How Does Product Recovery Affect Quality Choice?

1. How Does Product Recovery Affect Quality Choice? Gil Souza, Indiana University (with AtalayAtasu, Georgia Tech) Presented at: Quality Choice and Product Recovery - Atasu & Souza

2. Some Self Promotion • Released in April 2010 • Self contained chapters • Written with managers in mind • Can be used in MBA classroom Quality Choice and Product Recovery - Atasu & Souza

3. Agenda • Strategic vs. tactical decisions on CLSCs • Example of a Strategic Problem: Network Design • Motivation: examples of firms that practice product recovery and how that impacts their product quality design • Research question • Related literature • Model structure and basic assumptions • Structural results • Extension 1: Competition • Extension 2: Differentiated remanufacturing • Conclusion Quality Choice and Product Recovery - Atasu & Souza

4. Strategic vs. Tactical Decisions in CLSCs Quality Choice and Product Recovery - Atasu & Souza

5. Example of Network Design Problem: Consumer Returns at HPWhy Do Consumers Return Products? Gil C. Souza 5

6. What Happens to Commercial Returns? Factory Distributor Retailer Sales Returns New returns • Large delays in reverse chain (e.g., 60-90 days for remanuf. of printers) • This is critical for time-sensitive returns (e.g. printers) Returns Evaluation of returns Secondary market Remanufacturing Sales Disposal Gil C. Souza 6

7. Queuing Network Model of Commercial Product Returns Supply Chain Factory Distributor Retailer f d s Sales pr e r c Evaluation of returns Customer Returns Sales to secondary market Remanufacturing m 2 Consumption Note: Nodes are modeled as queues p = proportion of “new” returns  = net demand rate (demand per day) r = returns rate i = processing rate at node i Reverse chain: M/M/1 queues Forward chain: M/G/ queues Gil C. Souza 7

8. HP Deskjet Printers: Value of One Day • Large opportunities in the reverse network because of existing delays  a reduction of current 40-day delays to 20-day delays implies $1.5 million savings over life cycle of printer! Gil C. Souza 8

9. Bosch Power Tools: Value of One Day • Number are much lower than HP’s (particularly considering very long life cycles for power tools) • It is clear that Bosch needs an efficient reverse supply chain, whereas HP needs a responsive reverse supply chain

10. Quality Choice and Product Recovery: The Interface Between Product Recovery and Product Design Quality Choice and Product Recovery - Atasu & Souza

11. Motivation 1: Undifferentiated Remanufacturing - Xerox • Newly manufactured copiers contain a significant amount of remanufactured modules • We denote this case here a “remanufactured” copier • A higher quality module (e.g., faster paper feeding) increases a consumer’s WTP for the product (but more expensive to produce) • If Xerox can remanufacture that module (when the product comes back), it can decrease its average production cost for the product Finishing Module Paper Input Module Imaging Module Xerox iGEN 3 Quality Choice and Product Recovery - Atasu & Souza

12. Before Remanufacturing After Remanufacturing Motivation 2: Differentiated Remanufacturing (Cummins) • Remanufactured engines (or parts) are sold at an average discount of 35% relative to new - imperfect substitutes for new engines (or parts) • A more powerful turbocharger, for example, increases consumers’ WTP for the engine but that turbocharger is more expensive to produce • If Cummins can remanufacture the turbocharger, it can reduce its average remanufacturing cost for the engine • Cummins said that remanufacturability impacts product design Quality Choice and Product Recovery - Atasu & Souza

13. Motivation 3: Recycling • Costly recycling: European Recycling Platform (ERP, a consortium founded by HP, Sony, Braun and Electrolux) pays 7.5¢/kg to recycle small appliances in Europe • Recycling here mandated by take-back legislation • The link between design quality and recycling is the sales volume of new appliances • Example: increasing quality increases WTP; you may then increase prices, reducing sales volume (and consequently future recycling volume & associated costs) • Profitable recycling • Cell phones recycling can be profitable (Geyer and Doctori Blass 2009) Quality Choice and Product Recovery - Atasu & Souza

