August is traditionally the month in which most manufacturers file their Form 10-Q and 10-K reports with the U.S. Securities and Exchange Commission. As of today, 48 of the top 50 warranty-issuing manufacturers have done so, though in the lower ranks we're still waiting for a bunch to make their filings for the second quarter of 2004. While we're waiting, though, it's time to give a brief report of changes in warranty claims and accruals among the top 50 warranty providers.

These 50 companies account for more than 80% of all warranty expenditures reported by U.S. manufacturers. As a group, these 50 seem to experience both warranty claims and accruals at a lower rate than all 750 manufacturers taken together. For instance, for all manufacturers the claims rate hovers at 1.6% to 1.8%. For these 50, however, the claims rate was 2.5% during the second quarter of 2003 and 2.2% during the second quarter of 2004. Their accrual rate was 2.4% during both periods, while for manufacturers in general, 1.8% is closer to the norm.

Is it true that larger manufacturers are somehow more likely to pay claims? Or perhaps their well-known brands are more likely to attract claims? Or is some other force at work here? Perhaps the nature of a large company and its need for well-defined processes creates inefficiencies not present at smaller companies? In other words, perhaps when the entire warranty department consists of just one or two people, the overhead costs per claim are lower? This certainly deserves further study.

These are the top 50 warranty providers in terms of the dollar amounts spent on claims and set aside as accruals. However, in the chart below, they are ranked not in terms of dollars spent or percentage of sales spent on warranty. Instead, they are ranked based on the observed changes from a year ago.

Companies Not Comparable

Readers are cautioned not to take the percentages below as evidence of the superiority or inferiority of any one brand over another. Even in the case of similar companies, there are internal accounting differences which on their own can produce differences in claims and accrual rates. For instance, one company might include the cost of returned parts shipments as warranty expenses while another might place it in another cost-of-sales account besides warranty. Or one company might be better at recovering warranty costs from their suppliers than another otherwise identical company. Or one company might settle for "as-is" deliveries from its suppliers, in return for a lower component price. Such a company might show a lower cost of sales but a higher warranty claims rate, because they must absorb 100% of the cost of warranty themselves, with no recourse to their suppliers.

There are numerous other reasons why it would not be wise to compare companies against each other, including differences in product mix and warranty durations. We also suspect that some companies are mixing product revenue together with finance and service revenue precisely to obscure apples-to-apples comparisons between competitors. Manufacturers are supposed to break their revenues into meaningful segments, but some companies do so geographically rather than by product type. Therefore, the percentages below should be taken only as approximations. In fact, in cases where the manufacturer is known to generate service and/or finance revenue but doesn't report it separately, Warranty Week has generated its own estimates based upon the ratios reported by close competitors.

However, that having been said, it is entirely appropriate and accurate to compare one company against itself. Unless a company is constantly changing its accounting methodology from quarter to quarter, what they reported during the second quarter of 2003 should be comparable to what they reported during the second quarter of 2004. Changes in warranty claims and accruals, while highly dependent upon other factors such as an improving economy, should also reflect changes in product quality and reliability. While claims are historical, accruals are forward-looking. Therefore, if a company is increasing its accruals rate year over year, it also is signaling a change in its forecast of expected future claims.

It's entirely possible that some companies are suffering the dual impacts of declining sales and declining quality. It's also possible that a company is seeing both its sales and quality increase. But they rarely change at the same rate, and the peaks and valleys tend to flatten out over time. So one good or bad quarter does not a trend make. But since this is the sixth consecutive quarter in which most manufacturers have reported upon their warranty expenses, it is now becoming easier to tell the difference between one-time anomalies and longer-term trends. It's also becoming easier to compute a range of "natural" warranty claims and accrual rates for a given company or a given industry, as we shall see in the graphics included in columns over the next few weeks. This time, we'll start with the top 50, compared with a year ago.

Individual Changes

Warranty claims and accrual rates are computed at the end of a given fiscal period, be it a quarter, a year, or a half-year. Expressed as percentages, they are the result of a simple division of a company's claims or accruals by its product revenue. In percentage terms, 14 of the top 50 warranty providers saw claims rise as a percent of product sales between June 30, 2003 and June 30, 2004. Six stayed the same (though for three of those the reason was a lack of new data). A full 30 saw their claims rate fall as a percentage of sales. However, the great majority of the changes were relatively slight.

Was this the result of rising sales? Yes, in some cases. Was this the result of actual declines in claims? Yes, in some cases. But in most cases we suspect it was a combination of the two. In dollar terms alone, 30 companies saw increased claims while only 17 saw decreased claims. So obviously changes in sales had a significant effect.

Only Maxtor saw its claims rate rise by more than 1% during the past year. For Maxtor, the change in percentage was caused by both rising claims and falling sales. While claims during the second quarter rose from $40.5 million in 2003 to $48.7 million in 2004, sales fell from $911 million to $818 million. As a result, the claims rate rose from 4.45% to 5.95%.

Meanwhile, five manufacturers -- Cummins Inc.; Lexmark International; Applied Materials; Lucent Technologies; and Gateway Inc. -- saw their claims rate fall by more than 1%. Most notably, Gateway saw its claims rate fall from 6.6% of sales at June 30, 2003 to 2.3% at June 30, 2004 -- a 4.3% decline. The company is in the midst of transitioning away from storefront retailing and towards consumer electronics product lines, which may explain some of that decline.

On the warranty accruals side, 20 manufacturers reported percentage increases while 23 reported percentage declines. Seven companies remained the same, though for two the reason was a lack of new data (see notes below). Maxtor, Apple Computer, and General Electric were among the companies accruing at a rate at least 1% higher in 2004 than in 2003. AutoZone, Lucent, Lexmark, and Gateway were the four companies accruing at a rate at least 1% lower than in 2003. In dollar terms, 33 saw accruals increase while 16 saw accruals decrease (Xerox stayed the same).

Warranty Lag Time

Claims rise and fall based upon the quality and reliability of products sold in the past. Though warranty claims sometimes arise during the same quarter as the sale, in most cases the revenue was booked in a past quarter. Since for most companies sales volumes fluctuate from quarter to quarter, a comparison of current claims to current sales will seldom equal the true underlying claims rate. Readers are cautioned that the percentage can fluctuate for numerous reasons besides changes in product quality. Chief among them is a change in sales volume.

For instance, a company with $100 million in sales and $2 million in claims will have a 2% claims rate. If sales increase to $120 million and claims remain the same, the claims rate will drop to 1.7%. If sales remain the same but claims drop to $1.7 million, the claims rate will drop to 1.7%. The point is, identical percent changes can occur for very different reasons. Keep that in mind as you skim the chart below.

Source: SEC Form 10-Q & Form 10-K