April 17, 2014

Automotive OEM Warranty Report:

While warranty expenses are down significantly among vehicle makers as a group, the real progress has been made primarily by Ford and GM.

When it comes to warranty cost-cutting, most of the progress seems to be in the middle. Automotive OEMs, if we classify them by the size of the vehicles they make, are having varying levels of success when it comes to warranty cost-cutting. While those that make very small vehicles and large heavy equipment are lucky if their expense rates remain steady, the makers of passenger cars and light trucks are cutting their costs by incredible amounts.

We began with a list of 50 U.S.-based automotive OEMs that make everything from golf carts to dump trucks. And then we split them into three groups based on the typical size of the vehicles they produce. There were 19 making small vehicles of one sort or another, three making passenger cars, and 28 making large vehicles such as trucks, buses, or recreational vehicles.

The "small vehicle" group was led by motorcycle makers such as Harley-Davidson Inc., but also included companies such as Textron for its forklifts and Ingersoll-Rand for its Club Car. The "large vehicle" group was even more diverse, stretching from the farm equipment of John Deere to the tow trucks of Miller Industries.

GM, Ford & Tesla?

The group comprised of only three companies makes passenger cars and light trucks -- or two of them do. For while one might assume that these are the Big Three of Detroit, Chrysler is still missing from the list of reporting companies (actually its warranty expenses are now consolidated with and reported by its parent company, Fiat S.p.A.). So standing in for them is Tesla Motors Inc., a company which is upsetting the whole dealer-centric passenger car warranty model, and which is on the verge of becoming one of the country's largest warranty providers.

In Figure 1 below, we've chopped up the $9.12 billion we counted for OEM claims payments in 2013 into those three categories. The small vehicle segment was very small -- only $670 million in claims payments last year. The large vehicle makers accounted for only a third of the total with $3.07 billion in claims paid last year. It was the passenger car segment that dominated -- and that was really only the addition of Ford and GM warranty data, with a tiny bit added by Tesla -- and accounted for almost 60% of the total.

Figure 1
Automotive OEM Warranties
Claims Paid by U.S.-based Manufacturers
(in US$ millions, 2003-2013)

Figure 1

At this scale it's a little hard to see the contribution of the small vehicle makers. But it's ranged between $400 million and $750 million per year, with the peak coming in 2009 and a gradual tapering since then. Each year, its share of the claims total has remained within a range of four to eight percent.

The large vehicle makers have actually seen their share grow over the past decade, from around 20% back in 2005 to 34% in 2013. And it's not only because the passenger car makers are paying out less. The large vehicle makers paid out more than $3 billion per year for the first time in 2013, surpassing their previous peak year by more than $100 million.

Peak Year Was 2007

The passenger car makers, as mentioned, are themselves paying out billions less than they did in 2003-2008. It is this massive decline that makes 2007 the peak year for all the OEMs together: $11.72 billion in claims paid. However, the passenger car makers actually paid out more in 2005 and 2006 than they did in 2007.

There is a "before and after" quality to the data in Figure 1. Even if the year labels were removed, one could see that something changed somewhere in the middle. The first six years are different from the last five years, with claims first rising then falling.

Of course, the catalyst is the recession, and the decline in vehicle sales it caused. But that recession is more easily and unmistakably visible in the data of Figure 2, which tracks warranty accruals. That's because while a recession might actually increase warranty work (customers holding onto vehicles longer, worrying more about their condition, feeling entitled to free fixes to their problems, etc.), accruals typically rise and fall in sync with product sales volumes.

In Figure 2 we can see the depths of the trough, with OEMs setting aside a collective $11.9 billion in 2007 and then cutting their accruals to five billion less only two years later. The passenger car makers cut their accruals in half from 2007 to 2009, while the small and large vehicle makers saw 20% increases and 23% declines, respectively, in their annual accrual totals over the same period.

