September 14, 2004

The Warranty Reserve:

With 18 months of data in hand, it's now possible to begin defining a normal range for the size of the warranty reserve fund, expressed as a multiple of the average amount spent per month on claims.

As we close out this round of analysis of the warranty expense data filed quarterly by some 750 manufacturers, we're going to concentrate on the warranty reserve fund. The simple question is, how much is enough?

Most companies use sophisticated algorithms to decide how much money to put away to fund future warranty claims, and theoretically the warranty reserve fund balance should be a function of those calculations. If a company is expecting a 2% claims rate in the future, it should now be accruing 2% of current revenue. The ending balance of the reserve fund should rise or fall depending upon how accurate that forecast turns out to be.

Most companies also maintain a sizeable cushion in that reserve fund balance, meaning that the ending balance will always be non-zero. That cushion's function is to protect the company and its shareholders from unexpected spikes in the claims rates, perhaps caused by a manufacturing defect that went unnoticed until customers began reporting failures.

In past editions of Warranty Week, we've computed the typical size of that cushion to be in the vicinity of 15 to 17 months, give or take a few months. What we mean by that is a typical manufacturer will maintain a cushion in their reserve fund equal to the amount spent honoring warranty claims over the preceding 15 to 17 months.

If, for instance, a manufacturer is spending $1 million per month on claims (or $3 million per quarter), they would on average maintain a reserve fund with a balance of $15 to $17 million. In practice, the range is actually quite wide, running the gamut from half a month to literally hundreds of months.

The Weighted Average

Past examinations have taken a snapshot of the 750 manufacturers at the end of any given quarter. But now we have on hand six quarters of data, or roughly 4,500 different measurements of the ending balance in the warranty reserve fund. With that many measurements over the course of a year and a half, it's now possible to define what constitutes the average range for all manufacturers.

There is no set formula. The size of the cushion also depends upon other factors such as the average duration of the warranties issued by the company, not to mention the product mix. Some say it also depends upon the mission-critical nature of the product, its durability, and expectations that it will be repaired rather than replaced. In other words, the failure of a diesel engine in a $100,000 truck is a catastrophic failure that jeopardizes the cargo as well as the livelihood of its driver. The failure of an inexpensive CD Walkman is annoying, but is hardly a crisis. If it's covered by only a 90-day warranty, a manufacturer could get away with only a minimal cushion, with the expectation that relatively few customers will take the time to make a claim.

Still, it does appear that there is something of a comfort zone for most manufacturers. But we're making one big assumption here. We're assuming that each manufacturer is using their best estimate of future claims and is making their best estimate of how much of a cushion is required given the nature of their business and their product line. In other words, we're assuming that the 4,500 measurements reflect nothing but the best predictions possible.

That means we're assuming that no companies are manipulating their accruals to "make their numbers," over-accruing during the good times as a hedge against earnings shortfalls during the bad times. We're also assuming that every chief financial officer is basing the amount they accrue solely on product failure data, and not something as arbitrary as a number they pick out of a hat. In a perfect world, the warranty reserve fund should not be treated like a Christmas Club savings account. Then again, in a perfect world the amount put away as a warranty accrual should never be exactly the same as the amount spent on claims.

Without naming any names, several companies seem to do exactly that. They always seem to put away exactly as much as they spend, maintaining an unchanging reserve fund balance from one quarter to the next. Here's why that should never happen: If a company's claims rate is always 2% of sales, their accrual rate also should be exactly 2% of sales. However, the claims rate reflects a percentage of sales made in the past, while the accrual rate reflects an assumption about future claims expected from current sales. Only in the unlikely event that sales are also constant and unchanging should the dollar amount of claims and accruals be exactly equal. The claims and accrual rates should always be close in percentage terms, but in dollar terms they should not be the same. And the reserve fund balance should not remain the same.

Quarterly Fluctuations

Over the past 18 months, American manufacturers have seen their aggregate warranty reserve fund balance fluctuate from a low of $33.6 billion to a high of $34.8 billion. Monthly claims have fluctuated from $1.9 billion to $2.0 billion, and monthly accruals have ranged from $1.9 billion to $2.2 billion. In rough numbers, therefore, American manufacturers generally maintain a warranty reserve equal to 15 to 17 months of claims. At the same time, the average amount spent on claims has ranged from 1.6% to 1.8% of product revenue.

In the following graph, we're plotting the data points for the past six quarters in two ways. The blue dots represent the mathematical averages computed by dividing the monthly total for claims by the total size of all reserve funds. This we're calling the weighted average, because it is heavily weighted by the behavior of warranty giants like IBM, Hewlett-Packard, Dell, General Motors, and Ford. Since GM and Ford tend to keep a larger cushion in their reserve funds than most others, their weight tends to raise the average considerably.

The red dots represent the median calculations for the reserve-to-claims ratio. In other words, if there are 750 companies reporting warranty expenses, these red dots represent the point at which 375 companies are above, and 375 companies are below. Since the warranty reserve fund balance always depends on the best assumptions and predictions of each company's financial planners, the median should represent the consensus.

Warranty Claims Rates and Reserve-to-Claims Ratio,
Weighted Average and Median,
First Quarter 2003 to Second Quarter 2004

Source: Warranty Week from SEC data

Note the clusters of the dots (there really are six of each color). The left-most pair of dots represents the first quarter of 2004, which is looking more and more like an aberration. Claims had been growing in dollar terms for four consecutive quarters, when suddenly they dropped to a rate of $1.98 billion a month. During the second quarter, claims once again surpassed $2 billion per month, and the claims rate returned to a more typical 1.7% share of sales. The second quarter of 2004 is represented by the dots in the middle. The four quarters of 2003 are represented by the right-most clusters.

We have enclosed all twelve dots by boxes to define what we're calling an "average" range for both the claims rate and the reserve-to-claims ratio. But only a relative few manufacturers lie within these borders. The reserve-to-claims ratio falls between 13 and 18 months for just under 15% of manufacturers. However, the claims rates of only 5% of manufacturers fall between 1.60% and 1.85%. Only a handful of companies such as the Manitowoc Company Inc. consistently land within the box from one quarter to the next.

The Comfort Zone

Still, it's useful to think of this as the midpoint region. Any company that keeps a reserve fund balance between 13 and 18 times their monthly claims total is at the midpoint of the planning assumptions of 750 different manufacturers. Those with a ratio between 10 and 20 months are close enough to the midpoint to be comfortable. And indeed, 36% of manufacturers are within this slightly wider range. Likewise, 38% of all manufacturers fall within a claims rate range of 1% to 5%, which we would call the comfort zone.

We should note that this reserve-to-claims ratio works for both the largest and the smallest companies. General Motors most recently attained a ratio of 23.9 months based on monthly claims of $376.7 million and a reserve fund of $8.987 billion. At the end of last year, alternative fuel meter manufacturer IMPCO Technologies Inc. had a ratio of 18.7 months, based on claims of $36,030 a month and a reserve fund of $672,000. Despite their massive size difference, each company's pair of data points reflected the best estimates of their financial planners as to how much of a cushion is required to plan for the unexpected.

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