September 13, 2012

Automotive Warranty Metrics:

While the major OEMs have made great strides with their warranty cost reduction programs and with efforts to use warranty data to improve product reliability, their suppliers are struggling to get back to where they were before the recession hit.

Now that most of the vehicle manufacturers and their suppliers have filed their mid-year financial reports with the U.S. Securities and Exchange Commission, it's time to take a look at a couple of trends in warranty benchmarks.

While the vehicle manufacturers -- the OEMs -- continue to reduce their warranty expenses, and in fact are now enjoying the lowest expense rates of the past decade, their suppliers are not even back to where they were five years ago. The OEMs, it seems, have mastered the art of pushing warranty expenses back onto their suppliers, while the suppliers are still learning how to push back.

At the end of each quarter, we collect three warranty metrics for each automotive company: the amount of claims paid, the amount of accruals made, and the warranty reserve fund balance. There are sometimes a few other adjustments as well, for foreign exchange fluctuations, acquisitions, and other factors. But these are the three primary metrics.

Changing the Roster

Over the past decade, the names of some of the companies have changed. Some have merged. Others have gone out of business. A few new market entrants have appeared. Since early 2003, we've tracked some 45 automotive OEMs and 108 of their suppliers at one time or another. But because of attrition, the current pool of warranty providers has diminished.

As of June 2012, there were 28 OEMs and 62 suppliers still reporting their claims and accruals. Some of the notable departures include Baldor Electric Co.; Delphi Corp.; Energy Conversion Devices Inc.; Fleetwood Enterprises Inc.; Midas Inc.; and Monaco Coach Corp. Some fell victim to the recession. Others fell into bankruptcy. A few were acquired or taken private by investors.

Among the top OEMs still reporting are General Motors Co.; Ford Motor Co.; Caterpillar Inc.; Deere & Co.; and Navistar International Corp. Among the top suppliers are Cummins Inc.; Johnson Controls Inc.; Eaton Corp.; Brunswick Corp.; and Standard Motor Products Inc.

The latter is actually more in the aftermarket parts business, but parts are parts, so they're in with the suppliers. Some of the suppliers make finished vehicles and some of the OEMs make parts or vehicle components such as engines. But they've been categorized based on their dominant product lines.

All of the companies are U.S.-based. That means European-based suppliers such as Robert Bosch GmbH and Autoliv AB are not included. Nor are OEMs such as Chrysler, Toyota or Honda, each of which produces vehicles within the U.S. but none of which are domestic public companies.

Claims Totals

In Figure 1, we've detailed the claims payment totals for both OEMs and suppliers over the past 38 quarters. You'll notice the bottom of the vertical scale has been chopped off, in order to better show the totals for the parts suppliers and to better show the peaks and valleys of the combined figures.

Figure 1
U.S. Automotive Industry
Warranty Claims Paid, 2003-2012

Figure 1

Notice that while the peak came at the end of 2007, the bottom was in the second quarter of 2010. The peak quite closely matches the official beginning of the recession in December 2007, but the bottom is a full year after the official end of the recession in June 2009.

Part of the reason may be that vehicles normally need to be sold and age for a while before they need warranty work. And the bottom in terms of unit sales was definitely in 2009. So it would follow that the least amount of warranty work was done a year later.

By the way, we're including not only the passenger cars and light trucks sold by GM and Ford, but also the trucks of Navistar and Paccar, Harley-Davidson's motorcycles, Caterpillar's construction vehicles, Deere's farm equipment, as well as lots of specialty, sports and vocational vehicles. And each of those sub-industries was on its own boom and bust schedule, though 2009 was generally the worst for all of them.

Accruals vs. Sales

Warranty accruals usually react faster to changes in sales, because traditionally the manufacturers make a fixed accrual every time they sell a vehicle. No sales means no accruals. And there's no lag time, because if your past-year accruals were correct, you don't need to make further accruals for vehicles already sold.

In Figure 2, therefore, it's no surprise to see a nine-month notch in the accrual totals during 2009. No doubt about it: this was the slowest time for sales, and for accruals. But there was quite a spike in the final quarter of 2009, as one would expect during the start of a recovery that was adrenalized by sales incentive programs.

Figure 2
U.S. Automotive Industry
Warranty Accruals Made, 2003-2012

Figure 2

Total claims payments by OEMs and their suppliers topped $4.96 billion during the first half of 2012. But that was down about 9.2% from the first half of 2011. As we shall show later on, some of these reductions were driven by increased reliability in recent model years, which reduces the need for warranty work.

Total accruals by OEMs and suppliers grew to nearly $5.3 billion in the first half of 2012, up from $4.87 billion in the first half of 2011. That probably has lots to do with big sales gains by Caterpillar, Paccar, Polaris Industries Inc. and Terex Corp., offset by sales declines by Ford and GM, and weaker growth by Navistar, Thor Industries Inc., and others.

Warranty Reserves

In Figure 3, we've tracked the balance left in the warranty reserve funds of all the OEMs and suppliers, after adding in new accruals and paying new claims. Again, as with claims, the peak was in 2007 and the bottom was in 2010. For suppliers, the bottom came in early 2010. For the OEMs, the bottom came six months later, in the third quarter.