14. Research Question • Take-back and reprocessing (recycling or remanufacturing) of used products by an OEM is driven by two factors: • Take-back legislation (mandated) • Value recovery (mostly economic reasons) • How does the possibility of product recovery impacts the design quality of a product? • Quality here is interpreted as an observable performance measure that increases consumers’ valuation for the product Quality Choice and Product Recovery - Atasu & Souza

15. Related Literature • Closed-loop supply chains: why engage in remanufacturing? • Atasu et al. (MS 2008), Debo et al. (MS 2005), Ferguson and Toktay (POM 2006), Guide & Van Wassenhove (OR 2009), Hauser & Lund (2003) • Closed-loop supply chains: economic impact of take-back legislation on product design • Atasu & Subramanian (2009), Plambeck & Wang (MS 2009) • Our paper differs here in that our design variable is quality—it impacts consumer valuation for new product • Marketing: quality choice models • Mussa & Rosen (1978), Moorthy (1988), Desai (2001) • Difference is that we consider product recovery Quality Choice and Product Recovery - Atasu & Souza

16. Model: Basic Assumptions • Monopolist, single period, single product • We consider duopoly extension later • Single period: slice of a “steady-state” infinite horizon • Consumer’s valuation for quality  ~ U[0,1] Consumers with positive utility u  0 Market size = 1 Net utility Quality Price Consumer type 1 0 Quality Choice and Product Recovery - Atasu & Souza

17. Three Recovery Types • Quality recovery: quality inducing components are recovered and (re)sold again. Profitable. Typical example: remanufacturing • Profitable material recovery: recovery of quality inducing components not possible, but recovery overall is profitable. Typical example: profitable recycling [of cell phones] • Costly recovery: recovery overall is not profitable; mostly done due to legislation. Typical example: costly recycling [WEEE] Quality Choice and Product Recovery - Atasu & Souza

18. Basic Assumptions II: Recovery • A fraction  (exogenous or decision variable) of total products sold (in previous period) can be recovered • If recovery is in the form of quality recovery: •  is the fraction of demand q met with recovered products (1 -  is fraction of demand met with new) • This is the undifferentiated remanufacturing case • We have extended the model to the differentiated remanufacturing case; later • If recovery is in the form of recycling (costly or profitable) • All demand q is met with new products •  is proportion of end-of-use products q recycled Quality Choice and Product Recovery - Atasu & Souza

19. Basic Assumptions III: Costs (Quality Recovery case) • Unit variable cost of producing a brand new product with quality s is (Moorthy 1988): • Average variable cost of production to meet total demand q with recovery level t is • Where is average cost of quality with recovery • r is cost savings from remanufacturing of quality-inducing components • n is remanufacturing cost that is independent of the quality choice Quality Choice and Product Recovery - Atasu & Souza

20. Basic Assumptions IV: Costs (Recycling case) • Recycling can be thought of a particular case of remanufacturing where r = 0 (no quality recovery) • That means and thus avg cost is • If recycling is profitable, n < 0 • If recycling is costly, n > 0 Quality Choice and Product Recovery - Atasu & Souza

21. Basic Assumptions V: Additional Convex Increasing Collection Cost • Literature suggests diseconomies of scale in recovery costs as recovery volume increases (Ferguson and Toktay 2006) • We also have empirical evidence from two data sets North American Chemical Company European Consumer Electronics Firm Quality Choice and Product Recovery - Atasu & Souza

22. Our General Model Is Then: Firm chooses Price p Quality s Collection rate  Convex collection (recovery) cost Avg cost of production Non-negative sales quantity Non-negative price Logical constraint Notation reminder Quality Choice and Product Recovery - Atasu & Souza

23. Benchmark Result: No Recovery (Moorthy 1988) Quality Choice and Product Recovery - Atasu & Souza

24. Result 1.1 (Legislation Case:  Exogenous) • The optimal quality level with quality recovery or costly recycling (n > 0) is higher than the non-recovery case: • Due to take-back costs, take-back legislation provides an incentive for firms to increase the quality of their products: they are able to charge higher prices, decreasing consumption (and thus environmental impact) Quality Choice and Product Recovery - Atasu & Souza

