June 8, 2004

The Warranty Cushion:

Very large companies put aside proportionally more to pay warranty claims than either mid-sized or small companies, while very small companies allow their reserve fund ratios to rise and fall. The difference between them is their skill at the arts of warranty estimation and accruals.

The larger the company, the more it puts aside for warranty claims, not just in dollars, but as a percent of their costs. The top 5% of manufacturers as a group have mastered the arts of estimation and accruals to keep their warranty reserve funds remarkably proportional to costs. But they accrue towards the conservative side, putting aside a relatively thicker cushion than small or medium-sized companies.

In the past, when looking at warranty reserve fund capacity, Warranty Week has carved up the universe of manufacturers by the type of product they make. This time, we set out to do something different. We carved up the universe of 790 warranty-reporting manufacturers by the size of their reserves. The results were surprising.

The larger a company's warranty reserve, the higher it's capacity to pay claims.

That may seem impossibly obvious. It may sound the same as saying the more money in your pocket, the more you have to spend. But that's not what it means at all. What it means is that the larger companies routinely keep a higher multiple of the amount they pay in claims each month in their reserves, and the smaller companies routinely keep a smaller multiple in reserve. While many smaller companies get by with a year or less in reserves compared to claims, larger manufacturers prefer a ratio closer to a year and a half or more.

Let's take two real world examples, to help explain what is meant by this statement. Let's compare the aerospace and air conditioning giant United Technologies Corp. and the small medical device manufacturer Angeion Corp. In calendar 2003, United Technologies reported product sales of $22.36 billion. Last year, Angeion reported product sales of $15.7 million. So in round numbers, UTC is roughly 1,000 times the size of Angeion.

As of March 31, 2004, UTC held warranty reserves of $1.139 billion. It's one of only six American companies to have a billion or more in the reserve. Angeion held warranty reserves of $138,000, about 1/10,000th as much. UTC reported $111 million in claims during the first quarter, or roughly $37 million per month. Angeion reported claims of $56,000 during the first quarter, or roughly $18,667 per month.

The capacity of UTC's reserves, calculated by dividing the ending balance of the reserve fund by the monthly rate of claims, was 30.8 months. This means that if UTC continued paying $37 million per month without adding any additional funds to its reserves, the balance would last 30.8 months. It doesn't mean they're going to stop making accruals. It just means that right now, UTC's accountants and auditors feel comfortable having enough funds "in their pocket" to pay the current rate of claims for 30.8 months, or double the current rate of claims for 15.4 months, or triple the current rate of claims for 10.3 months, and so on. In other words, they're behaving somewhat conservatively, given that most companies of their size generally keep 17 to 19 months in reserve. They have an extra cushion, able to pay for the next year and a half even if they stopped making accruals.

The capacity of Angeion's reserves was 7.4 months at the end of the first quarter. Its $138,000 in reserves would last only 7.4 months if claims continued rolling in at their most recent rate of $18,667 per month. This is a level the smaller company feels is adequate, but is much less of a cushion than the big company's accountants and auditors feel is necessary. But there's no right or wrong about this. Each company does its best to estimate future claims and to make sure reserves are adequate to pay those claims. So it's always an estimation of the future, based on past experience. Given Angeion's experience in the cardiopulmonary measurement device industry, and its track record of sales and claims, it's entirely possible that 7.4 months is a prudent and adequate amount to keep in reserves. Given UTC's diverse product mix, pricing, and warranty durations, 19 months is a more appropriate estimation.

The Art of Estimation

It turns out that most large companies estimate on the conservative end of the spectrum, and most small companies estimate on the optimistic end of the spectrum. And it turns out that where they fall on the spectrum is somewhat proportional to their size. Among companies who keep $100 million or more in their reserve funds, the average capacity has varied from 17 to 19 months over the past five quarters. Among companies who keep $100,000 or less in their reserve funds, the average has remained in a range of 6 to 9.4 months over the past five quarters. So it's a durable trend.

What's amazing is that every class of companies in between is proportionally within this same range. In other words, the extra large companies (over $100 million in reserves) have the highest capacity, followed by the large ($10 to $100 million), the medium ($1 to $10 million), the small ($100,000 to $1 million, and the very small (under $100,000). As shall be shown in a minute, each size has its own typical ratio between claims and reserves, give or take a few months.

There's one caveat that needs to be mentioned. The reason we chose Angeion -- in the small size, but not the very small size -- is because the volatility within the smallest 9% of companies is quite high. Sales are volatile, claims are equally volatile, and the reserve fund can easily double or halve its size in just a few months. For instance, Castelle, a very small warranty provider that manufactures computer-fax systems, has averaged $30,000 in its reserve fund over the past 15 months. But that balance swung from $39,000 as of Sept. 30, 2003 to $23,000 as of March 31, 2004. Reserve capacity has swung from 15 to 3 to 69 months in the past three consecutive quarters. Very small warranty providers as a group produced the curviest line, which reflects the most volatility.

