Amir Heiman, Bruce McWilliams, Jinhua Zhao, and David Zilberman

The money-back guarantee (MBG) is a guarantee offered by retailers or manufacturers to buyers, ensuring that a buyer can return a purchased product to the store or manufacturer within a specified period for a refund or for in-store credit. MBGs are particularly effective in helping customers identify whether the product fits their particular needs. For example, providing an MBG on a dress allows the customer to take the product home, see if it fits with other elements of her wardrobe, and get feedback from others about whether the dress looks good on her or not.

Previous research has examined the role of MBGs in increasing demand by reducing consumer risk, or has characterized MBGs as a means of signaling to customers that a product, or the store in which it is purchased, is high quality. This research extends the risk-reduction literature by modeling the MBG as a put option. A put option is a financial instrument that guarantees the holder of the option the right to sell asset at a predetermined price, which is what the MBG does for the buyer of a consumer good. Using this financial option framework allows us to consider the basic price of the product and the price of the MBG return option independently under various market conditions. This means that a retailer can consider "unbundling" the MBG contract from the product, offering the MBG only to customers that are willing to pay for it, just as extended warranties are currently offered in many electronic products to customers that are willing to pay for them.

The value of an MBG option to the consumer depends on several factors. The lower the likelihood of product fit and the higher the price of the product, the greater is the value of the return option. A longer return period for accepting MBGs increases the option value, while offering customers in-store opportunities to test the product reduces the option value.

We analyze three potential retailer return policies: no MBG, bundled MBG and unbundled MBG. In the bundled case, the customer automatically gets an MBG when purchasing the product, whereas in the unbundled case, the customer first purchases the product and then decides whether to purchase an MBG for the product.

We model demand when consumers are heterogeneous with respect to both product valuation and probability of fit. When no MBG is offered, customers with high valuations and medium-to-high probability of fit, as well as customers with medium valuation and very high likelihood of fit will purchase the product. If a bundled MBG is offered, it will necessarily come at a higher price, eliminating demand from many of the customers with medium valuation, but allowing customers with high valuation but low likelihood of fit to purchase the product.

The third policy, the unbundled MBG, essentially allows the seller to charge two separate prices: the base product price to customers that have a high probability of fit, and a higher price that includes payment for the MBG contract to customers that have a lower probability of fit. This pricing policy allows the seller of the unbundled MBG to capture customers with medium valuation and high fit (buying without an MBG) as well as those with high valuation and low fit (buying with an MBG), thereby covering a broader range of consumers than do the no MBG or bundled MBG policies.

Simulation analysis reveals that for the retailers, if return costs are not excessive, the unbundled MBG is the best policy to adopt when customers vary greatly both in their probability of fit and in their product valuation. When consumers consistently perceive a high probability of product fit or when either seller or buyer return costs are very large, the optimal retailer policy is to offer no MBG for the product. Finally, if there is very little variation in consumer valuation of the product but consumers vary greatly in their probability of fit, the optimal retailer policy is to offer the bundled MBG and charge a price close to the consumers' valuation.

There are few examples of explicitly unbundled MBG contracts in the US market due possibly to retailer desire to create a simple and uniform storewide policy for returns and meet consumer expectations that no additional charges should be made for MBGs. Nevertheless, the analysis in this research suggests that unbundled MBG contracts should be considered in high-priced product categories where product valuation and purchase confidence vary greatly from one consumer to the next. Such contracts may benefit both consumers with different preferences as well as the retailer.

Real world examples are offered of either implicit or explicit MBG unbundling of products. Implicit MBG unbundling is observed when retailers occasionally offer products on sale without the MBG option. Music stores that rent out instruments with the future option to purchase are essentially offering a MBG, and have a lower price for customers that purchase the product outright. An explicit example of unbundled MBG contracts is that fertility clinics charge different prices for one-time treatments and for guaranteed outcomes. These and other examples show how the unbundled MBG has been modified for use in different product categories.