direct costs to manufacture a given product. More importantly, overhead covers your ancillary support costs - those that were involved in completing the customer's order. Take your company's overhead percentage and multiply it by your holding costs. Here is what the restocking fee calculation looks like.
Restocking Fee: {(Inventory Holding Cost) + (Inventory Holding Cost)}* Company Overhead Percentage
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Inventory Holding Cost: $50.00
- Company's Overhead Percentage: 50%
- Restocking Fee: (Inventory Holding Cost) + ({Inventory Holding Costs} * Company Overhead Percentage)
- Restocking Fee: ($50.00) + ($50.00 * 50%)
- Restocking Fee ($50.00) + ($25.00) = $75.00 Restocking Fee
"The above restocking fee only represents 3% of the product’s COGS of $2,500.00. To some, this might not be enough, or is it?"
Is this Approach Too Lenient?
Some may argue that this approach is far too lenient and instead prefer to charge customers a straight 15% to 25% restocking fee on the product’s sales total. However, this is far too strict and doesn’t lend itself well to managing customer relationships. There are all kinds of reasons customers may choose to return a given product, and not all of them have to do with trying to take advantage of your company. Your focus must be on assigning a cost that is both fair and representative of your company’s holding costs.
Your restocking fees must be higher for those products where your holding costs are higher and lower for those products that sell quickly. Make sure your restocking fees are representative of your product's category.
Granted, it’s never easy to accept returned product. Your company can’t simply take product back without charging a restocking fee. Also, if you covered freight as a service to your customer's location, then you should include this as a portion of your restocking fee. However, that fee shouldn’t be so exorbitant that it causes friction between you and your customer.
Those companies that advocate a strict 15%-25% restocking fee do it regardless of their product’s turnover rate. Some claim this percentage is warranted when factoring in the company’s freight costs, processing time, invoicing etc. However, the whole purpose of using a restocking fee is to cover your direct inventory holding costs, your lost opportunity costs and to cover a portion of your overhead and support costs. This approach may seem simplistic, but a restocking fee is just another way to cover your cost drivers and assign some responsibility for customer returns.
To read more about the 3% monthly inventory holding cost, please read: Sample Inventory Costing Excel Sheet: Graph & Pie-Chart of Expenditures
To read more about determining your company's overhead rate & percentage, please read: Calculating Overhead Rate & Percentage for Small Businesses
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