These sorts of gyrations seem to be normal at the very small end of the warranty scale. They seem to be rather rare at the very large end of the scale. The data for most of the very large warranty providers is flat, flat, flat. For instance, the reserve capacity at the Ford Motor Co. has come in at 20, 19, 18, 18, and 19 months over the past five quarters. Where volatility has been seen, at companies such as UTC, Cisco, and Lucent, it has usually come as the result of massive recent decreases in claims. Their reserve fund balance barely budges, though its capacity rises.

Five Sizes

Warranty Week took the 790 manufacturers who have reported their warranty expenditures at least once in the past five quarters and divided them into five classes based upon the average size of their reserve fund over the past 15 months. The allocations were as follows:

Size Warranty Reserves   Companies   Percent 
Extra Large Over $100m 37 5%
Large $10m to $100m 157 20%
Medium $1m to $10m 292 37%
Small $100k to $1m 235 30%
Very Small Under $100k 69 9%
Average $51.3m 790 100%

The problem with averages, of course, is that sheer weight of the extra large companies skews the data towards their end. General Motors alone averages nearly $8.8 billion, or more than 21% of the total. So while the "average" company keeps a warranty reserve of $51.3 million, it turns out that only 61 of the 790 manufacturers kept a fund that large. Of the total reserves held by all companies, 83% of the funds were held by the largest 5% of companies. Another 14% were held by the large companies with warranty reserves between $10 million and $100 million. Only 3% were held by the remaining 596 companies.

Likewise, the weighted average for reserve fund capacity is heavily skewed towards the plus sizes. Over the past 15 months, the weighted average has varied only slightly, from a low of 15.7 months at the end of the third quarter of 2003 to a high of 16.7 months at the end of 2003. This coincides rather precisely with the ups and downs of the class of companies we're calling the extra large.

We should mention one additional caveat. In no quarter did all 790 companies report their warranty expenditures. Compliance varied from 620 to 750 companies, more or less. So in the case of all the partially-compliant companies, such as those who have chosen to report only once annually, estimates were constructed to fill in the blanks during other periods. This had the effect of expanding the cumulative size of all reserve funds by about 20%, because suddenly General Electric's $1.4 billion and Motorola's $366 million were being counted across five quarterly periods instead of just the one they reported in. Because each estimate of quarterly claims and accruals was the same, this may have contributed somewhat to the flattening of the curves in the following chart.

Warranty Reserve Fund Capacity
Monthly Claims vs. Ending Balance
Five Sizes of Companies
First Quarter 2003 to First Quarter 2004


Source: Warranty Week from SEC data

The 37 extra large companies are portrayed by the red line, which is now 1.8 months below its level of a year before. This means that in the year between March 31, 2003 and 2004, the largest manufacturers either allowed the balance of their reserve fund to decline, or saw their warranty claims rise. For most, it was a combination of both. But for the lucky few -- Cisco, UTC, Lucent, etc. -- claims fell and capacity rose.

The black line represents the weighted average for all manufacturers. As mentioned, it is largely determined by the ups and downs of the extra large class of warranty providers. In fact, as of March 31, 2004, they were barely a month apart.

The orange line represents the large warranty providers, who keep a reserve of at least $10 million but less than $100 million on average. Three companies averaged below $100 million but spent at least one quarter above that level, while around 15 dipped below $10 million but averaged above it.

The green line represents more than a third of all warranty-reporting manufacturers, who each maintained a warranty reserve that averaged in size from $1 million to $10 million. The chart shows a slight upwards bump during the third quarter (exactly the opposite of the red line) but otherwise it remains steady in a range of 10.6 to 11.3 months.

Increased Volatility

The blue line represents just under a third of all manufacturers. The range is 8.7 to 9.2 months, with a slight dip in the third quarter. And finally, the purple line is representative of the smallest 9% of warranty providers: those with reserves of $100,000 or less. The smallest of them, setting aside those who have completely depleted their reserve funds paying claims, was smart card security device manufacturer Datakey Inc., which reported exactly $2,373 in its reserve fund at the end of 2003 and $1802 in claims last year. But because the company made no accruals all year, its reserve capacity varied widely from 132 months down to 12.

At the very small end of the scale, warranty claims vary tremendously from quarter to quarter. With less units sold per year than the GMs and HPs of the world, one bad run has a magnified effect. This would seem to suggest a need for relatively larger reserve ratios than is evidenced by the chart above. These smallest 9% of warranty providers are the mirror opposite of the top 5%. Where the very large see their ratios change slowly, the very small see them vary widely. Where the very large have perfected the arts of estimation and accrual, and keep their reserve fund balances level, the very small let them vary widely.

Not only were the companies in the very small class the most volatile. They also were the most likely to report $0 in claims or $0 in accruals during any given quarter. For some of them, the warranty reserve seems more like an emergency fund. They might go three quarters without a single claim, but then the claims pile up during the next quarter, and they need to tap into the reserves. For a few of them, the reserve fund was established only after such a spike, in order to flatten out the earnings effect of the next spike.

There is nothing more embarrassing than having to admit in a financial statement that earnings are down because of an unexpected rise in manufacturing defects and returns. That's the cushion a warranty reserve fund provides. It flattens out the peaks and valleys, allowing a manufacturer to include warranty accruals rather than actual claims in the cost of sales calculations. What's amazing is how proportional the thickness of the cushion is to the size of the company and the amount it pays in claims.

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