Product Warranty Trends:
Manufacturers seem to pack their end-of-year reports with as much warranty expense as they can find, creating a kind of step function in the quarterly data.
With seven quarters of detailed warranty data now available for more than 750 different manufacturers, some trends are becoming apparent that until now were merely theories. In the early months of 2004, US-based manufacturers reported a noticeable drop in their first quarter warranty claims -- the first drop they ever disclosed publicly. What was missing was an explanation.
It was thought at the time that perhaps warranty claims were somewhat seasonal in nature. Perhaps claims are lowest in the cold months and higher in the warm months, and perhaps they're highest of all towards the end of the year? But again, the missing piece was an explanation why.
Industry sales patterns didn't fully explain it. Automotive warranty claims, which make up almost half of all warranty claims, spike during both the warmest and the coldest months. The consumer electronics purchased for the holidays would start showing up for repairs in the new year, not the fourth quarter. And all the new home construction would tend to peak in the spring and summer months.
Economic data didn't fully explain it. While the upward trend in warranty claims during 2003 was roughly in step with sales gains, there was no recession in the early months of 2004. The upward trend during the second quarter of 2004 made the first quarter look like an anomaly, but now we have third quarter data to add to the mix.
The Step Theory
We have a new theory. And we have a new chart. This theory is based less on the seasons or the economic recovery and more upon the tax deadlines and specifically the earnings calendar. In short, the same effect seen with product sales at public companies is seen with product warranties. Just as there is pressure on the sales force towards the end of the month/quarter/fiscal year to get their last few sales in before the deadline, so too is there pressure on the accountants and warranty managers to find all the expenses they possibly can. Warranty expenses that were missed in the first or second quarter will be picked up during the third. Expenses missed during the third quarter will be picked up during the fourth.
As the end of the fiscal year approaches, the pressure is on to sweep up all the possible warranty expenses, making sure they can be claimed. The result is a gradually escalating total for quarterly warranty claims, which falls back after the end of the year. not every company is on a fiscal year ending on Dec. 31, but enough are to make the trend readily visible.
It sounds so simple, and perhaps it is. What's new is the statistical proof that it's happening. We won't have any year-end 2004 data for another month or two, but already we have data for the 21-month period stretching between Jan. 1, 2003 and Sep. 30, 2004. What this data suggests is that warranty claims stepped up like a staircase throughout 2003, fell back in early 2004, and are now once again climbing up the stairs. Also, the total for each quarter of 2004 has been slightly higher than the corresponding quarter of 2003, suggesting that this step function has a gradual upwards incline.
Take a look at the following chart and you'll see the trend in the blue columns, which represent the aggregate warranty claims for all reporting manufacturers in dollars. The red line represents warranty claims as a percentage of total product sales, and the green line represents warranty accruals as a percentage of sales. The blue columns use the scale on the left, while the red and green lines use the percentage scale on the right.
Warranty Claims & Accruals by Quarter
Jan. 1, 2003- Sep. 30, 2004
Note how the dollar amount spent honoring warranty claims during each quarter is slightly higher than the total for both the quarter before and the year-ago quarter. There are no huge changes (the scale is exaggerated to better show the steps), but there is certainly a pattern. And that pattern is now fairly obvious thanks to seven quarters of data.
Longtime Warranty Week readers of course know that U.S.-based manufacturers began disclosing their warranty claims and accruals in early 2003 in response to the rulemaking of the Financial Accounting Standards Board, specifically Interpretation No. 45. Until those first few Form 10-Q and 10-K reports containing warranty data began trickling out during the spring of 2003, most of us were merely making our best guesses as to how much manufacturers were spending on warranty claims. Now we have 21 months of detailed data.
Manufacturers don't segment their warranty expenses by product line or division, the way they usually do with revenue. Or more precisely, manufacturers don't disclose that level of detail. Instead, what they give us are aggregate figures for claims paid minus reimbursements received, and of course beginning and ending balances for their warranty reserve funds. Some manufacturers still disclose this data only once a year despite the clear language of FIN 45, but during the past seven quarters most have made a disclosure at least once.
A total of 772 US-based companies have made at least one warranty report during the past 21 months. For this article, all manufacturers who have reported warranty expenses at any time during 2003 or 2004 were grouped into one of 14 different broadly-defined industries. Each company was placed into one and only one industry, despite the reality that numerous companies are conglomerates of multiple unrelated manufacturing enterprises.
Therefore, United Technologies was placed into just the aerospace category despite their presence in HVAC. Motorola was placed in the telecom equipment category despite their presence in both automotive and home electronics. General Electric was placed in the appliance category despite their presence in several other categories. And so on.
The net effect is to blur the edges of each industry category, making the percentages somewhat inexact. Were United Technologies to be shifted to the HVAC category, for instance, the $324 million it's spent on warranty so far in 2004 would have boosted the HVAC share of the total from 2.0% to 3.8%, and would have reduced the aerospace share from 5.4% to 3.7%. It might have made more sense to split each conglomerate's warranty expenses using revenue segmentation data as a guide, but that would assume that warranty occurs at the same rate in each part of the company. We know that not to be true, and felt there was no reason to corrupt the data with incorrect assumptions.
