American manufacturers seem to be getting their warranty expenses under control, as evidenced by just a very slight increase in claims paid in 2007.

During the calendar year, some 700 U.S.-based manufacturers spent $28.3 billion on warranty claims worldwide, an increase of only 1.4% from the $27.9 billion counted in 2006. As a percentage of product revenue, claims remain very close to the 1.7% level that they've been at for most of the past three years, which in turn is a little below the 1.8% level seen in 2003 and 2004.

Warranty accruals, meanwhile, jumped by 5.5% in 2007 to $29.9 billion. In other words, American manufacturers are putting more aside, but are paying out only a little bit more than they did a year ago. They're paying out considerably more than they did in 2003 or 2004, but as a percentage of product revenue it's somewhat less. That's because sales have grown faster than warranty claims, which causes the percentages to fall.

Because of accounting changes spurred by the Enron and WorldCom scandals, since 2003 all American manufacturers have been required to reveal the net amounts they spend on warranty claims, as well as changes in their warranty reserve fund balances. Warranty Week has been collecting this data on a quarterly basis, comparing it in each case to product revenue to calculate both a claims rate and an accrual rate.

The figures above are a weighted average of all claims and all accruals divided by all product revenue. So of course, big warranty providers such as General Motors, Dell, Ford and Hewlett-Packard pull the average upwards somewhat. Over the course of the next several weeks, we'll delve deeper into these figures, computing baseline averages for specific industries as well as different company sizes.

Growth You Don't Want

Right now, we'll give just the totals for claims paid over the past five years, along with the annual increases. As is apparent thanks to the exaggerated vertical scale used in Figure 1a, it seems as if claims are starting to level off just above the $28 billion mark. Whether this is a product of a slowing economy or a result of more efficient warranty management and quality control remains to be seen. We hope it's the latter, but at least it's very good news to report that warranty costs are not soaring.

The picture for warranty accruals is even less clear. As is apparent in Figure 1b, the amount set aside as warranty accruals in 2006 was actually a bit below 2005 levels. The 2007 total of $29.9 billion is higher than it was in either 2006 or 2005, but again, soaring would be the wrong way to describe this increase.

We're still working with the data and making some adjustments, but we're happy to report that all but six of the top 100 warranty providers have filed their year-end warranty reports with the U.S. Securities and Exchange Commission. For those six, we've calculated place-saving estimates, which hopefully will turn out to be close to the actual amounts they eventually file with the SEC.

It's never appropriate to compare one company against another, because it turns out that the concept of warranty cost is subject to interpretation. For instance, some companies include the cost of recalls and call centers, while others do not. Different companies might calculate the cost of parts differently, and some might not include them at all.

Constant Methodology Over Time?

Whatever the formula a company uses for warranty costs, however, we have to assume that it doesn't change over time. In other words, a company wouldn't include the cost of call centers during 2005 and 2006 but exclude them in 2007 and 2004. At least we hope so. For what follows is a comparison of the top 100 warranty providers to themselves over the past year, in the form of six lists that rank the top ten gains and declines in claims rates, accrual rates, and warranty reserve balances.

If a given company ended 2006 with a claims rate of 5% and ended 2007 with a claims rate of 4%, we would calculate that to be a 20% decline. That would earn the company a place towards the bottom of the top ten list detailed in Figure 2, because nine companies saw their claims rates fall by more than 20% during that period.

The prize for the top decline in claims rate from 2006 to 2007 goes to Visteon, which a year ago saw its claims rate spiking from the 0.2% level that it ended 2005 with. We'll leave the discussion of this to a future column on auto parts suppliers. For now, suffice it to say that the trend towards automakers pushing more of their warranty expenses back onto suppliers, for which Visteon was something of a shining example in 2005-2006, didn't seem to last. For Visteon at least, it's back to business as usual. However, it's a different story for ArvinMeritor, BorgWarner, and Delphi.

