We develop game‐theoretic models to study the sourcing strategies of the two competing manufacturers who face customer returns due to product design mismatch. The manufacturers have opportunities to reduce the likelihood of customer returns by putting efforts into improving product design. Each manufacturer has the option to outsource product design and production to an upstream supplier or keep product design and production internally. We show that the sourcing decisions of the two manufacturers depend on the level of relative return from design investment (determined by the cost of design efforts, degree of horizontal product differentiation, and expected costs related to returns). We identify the sourcing strategy equilibrium and show that the higher cost of design effort and/or the higher degree of horizontal product differentiation expand, while the higher costs related to returns shrink, the range in which symmetric outsourcing is an equilibrium. Furthermore, as compared to symmetric insourcing, symmetric outsourcing not only softens the price competition but may also increase design effort levels, and thus both manufacturers are better off from outsourcing. However, symmetric outsourcing may hurt both consumer surplus and social welfare.