25. Result 1.2 (Legislation Case:  Exogenous) • The optimal quality level with profitable recycling (n < 0) is: • Higher than the non-recovery case ( ) if • Lower than the non-recovery case ( ) if • With profitable recycling and low enough , collection costs are low enough so that recycling overall is profitable • Firm has an incentive to choose a lower quality level, charge a lower price, and sell more • With high enough , legislation accomplishes its goals of reducing environmental impact through higher quality products, lower consumption Quality Choice and Product Recovery - Atasu & Souza

26. Result 2.1 (No Legislation Case:  is a Decision) • The optimal quality level with quality recovery is no lower than the non-recovery case: • With costly recycling, • Only difference from the case with take-back legislation (exogenous ) is that for high enough recovery cost n, the optimal collection rate is zero ( ), implying Quality Choice and Product Recovery - Atasu & Souza

27. Result 2.2 (No Legislation Case:  is a Decision) • The optimal quality level with profitable recycling (n < 0) is: • Same as non-recovery case ( ) if • Lower than the non-recovery case ( ) if • Bottom line: for any type of product recovery, regulated markets for product recovery (setting a minimum recovery rate ) perform better—higher product quality, lower consumption—than in unregulated markets Quality Choice and Product Recovery - Atasu & Souza

28. Environmental Impact of During Life Cycle with Recovery • Denote ex as environmental impact per unit during product life cycle stage x. • Production: new + rem. • Use: • End of life: fraction going to landfill = • Total environmental impact • EI = production + use + end-of-life Increasing in q and decreasing in  Quality Choice and Product Recovery - Atasu & Souza

29. Environmental Benefits of Recovery Compared to No-Recovery Case Remember that consumption (q) is always lower under quality recovery and costly recycling, but higher under profitable recycling Quality Choice and Product Recovery - Atasu & Souza

30. Impact on Consumer Surplus ( = 0) Consumers who buy Consumer surplus and manufacturer’s profits are aligned (if collection costs are linear in recovery rate) 1 0 Quality Choice and Product Recovery - Atasu & Souza

31. Extension 1: Duopoly • Consider two identical firms with the same cost structure • One possible equilibrium is symmetric: firms price at marginal cost, and obtain zero profit • We focus on asymmetric case, where one firm chooses a high quality (sh) at price ph, and the other a low quality (sl) at price pl • Thus, consumer of type  gets utility from firm i Quality Choice and Product Recovery - Atasu & Souza

32. Quantities Sold By Each Firm 0 1 Consumer type θ Quality Choice and Product Recovery - Atasu & Souza

33. Problem Faced by Each Firm i Again, solve sequentially: for given si and sj, each firm optimizes its prices. Then, substitute pi(si,sj) into above, and find optimal si, sj Quality Choice and Product Recovery - Atasu & Souza

34. Results • Can find closed form expressions for prices as a function of qualities • However, solution of optimal quality levels can only be found numerically • Results confirm monopoly results • With quality recovery or costly recycling, both firms chose a quality level that is higher than under no recovery: s* > sNR • Quality level can be lower than no-recovery case if recovery is in the form of profitable recycling • Firm’s profits (and consumer surplus) are higher than no-recovery case with profitable recovery Quality Choice and Product Recovery - Atasu & Souza

35. Impact of Recovery on Firm Quality under Competition Quality of high-quality firm Quality recovery Quality gap between firms increases with recovery Costly recovery Profitable material recovery Quality gap between firms decreases with recovery Quality of low-quality firm Quality Choice and Product Recovery - Atasu & Souza

36. Extension 2: Differentiated Remanufacturing (Quality Recovery) Consumer’s utility for a new product of quality s and price pn Consumer’s utility for a product of quality s that is remanufactured and sold at price pr Where  is the consumer’s perceived “quality gap” between a new and remanufactured product. This results in: Quality Choice and Product Recovery - Atasu & Souza

37. Optimization Problem: Differentiated Remanufacturing Can show that, just like in the undifferentiated remanufacturing case: Quality Choice and Product Recovery - Atasu & Souza

38. Conclusions: Impact of Product Recovery on Quality Choice • Firms typically design products with higher quality when there is product recovery (compared to the case of no recovery) • Exception occurs if there is profitable material recovery at relatively lower recovery rates mandated by legislation • Results are robust Quality Choice and Product Recovery - Atasu & Souza