Figure 2
Automotive OEM Warranties
Accruals Made by U.S.-based Manufacturers
(in US$ millions, 2003-2013)

Figure 2

The farm equipment and vocational vehicle makers didn't cut their accruals by huge amounts during that two-year period, but the recreational vehicle makers made massive cuts. For instance, Thor Industries cut its accruals by 50% while Winnebago Industries made an even more drastic 73% accrual cut from 2007 to 2009. And that's just among the survivors.

The three combined classes of vehicle makers set aside $8.9 billion in accruals last year, a total which was actually down by about $110 million from 2012. The passenger car makers were down slightly but the large vehicle makers cut accruals by 5%. In contrast, the small vehicle makers accrued about 8% more in 2013 than they did in 2012.

Warranty As a Percent of Sales

The missing metric is sales. Though the accrual totals rise and fall in sync with sales, there are also other changes that affect accruals, such as quality and reliability issues, and new product launches. We suspect, for instance, that the quality issues plaguing one truck manufacturer is largely responsible for the record amounts of claims and accruals in the large vehicle category recently.

But even in the other categories, the ratio between accruals and sales is far from fixed. It's declining a bit each year for the OEMs collectively, but the strongest declines have come from the passenger car makers. And that. we think, is caused primarily by gains in quality, and corresponding declines in the need for warranty work.

In Figure 3 we've taken the small vehicle claims and accrual totals from Figures 1 and 2 and divided them by the corresponding sales figures, to calculate the average claims and accrual rates for manufacturers in this sector. Two things are obvious: first, there's a huge spike in 2009, and second, the group ends up worse off after the recession than it was before.

Figure 3
U.S.-based Small Vehicle Makers
Average Warranty Claims & Accrual Rates
(as a % of product sales, 2003-2013)

Figure 3

The big rise in the claims rate in 2009 happened because the small vehicle makers' annual claims payments actually rose, from a level of $660 million in 2008 to $741 million in 2009. And then there was a sales decline that served to magnify the size of the spike in the claims rate, which topped out at 2.45% in early 2009. But it was more about an increase in claims than a decline in sales.

However, the accrual rate also rose. And that happened despite a decline in sales. So can't blame the accompanying rise in accrual rates on the recession either, because accrual rates should remain the same as sales rise and fall. Therefore, manufacturers must have known there was a reliability problem coming. And they must have seen the need for increased accruals coming, because there's really no gap between the red and green lines, except for 2009 and a bit of 2010. That means the small vehicle manufacturers correctly anticipated the need for more accruals because they expected more claims. And they were proven right.

Before and After the Recession

Again with this chart, there's a sense of "before and after," with the pivot again being the recession in the middle. But this time, it's a matter of lower expense rates before and higher expense rates after. The reason, we think, has more to do with product quality and the cost and frequency of warranty work, and less to do with sales volumes.

In Figure 4, we're tracking the average warranty expense rates of Ford, GM and Tesla. Of course, Tesla's still a very small third member of this exclusive club, with only $61 million in 2013 accruals to GM's $3.2 billion and Ford's $2.0 billion totals. But its accruals are more than doubling each year as product sales soar.

We see the same spike in claims in 2009, but this time it's not answered by a rise in accruals. It's as if the carmakers knew it was just a bit of recessionary mathematics, and not the start of a new trend. They kept cutting accrual rates, and this time the claims rates came down to meet them.

Figure 4
U.S.-based Passenger Car Makers
Average Warranty Claims & Accrual Rates
(as a % of product sales, 2003-2013)

Figure 4

From 2005 until the present day, the trend for accruals made by the passenger car companies is downward. However, from early 2009 until the end of 2011, there was a wide divergence between their average claims and accrual rate. There was one spike in claims in early 2009, and then another in early 2011, neither of which was matched by a spike in accruals.

The first spike was primarily GM's fault, or should we say the old, pre-bankruptcy General Motors Corp. Back then, sales were so bad that the U.S. government had to buy up the "clunkers" and guarantee the warranty work. And then the 2011 spike was Ford's fault, caused by its switch from counting warranty-only costs to warranty+recall costs. Those two spikes in the claims rate produced a wide gap between the red and the green lines in Figure 4.

