Company Costs of a Product Recall: Incentives to Fix or Ignore Recall Effectiveness Problems (Full Post)

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

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.

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. [1]

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.[2] 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.