Natural resource scarcity has accelerated considerations of return logistics in manufacturing processes. Most supply chain designs now consider a closed-loop design where demand can be satisfied by both newly manufactured goods as well as remanufactured returns, allowing for maximum value creation over the entire life cycle of a product. This paper proposes an inventory system where returns are constrained and returns that cannot be remanufactured to an as-good-as-new state of the original product can be used to satisfy a secondary demand. It is also assumed that some items fail during manufacturing and these items are treated as returns that can be remanufactured to satisfy one of two types of demand. Returns are remanufactured to one of two states such that items that may not be remanufactured to an as-good-as-new state of the first product can satisfy a secondary customer demand at a lower grade. The remanufacturing processes require some other components to be procured in order to bring the returned items back to either of the two states of reuse. A modified Wagner/Whitin model for the alternate application of remanufacturing and manufacturing for the satisfaction of the top range item demand and supplemented by a modified reverse Wagner/Whitin model for the remanufacturing of the lower variety items is derived to solve the dynamic lot sizing model proposed in this paper. The model aims to minimize cost across a horizon and the total cost proves to be very sensitive to the manufacturing setup cost and the proportion of demand returned for remanufacturing.