Claims Equal Accruals?

However, that gap narrowed in 2012 and nearly disappeared in 2013, proving that the planners were right all along to call for sustained lower accruals several years ago, even as claims rates were soaring to new heights. For the last eight quarters, both the claims rate and the accrual rate of the passenger car makers have declined together. By the end of 2013, both expense rates were around 1.8% of revenue.

With large vehicles, the expense rate pattern is less clear. In Figure 5, one can see an accrual rate that gradually falls, but also seems to rise and fall each year. That's most likely caused by the heavy amount of farm equipment, RVs, construction equipment and other large vehicles that follows a seasonal pattern with both sales and repairs. In the middle two quarters of the year, the weather is good, sales are heavy, and so is equipment usage. But during the fall and winter, sales are slow and repairs are prevalent.

Figure 5
U.S.-based Large Vehicle Makers
Average Warranty Claims & Accrual Rates
(as a % of product sales, 2003-2013)

Figure 5

Note also that the same spike in the claims rate happens in 2009 with trucks and heavy equipment as happened in the other two categories. A quick glance back to Figure 1 shows that claims payments by large vehicle makers actually fell from 2008 to 2009, so the spike in the expense rate must have been caused by a collapse in sales.

The other feature of Figure 5 worth mentioning is the decline in the claims rate seen in 2012. Claims hit a new low of 1.5% of revenue in the spring of that year. But then it began rising, ending 2013 at 2.1%. So now we're back to 2010 levels again. And in fact, we're back to the same range the claims rate was in from 2003 to 2008.

Warranty Reserves Still Below Their Peak

Finally, our last metric for automotive OEMs is their warranty reserve balances. In Figure 6, we can see a balance that's recovering but still isn't quite back to pre-recession levels. The combined balances of all 50 automotive OEMs is approaching $16.6 billion, and that's their highest level since 2008. But that's still $2.7 billion below 2007 levels.

Figure 6
Automotive OEM Warranties
Reserves Held by U.S.-based Manufacturers
(in US$ millions, 2003-2013)

Figure 6

The amount of warranty reserves held by the passenger car makers was actually down in 2013, but that's not obvious because the large vehicle reserve balance was up. The small vehicle reserves were down just a tiny bit to $745 million in 2013, after taking a big tumble from 2011 to 2012. But the large vehicle reserve balances grew by 5% to $5.027 billion.

Over time, the relative shares of the three groups have changed in the same way. The shares of the total held by the small and large vehicle makers have grown, while the share held by the passenger car makers has shrunk. Back in 2003, the small vehicle makers held only 4% of $16.876 billion in reserves, while the large vehicle makers held 12%, and the passenger car makers held 84%. In 2013, the small vehicle makers were still at 4% of the total, but the large vehicle makers were up to 30%, and the passenger car makers were down to 66%.

The large vehicle makers have seen their warranty reserves grow in nine of the last 10 years. In contrast, GM's warranty reserve balance is $2.5 billion below its 2007 level, and Ford's is $2.5 billion below its 2005 level.

Three Different Stories to Tell

So there are three very different stories within the automotive OEM sector. Small vehicle makers have higher warranty expenses after the recession than they did before it. But at least their new expense rates are stable at the new higher level.

Large vehicle makers are paying out more than ever in claims, and are holding more than ever in reserves. But because sales are also rising, their claims and accrual rates are about the same as they were a few years ago.

The big improvement has come in the middle, where the passenger car makers have reduced claims payments to a new low level, have stabilized their accruals at about the same level, and have watched as their claims and accrual rates fell to extremely low levels.

GM ended 2013 with a 2.0% claims rate and a 2.1% accrual rate. Ford ended the year with a 1.7% claims rate and a 1.5% accrual rate. So after multi-year warranty cost-cutting efforts, they're each saving hundreds of millions of dollars per year in warranty expenses and have freed up billions in warranty reserves. If nothing else, Figure 4 illustrates that over time, hard work pays off.

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