April 21, 2011

Computer Warranty Report:

After years of cost cutting, warranty expenses remained low last year and look to stay there this year, even as sales continue to rebound. Apple, meanwhile, is beginning to feel the effects of the increased warranty cost that comes in small packages.

Computer manufacturers are beginning to enjoy the benefits of their multi-year efforts to reduce warranty costs. While sales are climbing back to their pre-recession peaks, warranty expenses are not.

As a result, the computer OEMs based in the U.S. have never paid out a smaller percentage of their sales revenue to honor warranty claims. As a group, their warranty outlays have remained below three percent of product revenue during all of last year, and fell as low as 2.25% in the third quarter.

Last year, computer OEMs paid out just under $5 billion in claims, up about 4.6% from 2009's $4.8 billion total. And while that's still a bit below the peak years of 2006-2008, it's slightly ahead of 2005's levels.

In Figure 9 of the April 1 newsletter, we presented claims data for the computer OEMs, mixed in with other high-tech industry sectors. In this newsletter, we propose to cover the computer OEM sector's warranty accruals and reserves, and to spotlight three of its largest warranty providers.

Still Below the Peak

Both claims and accrual totals are still below their 2008 peaks, but they may never get there because of the twin fortunes of cost cutting and sales gains. The computer OEMs paid out $5.3 billion in claims in 2008, when that amount represented around three percent of their product revenue. Last year, they paid out a hair under $5 billion, but it was only 2.6% of their revenue.

It's the same story for accruals. The computer OEMs set aside $5.7 billion in accruals in 2008, when it was around 3.1% of their hardware revenue. Last year, they set aside $5.4 billion in accruals, but it was only 2.7% of their revenue.

In Figure 1 below, we've exaggerated the vertical scale to better show the year-to-year changes. As is immediately obvious, 2009 was the year that warranty accruals fell to their lowest levels since public disclosures began in 2003. And that annus horribilis is bracketed by the highest and second-highest annual totals ever recorded. Go figure.

Figure 1
Warranty in the Computer Business
Accruals Made by U.S.-based Companies
(in US$ millions, 2003-2010)

Figure 1

Along with the claims data in Figure 9 of the April 1 newsletter (in which 2009 was only the second-lowest year for claims, behind 2004), it's pretty clear that the recovery has taken hold in 2010. But those charts measure just the dollar totals spent on warranty.

Percentage of Sales

In Figure 2, we've taken those claims and accrual figures and compared them to the corresponding sales totals. That turns the dollar amounts of Figure 1 into figures that represent the percentage of hardware sales revenue that's set aside as warranty accruals. So if the accrual is $1.1 billion and sales are $36.7 billion, the accrual rate would be close to three percent.

Figure 2
U.S.-based Computer OEMs
Average Warranty Claims & Accrual Rates
(as a % of product sales, 2003-2010)

Figure 2

But nobody pays three percent of sales for warranty any more. As can be seen in Figure 2, the industry average has remained below that level throughout 2010, after first reaching it in 2005. Back in early 2003, before warranty cost-cutting became such a serious effort, claims rates were as high as 3.8% and accruals once stood at four percent.

How to Cut Costs

Computer OEMs are finding several ways to cut their warranty costs. One is to shorten their warranties from three years to one, or from 12 months to just three. Another is to push more of the burden back onto their suppliers, some of which (hello, Nvidia) are actually the cause of many of the most costly product failures.

But warranty costs have also been reduced by making better products that need less repairs and that also cost less to repair. Some OEMs have even taught their customers how to self-repair. In addition, by now most manufacturers have installed warranty claims processing automation software packages that lower overhead costs per claim. Some have also added fraud detection and analytics packages that reduce the number of claims by looking for tell-tale patterns.

Financial managers, however, may still be a bit reluctant to believe their own numbers. Yes, claims costs have been reduced, and accruals have also been reduced, but not by a fast enough rate to reduce the balance in the computer OEMs' warranty reserve funds. The balance, which stood at $4.2 billion at the end of 2009, grew by 11% to $4.7 billion at the end of 2010. These extra funds are not needed.

Figure 3
Warranty in the Computer Business
Reserves Held by U.S.-based Companies
(in US$ millions, 2003-2010)

Figure 3

This is what happens when spending is reduced significantly, but accruals for spending are reduced by less: the money flows in faster than it flows out, and the balance increases. Increasing sales account for some of the balance increase, but there also seems to be a bit of disbelief that warranty costs are lower for good.

Capacity to Pay Claims

As mentioned, computer warranties have in some cases gotten shorter. In Figure 4, one can see the downward trend in the line for computer OEMs, from 11.5 months in 2003 to 10 months in 2005. What this means is that the balance in the reserve funds at the end of 2003 was equal to what was being paid out in 11.5 months. By the end of 2005, the balance was equal to only 10 months of spending.

The capacity of the warranty reserve funds to pay claims has only gradually risen since then, but in 2010 it got back to 2004 levels. This means that manufacturers have allowed their reserve balances to rise not only in dollar terms, but also as a multiple of the claims cost.

Figure 4
Computer OEMs vs. U.S. Mfg. Average:
Reserves Held by U.S.-based Companies
(in $ millions & months, 2003-2010)

Figure 4

Notice also that computer OEMs are keeping their warranty reserves far below the average for all manufacturers. The typical warranty reserve fund is usually equal in size to the amount spent on claims in 16 or 17 months. But for computer OEMs, the average capacity to pay claims is usually around 10 or 11 months.

