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September 29, 2011

Computer Warranty Report:

The bigger the box, the smaller the warranty expense. And when phones get smart, and when computers get small enough to fit into pockets, warranty costs seem to grow proportionally. That's what the industry's warranty claims and accrual data, gathered over the past 8-½ years, seems to suggest.

When it comes to warranty cost, bigger is better. As a percentage of their selling price, IBM's Blue Gene supercomputers probably have lower warranty costs than Palm's personal digital assistants ever did.

In terms of warranty claims rates, desktops cost less than laptops. And notebooks cost less than hand-held devices. In fact, we'd suggest that the smaller the package, the higher the claims rate.

We looked at the computer industry's hardware revenue, claims payments, accrual totals, and reserve fund balances for the 34 quarters between 2003 and now. And the inescapable conclusion is that the big boxes aimed at businesses generate less warranty cost than the small hand-helds aimed at consumers.

Rising Claims From Rising Sales

In Figure 1, we charted the time series for quarterly claims totals reported by all the major U.S.-based computer OEMs from the beginning of 2003 until the second quarter of 2011. Claims rose to $1.31 billion in the most recent quarter, slightly higher than the fourth quarter of 2010 and the highest level seen since the second quarter of 2008.

Figure 1
Warranty in the Computer Sector
Claims Paid by U.S.-based Companies
(in US$ millions, 2003-2011)

Figure 1

For the first half of 2011, computer makers have reported $2.56 billion in claims, their highest total since, again, 2008. Ordinarily, one would expect higher expenses to be a bad thing, but in this case we're taking it to be a sign that sales and service are returning to normal. After a severe dip in both sales and expenses in 2009, the recovery that began in 2010 seems to have continued into 2011. Sales are up 21%, so of course warranty repairs are up too.

Not Back to the Peak Yet

From a quick glance at Figure 1, it's clear that the claims total reported in the first half of 2008 was the industry's all-time peak. Claims in the first quarter of that year reached $1.35 billion and topped $1.36 billion in the second quarter. So we're still quite a bit below those levels. But we're getting closer.

Equally clear is the bottom of the trough, which came in the third quarter of 2009. Claims reached levels that hadn't been seen since 2004, and then began to rebound.

It was much the same story with accruals, whose ups and downs are usually even more tightly coupled with sales fluctuations. In Figure 2, one can see the bottom of the trough reached in the third quarter of 2009, which also is the one and only time the industry's quarterly accruals have been below $1 billion mark. That was also the slowest quarter in terms of sales for most of the top manufacturers.

But in Figure 2, the all-time peak was back in late 2005, when industry accruals briefly reached $1.66 billion. That spike was caused primarily by Dell Inc., which during a fiscal quarter that ended on October 28, 2005 nearly doubled its typical accrual levels to $574 billion.

Figure 2
Warranty in the Computer Sector
Accruals Made by U.S.-based Companies
(in US$ millions, 2003-2011)

Figure 2

There have been other occasions where one or more computer manufacturers have suddenly raised or cut their accrual levels over the years, which makes the data in Figure 2 more erratic than in Figure 1. This, we believe, is because the claims totals are the result of millions of small repairs while the accrual totals are the result of just four or five corporate decisions. Each finance department decides how much they need to set aside, so if one or two sees something major coming on the horizon, the change can be both swift and large.

Shift Towards Smaller Units

It doesn't always have to be quality-related. Sometimes, it can be quantity-related. A company might forecast radically increased sales of a product that requires more or less warranty expense than the rest of the product mix, and may adjust accruals accordingly. For instance, several years ago when runaway sales of the iPod, iPhone and iPad changed Apple Inc. from merely a computer company into a consumer electronics company that also made Macintosh, it had to adjust accruals to match the change in the product mix.

In Figure 3, we've attempted to capture this change by plotting the "market share" of accruals in the computer industry over the past eight-and-a-half years. Back in 2003, Apple was sixth, behind not only Hewlett-Packard, IBM and Dell, but also Sun and Gateway. So far in 2011, however, Apple is second, behind only HP. It passed both Dell and IBM in 2010. And in 2011 so far, Apple has set aside more warranty accruals than both of them combined!

Figure 3
Warranty in the Computer Sector
Accrual "Market Share"
(percent of total, 2003-2011)

Figure 3

So what does this mean? Obviously, it's not all Macintosh sales. Apple's product mix has shifted towards smaller, hand-held units, which we believe produce more warranty expense than either laptop- or desktop-sized units. But since Apple doesn't break out its warranty costs by product line, that theory can't be confirmed.

Furthermore, we believe the consumer units with their one-year warranties produce more warranty expense per dollar of revenue than the much larger servers and workstations. In other words, the smaller the computer, the more likely it is to need warranty work.

Unfortunately, the manufacturers that best illustrated the big and small ends of this theory no longer report warranty data. Server maker Sun Microsystems became part of Oracle Corp., and handheld vendor Palm was absorbed by HP. Now, in their absence, HP, Apple, Dell and IBM account for almost all the U.S.-based computer industry's warranty expenses. In fact, HP is now the country's second-largest warranty provider in any industry, while Apple and Dell are fourth and fifth, respectively. Ford Motor Co. has fallen to third and Caterpillar Inc. has fallen to sixth.