If a company's claims rate went from 2% to 3% in a year, we'd calculate that to be a 50% increase. And sadly, that wouldn't even make the top ten this time. ArvinMeritor saw its claims rate more than double, while BorgWarner was up by 79%. Delphi's claims rate was up only 8.3%, though its accrual rate was up significantly (see Figure 5).

However, look closer at the data in Figure 3 below. Two of the companies paid out less in dollars yet they saw their claims rate rise. How so? Because their sales fell even faster -- a common problem particularly within the homebuilding industry. Lennar, for instance, saw home sales fall from $14.9 billion in 2006 to $9.5 billion in 2007. That more than wiped out the $6 million decline in claims paid. Two other homebuilders also saw their claims rate rise by more than 50%, primarily because of falling sales.

The Tyco Breakup

Tyco International, however, is a bit of a different story. In June 2007, the company actually shrank in size, thanks to the spin-offs of Covidien and Tyco Electronics into separate public companies. Covidien isn't reporting any warranty expenses for its healthcare lines of business, but Tyco Electronics is reporting roughly $5 million a year in claims on $13.5 billion in sales.

The problem is, Tyco International had a 0.24% claims rate a year ago, when it was all one company. And though companies might restate their revenues to account for discontinued operations, they can't "unspend" their year-ago claims. Whatever the entities are called now, in calendar 2006 Tyco International paid out $83 million in warranty claims. Though that amount declined to $69 million in 2007, the amount of revenue it's compared against fell even faster because of the spin-offs. Therefore, at least on paper, the claims rate went up by 168%.

And then there's Microsoft. Clearly, there's no acquisition or divestiture story to ameliorate its 2007 warranty experience. All there is is pain. There's the pain of a 1666% increase in its claims rate and there's the pain of a 1539% increase in warranty accruals. Both rates are now above 6% of the Xbox division's sales, up dramatically from their sub-1% levels of early 2006. Equally dramatically, Microsoft has now surpassed the likes of Boeing, Apple, and Paccar to become America's 13th largest warranty provider.

By the way, there is a full list of the top 50 warranty providers on the home page of Warranty Week. What we've done here is lengthened the list to 100 companies and calculated the biggest increases and declines. And by every measure, Microsoft comes out of 2007 as the biggest gainer. But of course, this is not a prize anyone would seek.

Small Changes for Big Companies

Before anyone asks what happened to the big four -- GM, Ford, HP and Dell -- only the latter managed to make any of the top ten lists, and it's towards the bottom of the lists in both Figures 2 and 4. For Dell, sales grew and both claims and accruals fell, in terms of both dollars and percentages. For Ford and HP, claims and accruals fell by single-digit percentages, and for GM, claims fell while accruals rose. But none made the top ten.

In Figure 4, we're calculating reductions in the accrual rates. These are less vulnerable to sales swings, and more accurately reflect changes in expectations. If, for instance, a computer maker expects future warranty claims on a $1,000 laptop to equal $40, they would put aside 4% of sales revenue as their warranty accrual. If they sell a thousand computers, they would set aside $40,000. If they sold only 500 laptops, they'd put aside only $20,000. Either way, the accrual rate would remain steady at 4%.

In Figures 4 and 5, however, what we're measuring is a change in the rate at which these companies set aside funds. Whether it's caused by a change in quality or product mix or repair cost we cannot say. As external observers, all we can do is report the math. It's up to shareholders to ask management why they're suddenly setting aside half as much or twice as much as they used to.

For Tyco, it's highly likely the change in accrual rates has a direct link to the spin-offs. For others, especially those that appear on both a claims and an accrual top ten, management is probably reacting to changes in quality.

But that still leaves a few mixed messages. Of the 49 companies that saw their claims rate fall from 2006 to 2007, 11 increased their accrual rate. Of the 44 companies that saw their claims rate rise, 16 cut their accrual rates at the same time.

Claims are what happens to you after a product is sold. Accruals are what you believe will happen in the future. So when a company increases its accrual rate despite a fall in claims, it is signaling that it expects claims to rise in the future. In the opposite case, a company is predicting that claims will fall despite the current increase. However, perhaps it's also possible that they think nobody's looking, so let's increase profits by shorting the warranty reserve fund during the slowdown?

