October 31, 2012, 2:21 PM

How Karmaloop cleaned up chargebacks

The retailer found the lowest chargeback rate isn’t always best.

Lead Photo

After slashing its chargeback rate, Karmaloop, an e-retailer of “streetwear” apparel and accessories for youthful buyers, found that a higher rate would boost sales while still keeping a lid on fraud.

Several years ago, the online retailer’s chargeback rate hit between 2% and 3% of orders, a level that put it in jeopardy of triggering penalties from payment card companies and even losing its ability to accept major credit cards like Visa and MasterCard.

“The credit card companies come down hard on you,” says Bounthay Khammanyvong, the retailer’s vice president of operations. But the steps that can cut a chargeback rate can also cut into sales, he adds. “It’s a double-edge sword. If you want to keep the chargeback rate low, you have to cancel more orders. But if you keep it too low, you can also cancel too many good orders.”

Chargebacks are payment transactions that credit card companies like Visa and MasterCard reverse, taking the funds from a merchant’s account. Typically this occurs after a card holder denies making the purchase or claims the products were damaged or otherwise faulty, and the card companies conclude that the merchant was at fault.

In 2008, Karmaloop, No. 138 in the Internet Retailer Top 500, started working with payment security technology and services firm Retail Decisions plc, and put in place a program that sharply reduced its chargeback rate to less than 1%. Using the security vendor’s ReD Shield software, Karmaloop automatically scored each payment transaction for its level of risk: the score goes up with each suspicious activity, such as when a customer requests shipping to an address separate from the billing address, or logs on from an IP address in a country known for fraudulent transactions.

Once a risk score reaches a certain number, Karmaloop temporarily holds a transaction for manual review. A member of Karmaloop’s risk management team then attempts to contact the cardholder to determine if there is a legitimate reason for any activity that raised a warning flag, such as that different billing and shipping addresses stemmed from a cardholder’s purchase of a gift for someone in another city. ReD Shield automatically blocks other transactions, such as ones made with a credit card already recorded as having made past fraudulent transactions.

But getting the chargeback rate down to under 1% wasn’t an ideal result, Khammanyvong says. In fact, the rate was too low, he adds, and resulted in a drop in sales as well as chargebacks.

By the time the chargeback rate dipped to a low of 0.11% in early 2011, Karmaloop was noticing a coinciding drop in sales. The retailer concluded that its risk management program was probably blocking too many good transactions along with the bad ones, Khammanyvong says.

Indeed, Karmaloop found that many of the transactions it was blocking turned out not to be the work of professional thieves but of young people using their parents’ credit cards without permission. The retailer responded to this “friendly fraud” by calling the cardholder during the manual review process; typically the parent either agrees to pay for the goods or returns them, Khammanyvong says.

The retailer determined that it maximized its profit at a point where the chargeback rate was higher than 0.11%, but still well within the expectations set by the credit card companies. After reviewing transaction and sales data in ReD Shield and its order management system, Khammanyvong set a target chargeback rate of 0.25% of orders. “We determined that if we moved the chargeback rate up to 0.25%, we’d make more money,” he says. “And now we’re getting more sales.”

To hit the 0.25% chargeback rate, Karmaloop used the ReD Shield software and advice from ReD security experts to adjust its risk scores, approving more transactions without holding them for manual review. Khammanyvong declines to say how much sales have increased since adjusting the chargeback target, but says Karmaloop has been able to maintain the 0.25% chargeback rate since early 2011.

More information on e-payment management and security companies can be found here

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