Reducing Warranty Expenses

The problem is that even though sales of smaller computing units have grown in recent years while sales of larger units have flattened, the industry as a whole has reduced its warranty expenses as a percentage of revenue. One would have expected warranty costs to grow as the products shrunk in size. But the downward trend, as can be seen in Figure 4, is both obvious and long-term.

Figure 4
Computer OEM Warranty Claims & Accrual Rates, 2003-2011
(as a percentage of product revenue)

Figure 4

Figure 4 is an extension of a chart we last ran in the April 21, 2011 newsletter, with an additional six months of data added in. And although both the claims and accrual rates were up a slight bit in the second quarter of 2011, the first quarter data represented new lows for both metrics.

In the first quarter of this year, the industry's average accrual rate hit 2.4%, marginally lower than last year's third quarter. And the industry's claims rate hit 2.2%, besting the previous low of 2.3% reached in the third quarter of last year. So whatever cost-cutting and quality-improving activities the industry players have under way, they continue to drive costs down.

Rising Reserves

There's one more metric we should look at. While warranty accruals are the additions or the deposits, and warranty claims are the subtractions or withdrawals, the warranty reserves are the resulting balance in the fund. And in Figure 5, we see that this balance has been climbing for the past eight quarters.

Figure 5
Warranty in the Computer Sector
Reserves Kept by U.S.-based Companies
(in US$ millions, 2003-2011)

Figure 6

Reserves hit a low mark of $3.97 billion in the middle of 2009, dipping below $4 billion for the first and only time since 2004. Ever since then, the balance has grown each quarter, setting a new record in the first quarter of 2011 and breaking it in the second quarter as reserves rose to $4.97 billion.

It's not because accruals are greatly exceeding claims. As can be seen in Figure 4, the claims and accrual rates have always been close together. In fact, during the last three years they've never been more than 0.3% apart. So the growing balance in the industry's collected warranty reserve funds is not caused solely by excess accruals.

The primary cause, we believe, is increasing sales. Our data shows a 21% increase in warranted product sales by the major computer manufacturers from the middle of 2010 to the middle of 2011. And those additional sales create additional accruals, which won't be spent until the claims begin to roll in. The result is a boost in reserves.

Capacity to Pay Claims

But there's another way to look at reserves besides counting the dollars. We could also look at the balance as a multiple of claims paid per month. In other words, if there was $12 million in the warranty reserve and a company was paying $1 million a month in claims, one could say their reserve fund had a capacity of 12 months. If claims rose to $2 million a month, the reserve would have a capacity of six months. And so on.

Given that most computers are covered by a one-year warranty, one would expect the industry to keep about 12 months of reserves on hand to pay claims. And as can be seen in Figure 6, that is exactly the case. Since the middle of 2008, the industry has kept its reserve fund balance at a multiple that ranged between 10 and 12 months of claims payments.

Figure 6
Computer OEMs vs. U.S. Mfg. Average:
Reserves Held by U.S.-based Companies
(in $ millions & months, 2003-2011)

Figure 6

In recent quarters the ratio has been at the upper end of that range. In fact, it rose to 11.7 months in the first quarter of 2011, eclipsing the high water mark set back in 2003 by a slight margin. In other words, the capacity of the computer industry's reserves to pay claims has never been higher than it is right now. So in both dollars and as a multiple of claims payments, reserves are at an all-time high.

Note that in Figure 6 we've also included a reference line for all manufacturers, including not only computers but also automotive, appliance, aerospace, and others. This metric fell to 15.5 months in 2009, but it's also been making new highs this year. In fact, while it's never hit 18 months, it came closest to doing so in 2011 and in 2003.

Getting Warranty Costs Under Control

We wanted to conclude with a snapshot of the warranty metrics of one of the top computer makers. We chose IBM for three reasons. First, they were left out of the April 21, 2011 newsletter because we included three others. Second, they support the bigger-is-smaller theory that correlates the size of a computer with its warranty cost. And third, after more than six years in which claims have exceeded accruals, the lines finally look set to cross.

Figure 7
IBM Corp.
Warranty Claims & Accrual Rates, 2003-2011
(as a percentage of product revenue)

Figure 6

IBM sold off its consumer laptop and desktop product line to the Lenovo Group Ltd. back in 2005. Almost immediately, IBM began cutting its accrual rate, as if it expected to reduce warranty expenses by concentrating on sales of larger servers and host computers. And for a while, its claims rate rose. But after it peaked at 4.3% in early 2006, it fell steadily.

Now, the claims rate stands at 2.5% while the accrual rate is 2.3%. At the end of 2010, both were near 2.3%. And that was the closest they'd been since 2005, when Lenovo bought the consumer product line and IBM began reducing its accruals. So whatever IBM's forecasters were expecting to happen back in 2005 seems to have finally come to pass, although it took five or six years to happen.

Lessons Learned By HP?

As HP now contemplates some kind of break-up of the company -- separating the server, storage and host product line from the consumer operations -- we wonder if they too foresee a reduction in their warranty cost ahead as they move away from the small end of the computer business? If that's the case, then perhaps they should have acquired Sun and passed on Palm?

In round numbers, IBM is now selling roughly $4 billion worth of computer hardware per quarter and is spending roughly $100 million per quarter on warranty work. Total revenue is much higher, but we don't count software or service in the calculations for claims and accrual rates. And by staying at the high end of the industry, or at least the large end of the box business, IBM is likely to keep its warranty expense rates both low and predictable.

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