A product recall is the process of retrieving and replacing defective goods for consumers. When a company issues a recall, the company or manufacturer absorbs the cost of replacing and fixing defective products. For large companies, the costs of repairing faulty merchandise can accumulate to multi-billion dollar losses.

Recently, car manufacturers Toyota (TM), General Motors (GM), and Honda (HMC) have suffered the embarrassing consequences of product recalls. In addition to the automobile industry, product recalls have also occurred in the food, medicine and consumer electronics industries.

The lasting financial effects most severely impact small companies. Smaller operations without robust cash flow and brand recognition generally cannot sustain the financial losses and brand degradation associated with a product recall. However, large enterprises are able to withstand the short term effects and rarely suffer long-term financial consequences.

Notable Historical Recalls

Public confidence that purchases of goods and services operate correctly and safely has a major influence on consumerism in America. It is the responsibility of a number of government agencies to test and recognize faulty products. These agencies include the Consumer Product Safety Commission (CPSC), Food and Drug Administration (FDA), and National Highway Traffic Safety Administration (NHTSA), to name a few. In the event an unsafe or defective product has been released to the public, a recall is issued by the supplier.

In the early 2000s Ford (F) issued a recall of 6.5 million vehicles with Firestone tires. The defective tires resulted in 1,400 complaints, 240 injures, and 90 deaths in the U.S. Likewise, Toyota has issued a number of massive recalls beginning in 2009, ultimately recalling over 10 million vehicles due to numerous issues including gas pedals that stuck and faulty airbags.

The drug industry has also suffered from devastating recalls. In the early 2000s, the drug manufacturer Merck (MRK) recalled arthritis medication Vioxx, which increased the risk of heart attacks. The drug cost Merck $4.85 billion in settled claims and lawsuits.

Recently Keurig, a coffee machine manufacturer, recalled 7.2 million single-service brewing machines due to claims of overheating. Regardless of the industry in which the recall occurs, it is evident that large companies are able to withstand both financial and reputation costs. (For more, see: 5 Most Costly Product Recalls.)

Financial Implications

As a result of consumer protection laws, manufacturers and suppliers must bear the costs of a product recall. Though insurance may cover a minimal amount to replace defective products, a majority of product recalls result in lawsuits. Between lost sales, replacement costs, government sanctions, and lawsuits, a significant recall can become a multi-billion dollar ordeal. For multi-billion dollar companies, an expensive short-term loss can be easily overcome, but when shareholders and customers lose confidence, there may be greater long-term effects such as plummeting stock prices.

Toyota’s recent stream of gas pedal recalls resulted in a $2 billion loss consisting of repair expenses and lost sales. In conjunction with the financial crisis, Toyota’s stock prices dropped more than 20 percent or $35 billion.

Likewise, Keurig saw a 2.2 percent fall in stock prices in light of the 7.2 million coffee machine recall.

Causes 

With quicker and more efficient means of transportation, the global supply chain has witnessed unprecedented transformation. A number of everyday products contain parts manufactured from around the world. In an attempt to remain competitive, companies have increased global supply chains, offshoring and outsourcing at the cost of product reliability.

For example, Apple (AAPL) iPhones can be broken down to hardware, casing, and assembly from Mongolia, China, Korea, and Europe. The final product, however, must comply with regulations in the country in which it is sold. 

Recovery

Sometimes, the financial and reputation impact of a product recall are insurmountable. Many small companies have declared bankruptcy as a result of defective merchandise. Larger corporations with more flexibility must work quickly to maintain customer loyalty and, most importantly, shareholder confidence.

Taking responsibility and fast action are the safest ways to save brand recognition from product recalls. While settlement claims and repair expenses can be robust, a decrease in stock prices will have longer lasting effects.

The Bottom Line

The effects of a product recall may be detrimental in the short run, but there is no evidence to support long-lasting decreases in sales or stock prices. Leaders in their respective industries, Toyota and Merck have witnessed brief financial consequences as a result of product recalls. Still, long-term trends indicate both companies' brands and stock prices have recovered.

With the supervision of government agencies, product recalls seem to have become almost weekly occurrences. This may be attributed to the increasing complexity of the global supply chain. To cut costs and remain competitive, modern merchandise incorporates manufactured parts from around the world, sometimes at the cost of reliability.