This makes perfect sense, because the warranties on computers are usually shorter than for cars or household appliances. But it's also somewhat surprising, given that computers account for 21% of all claims dollars and 24% of all accrual dollars. Yet it also explains why computer OEMs as a group accounted for only 14% of all warranty reserves (see Figures 5 to 7 in the April 1 newsletter for more).

Sony, Acer, Panasonic and Toshiba are not part of this data, because they are based outside the U.S. Sony and Panasonic do make annual disclosures about their warranty expenses, but they don't segment the totals by product line. Acer and Toshiba make no disclosures about warranty costs.

In addition, Sun Microsystems, which is now part of Oracle Corp., ceased making warranty disclosures after the acquisition was completed in 2009. Palm Inc. ceased making separate warranty disclosures when Hewlett-Packard acquired it last year. Gateway Inc. ceased making reports in 2007, when it was acquired by Acer.

Dwindling List of OEMs

The reason we mention all this trivia is that the number of reporting companies has dwindled considerably over the past eight years. Back in 2003, there were 16 U.S.-based computer manufacturers reporting warranty claims. Now there are only six. And we're about to spotlight half of them.

Every few months, it seems, Apple Inc. becomes entangled in some intrigue that makes for some great headlines. Today, it was "New Apple Product: iSpy?" on the Fox Business News and "Is your iPhone stalking you?" on MSN Money. The products, it seems, keep a log of time-stamped location data in their memory.

That doesn't have a direct bearing on warranty costs, but the cracked screens, dropped calls, misplaced antenna, and defective battery stories of years gone by sure did. Or did they? For as bad as the news has been for Apple, sales have never been better at Apple. And while iPod sales are now declining, iPad and iPhone sales are absolutely soaring. So it seems that old advertising slogan may be true: There's no such thing as bad publicity.

Rising With Sales

In Figure 5 below, which we should note includes warranty data for the first quarter of 2011 that just became available this week, one can infer the rising sales volumes from the increase in claims (blue bars) and the non-increase in the claims rate (red line). In fact, the claims rate has been around 1.2% for most of the past three years, even as the claims total quadrupled.

But notice also that Apple's accrual rate has been climbing steadily since bottoming out at 0.7% in mid-2009. This year, it went above two percent for the first time since 2006.

This, we'd suggest, is the recognition by the company that hand-held computers, smart phones, and digital music players attract a much higher level of warranty expense than do desktops and even laptops. Palm, in fact, used to regularly report claims and accrual rates above seven percent, before that became HP's problem.

So while we note the rise in the Figure 5 data, we can't say it's much of a surprise given the shift towards the small in Apple's product line.

Figure 5
Apple Inc.
Warranty Claims & Accrual Rates, 2003-2010
(as a percentage of product revenue)

Figure 5

Apple is on a fiscal year that ends in September. Dell is on a fiscal year that ends in January. HP's fiscal year ends in October. So before we created the charts in this newsletter, we had to convert all their data into calendar quarters and years.

We mention this because while most manufacturers and warranty providers are now filing their annual reports that contain data through the end of 2010, each of these computer OEMs have already filed reports for at least part of 2011. So readers with a sharp eye will see that Figures 5 through 7 contain data for 33 quarters rather than the standard 32.

Steady Progress

Dell filed its annual report a month ago, in which it listed more than $1 billion spent on claims last year. Compared to our estimate of $44.9 billion in warranted hardware sales (out of $61.5 billion overall), that translates into a 2.4% claims rate. And that, in turn, is right in the middle of the range that Dell's claims and accrual rates have roved since 2006.

Figure 6
Dell Inc.
Warranty Claims & Accrual Rates, 2003-2010
(as a percentage of product revenue)

Figure 6

The real shock, however, came when we did the math for the claims per quarter. Dell, which has averaged $300 million in claims per quarter for a few years now, saw claims drop to $233 million in its fourth fiscal quarter of the year ended January 28, 2011. And Apple, which has seen claims rise steadily since the last year-and-a-half, reported $249 million in claims during the quarter ended March 26, 2011.

Apple Passes Dell

This is the second time in the last three quarters that Apple spent more on claims than Dell, and it's the third quarter in a row that Apple set aside more than Dell in accruals. And sometime this year, Apple's warranty reserve also outgrew Dell's. So at least in terms of warranty work, we now have a new number two in the industry.

Number one, of course, remains Hewlett-Packard. In fact, HP has already pushed past Ford Motor Co. in two of the three warranty metrics (claims and accruals) and in May we'll know if it also got the third (reserves). So it's number one among computer OEMs and number two among all U.S.-based manufacturers (behind GM).

It's also number one in computer sales, of course. We say this because nobody really wants to be known for having the highest expenses in the industry. But HP should be rightfully proud of the cost-cutting job it has done over the past eight years. Figure 7 shows how in 2003 nearly 4.2% of HP's product revenue went to warranty work. In the first quarter of this fiscal year, that claims rate dipped under three percent for the first time since 2007.

Figure 7
Hewlett-Packard Co.
Warranty Claims & Accrual Rates, 2003-2010
(as a percentage of product revenue)

Figure 7

HP's accrual rate, meanwhile, is once again down to 3.2%, a level it reached during the first half of 2007, before 3Com and Palm became part of the product line. And so, with the warranty expenses of those acquisitions now coming under control, and with the return of increasing sales, the cost-cutting efforts are once again producing results.

Eighth Annual Product Warranty Reports

Here are the links to the online editions of all eleven parts of this series:

Readers needing more detailed snapshots of individual companies in either a PowerPoint or Excel format are invited to view the list of charts and spreadsheets available on the Warranty Statistics page.

AMT Warranty Corp.
Fulcrum Analytics
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