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Economics of Fraud

TL;DR
  • Total fraud cost = Direct loss + chargeback fees + review labor + tool costs + program fees
  • False positive cost often exceeds fraud loss—blocked legitimate transactions = lost revenue + lost customers
  • Goal: minimize net fraud cost (fraud loss + false positive loss + prevention cost), not just fraud rate
  • A balanced approach typically outperforms both aggressive and permissive strategies
  • See Risk Appetite for tolerance framework

The true cost of fraud, and the cost of prevention.

The Full Cost of Fraud​

Fraud cost extends far beyond the direct dollar loss:

Total Fraud Cost = Direct Loss + Operational Cost + Chargeback Fees + Recovery Cost

Direct Loss Components​

ComponentDescriptionTypical %
Transaction AmountThe fraudulent purchase value100%
Product/Service CostYour COGS on the fraud30-70%
ShippingFulfillment cost (if applicable)5-15%
Payment FeesInterchange, processor fees2-3%

Indirect Costs​

ComponentDescriptionTypical Cost
Chargeback FeePer-dispute processor fee$15-100
Review LaborManual investigation time$5-20/case
Tool/Vendor CostFraud prevention stack0.1-0.5% of volume
Program FeesNetwork monitoring programs$10-25K/month

The False Positive Problem​

Hidden Cost

False positive cost often exceeds fraud loss cost.

Calculating False Positive Cost​

FP Cost = Blocked Good Transactions × Average Order Value × Gross Margin

Example:

  • 1,000 transactions blocked
  • 70% were actually legitimate (700 false positives)
  • $100 average order value
  • 40% gross margin
  • FP Cost = 700 × $100 × 40% = $28,000

The Trade-off​

ApproachFraud LossFalse Positive LossTotal Loss
Very Aggressive$5,000$50,000$55,000
Balanced$15,000$15,000$30,000
Very Permissive$40,000$2,000$42,000

Optimizing the Trade-off​

Key Levers​

  1. Improve model precision – Better targeting reduces both fraud and FPs
  2. Segment your rules – Different risk tolerance by customer segment
  3. Use friction wisely – Step-up auth instead of hard blocks
  4. Invest in review – Manual review for gray zone, not auto-decline

Measuring Success​

Track Net Fraud Cost:

Net Fraud Cost = Fraud Loss + False Positive Loss + Prevention Cost

Goal: Minimize net fraud cost, not just fraud rate.

Next Steps​

Calculating your fraud costs?

  1. Add up full costs - Include indirect costs
  2. Calculate false positive cost - Often the bigger problem
  3. Find your trade-off sweet spot - Balance both sides

Optimizing the trade-off?

  1. Define risk appetite - Set clear targets
  2. Improve model precision - Better targeting
  3. Use step-up auth - Friction where needed

Measuring success?

  1. Track net fraud cost - Not just fraud rate
  2. Review fraud metrics - Full picture
  3. Compare to benchmarks - Industry standards