And then there are the six companies that we suspect should be in the top 100, but which have not provided enough data for us to be certain. Beazer Homes and Navistar International are late with their financial statements. Emerson Electronics chooses to provide only its reserve fund's opening and closing balances for the year. Meanwhile, Exide Technologies, Goodyear, and Xerox have decided they couldn't be bothered with compliance, so they have chosen to discontinue reporting their warranty expenses altogether. In each case, we have constructed place-saving estimates for 2007, but we didn't think it was appropriate to calculate the year-to-year changes.

Warranty Reserve Fund Changes

In Figures 6 and 7, we looked at the year-ending balances in each of the top 100 warranty providers and calculated the top gainers and decliners in size. Once again, acquisitions and divestitures account for several of the changes. There is not only the aforementioned Tyco story, but also major divestitures by Kodak and Ingersoll-Rand that have impacted warranty balances. When a division is sold, its warranty funds usually go with it.

That doesn't explain the warranty accounting of companies such as Centex and Sherwin Williams, however. Both saw their claims rates rise yet both cut their accrual rates. And of course that led to declines in their warranty reserve balances, since funds were leaving faster than they were arriving.

It's the opposite story at Cummins, Polaris, Medtronic, and four others. Claims fell, accruals rose, and the warranty reserve grew in size as funds arrived faster than they could be spent. But for none of these seven did the reserve grow by enough to make the list in Figure 7. The smallest of the top ten increases was Boeing, which saw its warranty reserve grow from $761 million at the end of 2006 to $962 million at the end of 2007 (a 26% increase). The largest was of course Microsoft, which thanks to the Xbox 360 debacle saw its warranty reserve surge to $861 million at the end of 2007 from what we estimate was an $11.5 million total at the end of 2006 (back then, the company didn't even bother reporting its warranty expenses).

For anyone keeping score, only 42 of the top 100 warranty providers made any of these six lists. GE, Hovnanian Enterprises, Microsoft, and Tyco International were the only companies to max out by making three of the six lists. Ten more made it onto two lists and the rest appeared only once.

At no point are we suggesting that one company's numbers are better than another's. Instead, we're comparing each company against itself, and then we're comparing the changes over time. And while a doubling of a given rate from 0.3% to 0.6% isn't as severe a fiscal drain as a doubling from say 3% to 6%, it's nevertheless a doubling.

Five-Year Trends

In a future column, we'll take a look at trends over the past five years, to see whether specific companies have formed a baseline over the period that defines what is "normal" for them. For one company, "normal" could be 0.3% while for another, 3.0% might be quite "normal" for its given product line and average warranty duration.

Over the past five years, each of these manufacturers has provided external observers with a baseline. Now, with five years of data in hand, we can spot departures from that baseline which can be used by an external observer as evidence of a spike or a trough that in turn might signal a change in quality or repair costs. Or it could be the result of a merger or a divestiture.

In other words, it's not the amounts, and it's not even the rates that matter. What reveals the most are the changes over time, when companies are compared against their own track records.

In the old days, before 2003, most of this data was kept secret by manufacturers, because it could be misconstrued by competitors and customers alike (not to mention newsletter editors). So perhaps we should all thank Enron and WorldCom for setting the bar so low that a change resulted in the regulations governing disclosures of guarantees. Ironically, neither provided any warranties, because both were service companies.

Complete Reports Available For Sale

Graphs of the top 100 warranty providers, all the individual members of these industry groupings, and both annual and five-year collections of warranty data for all U.S.-based manufacturers that report their warranty expenses are available for sale on the Warranty Week Web site at the address http://www.warrantyweek.com/fasb/. Individual company slides are priced at $25 while the entire collection is priced at $1,995. Credit cards are accepted, and purchases can be made in dollars, euros, or yen.

This Is Part One
Go to Part Two
Go to Part Three
Go to Part Four
Go to Part Five
Go to Part Six