Warranty is incredibly important in the automotive industry. In the U.S., automotive warranty claims account for about half of all product warranty expenses, while everything from airplanes to air conditioners makes up the remaining half.

In the passenger car industry, one cannot produce an advertisement that fails to mention the vehicle's factory warranty. It's become a coded way of touting the product's quality and reliability.

So what message does a company's warranty accounting deliver? Thanks to decade-old accounting reforms, we now know how much they spend on warranty. But is that more or less than their competitors? And is it enough to cover all their warranty expenses?

It's hard to say whether an estimate is right or wrong until it can be looked at in the past tense. Some companies legitimately expect their warranty expenses to always be minimal, until they aren't. And they don't know how wrong their estimates are until it's too late. Earnings take a hit and investors are told there's been a manufacturing excursion.

Sometimes, a company goes bankrupt and announces that it won't be paying warranty claims. There's no money left. If there was a warranty reserve, it wasn't big enough, or it was merely a bookkeeping entry with no actual cash to back it up. Either way, the remaining warranty liabilities will join the company's other liabilities in the bankruptcy proceedings.

But how much is enough? One would think there should be enough in a warranty reserve fund at any given moment to pay all claims on all warranties valid at that moment. But this is rarely the case. As we shall see, in the automotive industry, while the warranties may last 24 or 36 months, the warranty reserves are more likely to last only 15 to 24 months.

Warranty Calculations

In each of the four charts below, we started out with four warranty metrics and ended up with two others. The first metric we collected was the dollar amount of product sales for the period in question. The second and third metrics were the amount spent on warranty claims, and the amount set aside as warranty accruals, during the corresponding sales period. And the fourth metric was the balance in the warranty reserve fund at the end of each of the past 38 quarters (9-1/2 years).

We repeated these data collections for each of the quarters between early 2003 and the middle of 2012. Then we grouped the companies by the types of vehicle they sold. If they sold more than one type of vehicle, for instance trucks and buses, they were counted in each category into which they belonged.

Then we took the four basic metrics and combined them to create two new metrics. The amount set aside as warranty accruals was divided by the dollar amount of product sales for the period in question. This created a percentage that is labeled in the charts below as the accrual rate. For instance, if a company sells $10 million worth of product and sets aside $200,000 in warranty accruals, its accrual rate would be 2.0%.

Then we took the ending balance in the warranty reserve fund, and divided it by the amount being spent per month on warranty claims. This created a metric we're calling the warranty reserve capacity, expressed as the number of months of claims coverage in the fund. For instance, if the reserve fund contained $6 million and the company was spending $500,000 a month on warranty claims, the reserve capacity would be 12 months.

The charts below track two key assumptions that a company has to make: how much money should we set aside to pay future warranty claims, and are we keeping enough in the reserve given the length and cost of our warranties? In each industry, and for each product line, the answers will be different.

And of course, there's no one right answer for all the companies in a given industry. But by showing the averages of all the companies in a given industry or industry segment, we're tracking the best estimates of all those companies combined. So what we're really doing is charting the warranty estimates of all a given industry segment's members as a scatter plot.

Warranty Accounting Theory

A company is supposed to set aside enough funds at the time a product is sold to cover all the warranty liabilities the company expects. So if the maker of a $20,000 vehicle expects $500 in warranty expense over the life of its warranty, they're supposed to set that amount aside at the time of sale. They may not spend it all. They may spend more. But they're supposed to estimate the cost and accrue that amount.

If the warranty were for 48 months and if sales remained flat, the result of that accrual estimate would cause the company's accrual rate to remain flat at 2.5%. And if claims were paid at a constant rate of $125 per vehicle per year for four years, the claims rate would also be flat.

After a while, the warranty reserve fund would contain exactly 48 times as much as was spent in a month, which would give it a reserve capacity of 48 months. And this would be fortunate, because the company's warranties would expire after that amount of time.

If, for whatever reason, the company stopped selling vehicles, there should be exactly enough money in the warranty reserve fund to pay all claims until the last warranty expired. At least that's the theory.

Warranty Accounting Reality

The reality is that nothing stays the same. Claims never emerge at a constant rate per year or per month. And even if they did, other factors such as the timing of payments and supplier reimbursements would throw that tidy schedule off. And in the automotive industry in particular, some warranties expire on usage before their time is up. Also, product sales rise and fall, and product lines change.

However, the basic theory remains: At any given moment, there should be enough money in the warranty reserve to pay all remaining claims for products already sold. And if a company's products carry a 48-month warranty, the capacity of that warranty reserve fund (its balance divided by claims paid per month) ought to be somewhere close to 48 months.

In the figures below, we're measuring the real world fluctuation of a given product type's warranty metrics. The value of the vertical axis should be close to its average warranty duration. The value of the horizontal axis should be close to its expected warranty cost.

In Figure 1, we're comparing the scatter plots of three groups in the automotive supply chain. The red dots are an average of 49 automotive OEMs past and present, who make everything from golf carts to bulldozers. The green dots are an average of 28 drivetrain manufacturers, making engines, transmissions, gear boxes, axles, and other components. And the blue dots are the parts suppliers.

There is some overlap -- for instance Navistar is counted as both an OEM and as an engine manufacturer. And in subsequent slides, Navistar is triple counted as a truck, bus and recreational vehicle manufacturer. All manufacturers are included in all categories into which they fit.

