A widening gap is developing between the amounts companies spend on current warranty claims and the amounts they set aside to pay future claims.

Last week we suggested it has much to do with the sales downturn seen in 2008 and 2009, but since then several readers have suggested something more sinister is afoot.

Are manufacturers purposefully cutting their warranty accruals to boost profits or reduce losses? And if so, what happens in 2010 and 2011 when there's little left in the warranty reserve to pay for repairs?

According to the companies' own financial statements, warranty accruals are determined by the predicted cost of repairs, and are constantly adjusted based on the actual costs that arise. So if an industry cuts its accrual rate from 2.5% to 2.0%, there must have been a massive boost in product quality to justify the reduction, or else the auditors are going to object.

If claims later fall from 2.5% of revenue to 2.0% of revenue, thus confirming the change in accrual rates, the warranty planners look real good. But if claims soar to 3.0% or even 3.3%, they'll have some explaining to do.

Massive Divergence in Rates

The problem is, companies in at least two industry sectors have cut accrual rates to artificially low levels. In four more of the 14 industry groupings that we use to track warranty costs for some 800 American manufacturers, there's been a noticeable divergence between claims and accrual rates in the last one to three years.

Let's start with the automotive industry, which in this grouping includes not only the passenger car makers, but also the manufacturers of trucks as well as motorcycles, forklifts, and all sorts of vocational vehicles. In Figure 1, it's clear that the companies kept their claims and accrual rates close together for the five years from 2003 to 2007. But then in 2008 and 2009, claims soared and accruals fell.

A similar thing happened to their suppliers, although in that case, claims roe and accruals failed to keep pace. That's more like what should happen during a sales decline: the warranty department notices claims rates rising, so they nudge accruals up a bit, but not enough to cover the entire increase.

However, what's notable about the data in Figure 2 is the fact that for multiple years accruals usually exceeded claims, until something happened in 2008. What caused this change? Was it falling sales? Or the need to make costs fall too?

So what happened in 2008? Of course, the collapse of Lehman Brothers set off a worldwide financial panic on September 15, 2008, so that explains some of the strange accrual adjustments in the fourth quarter of 2008 and the first half of 2009. But the divergence trend in Figure 1, and indeed also in Figure 3, begins long before the recession even became official.

Building the Perfect Home

In previous newsletters, we've spotlighted the seeming manipulation of accruals practiced by some homebuilders. In some quarters, they accrue $2,300 per home to finance future warranty claims. In others, they accrue only $500 per home, and in a few instances they accrue nothing. It's not as if quality or claims are also oscillating. It's the accrual rate per home, and it seems to have little to do with repair costs.

In Figure 3, it's clear that for the past three years, claims have exceeded accruals in the homebuilding industry by a widening margin. If the U.S. Securities and Exchange Commission weren't such a bunch of bunglers, they might have noticed this by now. They might have asked KB Home and Beazer Homes how they once made homes so perfect that they needed to make absolutely no accruals.

To a lesser degree, the building trades that supply the homebuilders are also shortchanging their warranty reserves. As can be seen in Figures 4 and 5, the makers of appliances, heating and cooling systems, fixtures, furniture and building materials are spending more on warranty claims than they're setting aside in warranty accruals.

Of course, when a company goes into survival mode, the question of whether accruals will be sufficient to pay claims in two or three years becomes moot. The bigger question is whether the company will be around in two or three years. If not, they'll take their warranties with them to the bottom. So it really doesn't matter if their accruals are adequate.

Last week, we noted how companies in the building materials sector were the only group to see claims rise both as a percentage of sales and as a dollar amount. That rapid increase can be seen in Figure 5. But more importantly, it also shows how the claims and accrual rates so clearly diverged at the end of 2008.

A much smaller divergence is noted in the aerospace industry, where claims exceeded accruals six quarters ago and continued to do so throughout 2009. But the same thing happened back in 2003 and 2004, without much of a downside. And besides, the scale on some of these charts is so narrow that even minor gaps look like ravines. One could also say that in the aerospace industry, in general, claims and accruals approximate each other within a narrow range.

And indeed, that would be the end of the story, were in not for the other six industry groupings in which a noticeable gap either failed to develop, or it appeared and then disappeared. Granted, four or five of the six charts below show massive annual oscillations in both claims and accrual rates, but at least the balls are bouncing at the same time.

Reducing Warranty Costs

In the telecom equipment industry, a multi-year downtrend in both claims and accrual rates was interrupted in 2009 by a slight rise in claims. But by year's end, the two rates were back in synch, falling to around 1.2% -- their lowest level ever!

If telecom were a healthy, growing industry one could pass it off as an example of exactly the opposite of the trend impacting carmakers and home builders. But the top ten telecom and data communications equipment suppliers all saw sales decline, and Nortel was actually knocked out of business. Yet claims are down, and accruals have been reduced.

The same goes for the computer OEMs grouped together in Figure 8. Except for Apple Inc. all saw their sales fall in 2009. Yet claims and accrual rates failed to diverge. And while both rates have bounced around for the past two years, at least they bounced together.

When looking at the charts in Figures 9 and 10, one could be forgiven for thinking they must have been mixed up with the charts for seasonal industries such as lawn equipment or snowmobiles. But they're actually for semiconductors, printed circuit boards, medical equipment, and scientific instruments -- which one would assume are not at all cyclical.

After we wrote something similar in last year's report, a reader noted that there actually is a "season" to at least medical and scientific equipment, corresponding to the purchasing cycle of schools and universities. So that explains Figure 9. But what causes the pattern in Figure 10?

The pattern seen in Figure 11 is notable for what it doesn't show. Despite a trend toward longer warranties, there's also a noticeable trend toward lower warranty costs. This time, however, one could attribute the downward trend in costs to an upward trend in sales. All four of the top data storage warranty providers -- Seagate Technology, EMC Corp., Western Digital Corp., and SanDisk Corp. -- reported rising sales at the end of 2009.

Finally, we usually exclude the peripheral manufacturers from this array of industry charts, because its claims and accrual rate pattern always seems so chaotic. Well, in comparison to Figures 1 and 3, the pattern in Figure 12 looks quite a bit healthier. As with medical equipment, the rates may bounce around a lot, but at least they bounce together.

There are two additional industry categories that we won't include here, but not because they don't fit in with the trend. The charts for consumer electronics and for power equipment show some notable movements, but they're really just the machinations of those sectors' major players: Microsoft and General Electric, respectively.

Microsoft dominates the U.S.-based consumer electronics sector because almost everything else is imported. Even within just the game console segment, Microsoft is the only U.S.-based company. Besides Microsoft, there's Garmin, Harman, InFocus, Cobra Electronics, and a few other audio, GPS, and speaker manufacturers in the category.

GE dominates the power equipment sector (windmills, turbines, generators, etc.) because its $794 in warranty outlays comprises fully 96% of the U.S. total for that sector (several other major industry players are either counted in other industry categories or are importers). So there's little point in ascribing trends to the whole industry when in fact they're merely the trend of one company.

But just for the record, GE's claims and accrual rates have been within 0.1% of each other for the past four years. So it knows how to manage its money. Microsoft, of course, had a major warranty crisis with the Xbox 360 game console in 2007, but things are almost back to normal now.