Service Escape: Profiting from Customer Cancellations

Abstract

This paper explores the benefits of letting customers escape from pre-purchased service contracts by offering refunds for cancellations. We show that such a policy creates opportunities for multiple selling in a capacity-constrained service - i.e., collecting cancellation fees from advance buyers who cancel, and then reselling the freed slots. The better the alternative that motivates a cancellation, the more profitable is a refund-for-cancellations policy compared with a no-refund policy that "locks-in" customers. Such refunds can be profitable even when the cancelled unit has to be resold at a lower price and even when advance buyers would be willing to abandon the service for no refund.

In contrast to previous research on money-back guarantees for durable goods, we show that offering refunds for service cancellations can be profitable without charging a higher price compared with a no-refund policy, and motivates service providers to decrease rather than increase the hassle cost associated with customer cancellations. Our research complements the extant theory on advance-selling by suggesting a new profit advantage of advance selling: capturing some of the consumer-added surplus that is created when customers find new alternatives (i.e., when finding attractive alternatives, customers are willing to pay a fee to terminate the pre-purchased contract) - a profit potential that is not possible under a spot selling strategy. Finally, research on yield-management typically assumes exogenous "no-shows" by advance buyers. We model customer cancellations as endogenous and show that offering refunds for cancellation reduces the need to reserve capacity for high-paying customers and improves capacity utilization.

Keywords: Cancellations, refund, pricing, yield management, advance selling, service, money-back guarantees

JEL Classification: D4, D8, D82, M37