Notice that despite the overlap in specific companies, there's really no overlap in their placement on the chart. The general parts suppliers have always kept their accrual rates between 0.5% and 1.0%, while the drivetrain suppliers are clustered closer to 1.5% and the OEMs range from 1.5% to 3.0%.

The dotted lines, by the way, pinpoint the June 2012 average for all 192 companies that are represented on this chart. As of the end of the second quarter of 2012, the average accrual rate was 1.4% and the average warranty reserve capacity was 21.6 months. It's been falling for multiple years, thanks to some cost-cutting and reliability increases by the manufacturers.

Small Vehicles

Next, let's take a look at the automotive market by the size of the vehicles. In Figure 2, we're looking at the smaller end of the scale, and in Figure 3 we're looking at the larger end of the scale.

In Figure 2 below, the "other smaller vehicle" tag refers to 25 manufacturers of motorcycles, forklifts, golf carts, snowmobiles, all-terrain vehicles, scooters, and other small vehicles. The members of the passenger car and light truck category, however, are just Ford Motor Co. and General Motors, with a little bit of Tesla Motors in recent years. Including other OEMs from Europe or Japan would have entailed too many assumptions about exchange rates and product lines.

Once again, there's a clear separation between the clusters. The passenger car makers have accrual rates that are generally above two percent, while the smaller vehicle makers are generally below two percent. Both are clustered between 15 and 24 months, with only a few outliers beyond that range.

In terms of warranty reserve capacity, it's basically the same range as in Figure 1. And given that we're talking less than two years in almost every case, one wonders if these underfunded liabilities will ever be fully funded?

One of the big problems three-and-a-half years ago, as the auto bailouts began, was the lack of funds to pay warranty claims. The companies simply did not have enough funds to pay dealers for their warranty work. So the U.S. Treasury Department stepped in, temporarily guaranteeing the warranties of GM and Chrysler.

Unfunded Liabilities

If a company suddenly stops manufacturing, it's supposed to have a fully-funded warranty reserve fund that is capable of paying claims on all vehicles sold before that time. What we're seeing is an industry that, at current levels, would run out of funds in less than two years. In other words, their already-existing warranty liabilities are not fully funded.

Of course, sales will continue and warranties will continue to be issued. And some of that future revenue will go towards current liabilities, and nobody will notice because who really measures the capacity of their warranty reserve to pay claims? The auditors barely understand the difference between claims and accruals.

In Figure 3, we've charted three types of large vehicles. And as was already mentioned, industry giant Navistar International is part of all three. That's certainly one reason for the bunching. Another is simply that these three product types have more in common than different when it comes to warranties. For instance, there are likely different suppliers and different warranties for the engine, chassis, and interior.

In this chart, the June 2012 averages are a 1.6% accrual rate and a 21.6-month reserve capacity. However, as can be readily seen, most of the 114 data points are below and to the right of that midpoint. In other words, accrual rates have generally been higher and capacity lower in the past than they were in the middle of this year.

The trend, therefore, has been towards lower accrual rates, which are enabled by falling claims rates. Those claims rates are falling because reliability is rising, claims processing efficiency is rising, and reimbursements from suppliers are rising. And as claims rates fall, and as claims payments per month fall, the same amount of money in a reserve fund rises in capacity (because it would last longer thanks to smaller and less frequent payments).

So perhaps the warranty reserves aren't really under-funded? Perhaps, as sales rise and reliability rises too, the amount set aside will prove to be more than adequate to pay all claims? Let's hope, but it's a tenuous hope.

Vocational Vehicles

Our last chart this week covers some of the more identifiable types of vocational vehicles. We've selected emergency (fire, police, ambulance), farm equipment (everything from riding lawn mowers to harvesters), and mining equipment (tractors, shovels, graders, dozers, etc.). And once again, there's quite a bit bunching between two distinct groups.

This time around, the bunching can't be blamed on overlap. There are absolutely no manufacturers that are double-counted in both the emergency and the mining categories. And the only two companies common to both farming and mining equipment were taken private years ago, and so are no longer counted in any category.

None of these groups would seem to be fully funding their warranty liabilities (unless 18-month warranties are becoming common). But as with Figures 1 and 3, most of the data points are below the June 2012 average, which means warranty reserve capacities are rising and are higher now than they've been in the past. So the warranty liabilities are less under-funded now than they were.

Industry Benchmarks

However, notice how distinct the data points are for the farm equipment vendors. They're in a tight cluster centered on two percent and 16 months, while the other two categories are intermingled around one percent and 16 months. This suggests that we've come upon some actual benchmarks for this particular industry. These could be the data points that farm equipment manufacturers actually aim for when they make their estimates: Let's set aside two percent of revenue at the time of sale and keep our reserves around 16 times as much as we pay out each month.

In general, the tighter the cluster, the more relevant the metrics are as an industry average. In Figures 1 and 2, each segment or category was within an identifiable range, give or take a few outliers. So those are valid benchmarks for smaller vehicles, drivetrain components and parts suppliers. In Figure 3, the data was more scattered, though at least the truck category was in a tight cluster. In Figure 4, at least the mining and farm equipment are in a tight cluster, though the emergency vehicle data is more scattered.