Each manufacturer was assigned one industry category consistently, however, across the seven quarters for which warranty data is available. In other words, United Technologies wasn't categorized as an aerospace manufacturer during some quarters and as an HVAC manufacturer during others. So all the year-over-year comparisons to follow are at least internally consistent, even if the percentages can be radically altered by moving around a few very large conglomerates.
The goal was to produce a pie chart which slices up the warranty sector by the industry category of the warranty provider. We could have used Standard Industrial Codes (SICs) to do the same thing, but we found them to be somewhat misleading. United Technologies is SIC 3724 for aircraft engines and parts, but Brunswick Corp. is SIC 3510 for engines and turbines -- no mention of boats, billiards or bowling. Motorola is in the same SIC as Rockwell Collins. Johnson Controls and Lear Corp. are in a SIC called "public building and related furniture."
As our own alternative, we constructed 14 different common sense industry labels for which warranty expenses are an expected part of the business. No reason to include banking, food or pharmaceuticals -- product warranties are unusual if not downright rare. We included telecom and broadcasting, but from an equipment point of view because the services themselves do not carry warranties. The same goes for most raw materials and elementary components.
Auto, IT and Home
In the chart that follows, the dark and light blue slides represent the automotive OEM and the auto parts/supplier industries, respectively. The red, pink, orange, tan and brown slices represent five different sectors of the information technology industry: computers, telecom equipment, disk drives, semiconductors, and peripherals, respectively. The four greenish slices represent different sectors of the construction industry: home appliances, HVAC, new homes, and building materials. Purple is aerospace, white is medical and scientific equipment, and gray is everything else.
In the widest sense, the two automotive slices together are roughly 46% of the warranty spectrum, while the five IT slides are 33%, and the four home/furnishing slices are another 13%. There are minor fluctuations from quarter to quarter, but those percentages don't change by much. Outside of those three big groupings, there's aerospace, medical, and "other."
What, you may ask, goes into the "other" category? Primarily, it includes consumer electronics, sports equipment, warranted apparel, electrical power equipment, and whatever farming, food processing, mining or material handling equipment doesn't comfortably fit into a category such as automotive, appliance or HVAC.
Top manufacturers among the 66 stuck in the "other" category include American Power Conversion Corp.; Bucyrus International Inc.; Callaway Golf Co.; Cobra Electronics Corp.; Cybex International Inc.; Harman International Industries Inc.; Johnson Outdoors Inc.; Lone Star Technologies Inc.; Nautilus Group Inc.; and Oakley Inc.
Even with all those companies in the "other" category, its share barely equaled 0.7%. Surely, you say, consumer electronics and sports equipment must add up to more than 0.7% of the total warranty industry. No doubt, they do, but the problem is that much of that gear is manufactured abroad and imported into the United States. Therefore, most of the manufacturers/importers aren't reporting their warranty expenses to the U.S. Securities and Exchange Commission. One could guess at their shares, but then one would be mixing conjecture with facts. Suffice it to say that companies such as Canon, Hitachi, Matsushita, Sony, and Thomson would probably add another $1 billion to the total for the first nine months of 2004, and consumer electronics would have come close to 5.6% of the pie.
Warranty Claims by Industry
First 9 Months of 2004
Source: Warranty Week from SEC data
Overall, comparing the first nine months of 2003 to the first nine months of 2004, warranty claims are up by 2.57% in dollar terms. But of course, different sectors are growing at different rates. Among the fastest growers are warranty claims on new homes (+22%), and building materials (+11%). Among those showing little or no change are claims on computers and disk drives. Only three sectors showed a contraction of any size: auto parts (-1%), telecom equipment (-2%), and computer peripherals (-5).
Most of these changes have more to do with the ups and downs in quarterly sales volumes than with any fundamental changes in warranty, however. New home sales, for instance, were up by 25% from one year to the next, while sales of disk drives were down by 3%.
Of the 772 companies tracked, only 751 provided warranty data in both the third quarter of 2003 and of 2004, allowing year-over-year comparisons to be made. Of those 751 companies, 297 saw a decrease in their warranty claims total in dollars. A total of 391 saw a decrease in their warranty claims rate as a percentage of sales. And 231 of those saw warranty claims decrease in both dollar and percentage terms.
Overall, warranty claims during the third quarter of 2004 topped $6.13 billion, up 1.6% from the year before. Warranty claims for the first nine months of 2004 were up 2.5%, reflecting steeper growth in the early quarters of the year.
Looking at warranty reserves, the total for all manufacturers stood at $35.2 billion as of Sep. 30, 2004. This was up 3.2% from Sep. 30, 2003. Of the 679 manufacturers who reported their warranty reserve fund balances on both dates, 382 saw their reserves grow in size, 280 saw their balances shrink, and 17 saw their reserves remain exactly the same size.
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