Figure 3
U.S. Automotive Industry
Warranty Reserves Held, 2003-2012

Figure 3

Notice that there's a bit of a notch in the data for the third quarter of 2011. And in Figure 1, there's a bit of a spike in the fourth quarter of 2011. Both are statistical aberrations, most likely caused by Ford's decision to switch from reporting warranty-only figures to reporting warranty+recall figures. Though the company did that at the end of 2011, it has yet to release year-ago figures for the third quarter of 2011. So some of that recall expense is yet to be shifted in our totals from the fourth to the third quarter. We'll make that modification in November, when the data becomes available.

The thing about these metrics is that they only infer changes in sales. One can see the dip in recent years and speculate that it must have something to do with the recession. In Figure 4, we've made that relationship more than just speculation. We took the data from Figures 1 and 2, and related it to sales, calculating the percentage of automotive revenue that these claims and accrual totals represent.

Claims & Accrual Rates

The thing is, sales fell a lot faster than claims did in 2009. And because the manufacturers were essentially paying this year's claims on past years' sales, their claims rates rose dramatically. Because of the scale in Figure 4, it looks like the claims rate rose more for the OEMs than for their suppliers. But proportionately, the effect was large for both groups.

Figure 4
U.S. Automotive Industry
Average Warranty Claims & Accrual Rates
(as a % of product sales, 2003-2012)

Figure 4

Notice also that while the claims rate rose for both, the accrual rate rose less (for the suppliers) or actually fell (for the OEMs) over the same period. This is because the accrual rate should always be proportional to sales, so when one falls, so should the other. And the percentage should stay the same, unless there's been another change in circumstances.

We think what this chart is actually measuring is the OEMs closing the gap between themselves and their suppliers, through two factors. First, they're putting their warranty data to work, using it to boost reliability by preventing faulty products from ever leaving the factory. Second, they're using that same warranty data to sharpen their ability to justify larger reimbursements from their suppliers when they find fault with what they supplied.

Supplier Recovery

That, we think, is what's behind the OEM's long-term downward trend in claims and accrual rates, and the flat-to-slightly up trend for the suppliers. Plain and simple, the suppliers are paying a greater proportion of the total. The OEMs are reducing gross claims paid through increased reliability, and they're reducing net claims paid by increased supplier recovery.

Back in 2003-2007, the gap between the claims and accrual rates of the OEMs and suppliers was usually very close to two percent. If the OEMs were around 2.5% or 2.6%, their suppliers were usually around 0.5% or 0.6%. But then something changed. In 2009 the gap between their accrual rates dropped to only 1.1%, and in 2010 the gap between their claims rates fell to 1.4%. By June of 2012, both gaps had settled in at 1.3% -- far below their long-term averages.

But let's measure this a different way. Let's say that in any given quarter, the OEMs paid about 9/10ths of the industry's total claims, and their suppliers paid the remaining 1/10th. In round numbers, that's the ratio of the totals in Figure 1.

However, let's get exact. In Figure 5, we've taken the data from Figure 1 and changed the scale from dollars to percentages. And so, for instance, the $2.5 billion paid by the OEMs in the second quarter of 2004 represented just under 90% of the industry's $2.8 billion total.

That turns out to have been the high water mark. As can be seen in Figure 5, the OEM's share slipped below 85% in 2008, and has remained low ever since. They averaged 88% from 2003 to 2007. From 2008 to 2012, they've averaged 85%. And in five of the last 14 quarters, their share has fallen below 84%. It never did that until 2009.

Figure 5
U.S. Automotive Industry
Warranty Claims Paid, 2003-2012
(OEMs' & Suppliers' Share of the Total)

Figure 5

Actually, in recent years there seems to be a struggle going on, with the ratio going up, then down. Anecdotal evidence supports the theory that the OEMs are pushing costs out to their suppliers, and the suppliers are pushing back. The past three or four years of data seem to back up the idea that the shift has not been orderly.

As of June 2012 the ratio stands at 84% for the OEMs and 16% for the suppliers. This may not sound like much of a shift, but it's hundreds of millions of dollars for the OEMs.

OEM Cost Reductions

Scroll back to Figures 1, 2, and 3 for a second. One of the reasons we stretched the scale so much was to show that the big changes have always been on the OEM side. For instance, when the auto industry's reserve balance plunged by more than $6 billion from 2007 to 2010, most of that came out of the OEMs. When accruals dropped by more than $1 billion per quarter over the same period, most of that reduction came out of the OEMs.

Whatever the cause, the effect is that the OEMs are paying a lower percentage of their revenue than ever before for warranty work. Both their average claims rate and average accrual rate are now around 1.9% of revenue. And while their accrual rate has been that low for most of the past three years, this is a new low for their claims rate.

Meanwhile the suppliers are struggling to get back to where they were in 2003-2007. And they're not there yet, because of all the pressure from the OEMs and because sales are still on the rebound.

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