Over the past few years, every once in a while, a set of warranty expense numbers comes in that makes us wonder if there's been a typographical error in a company's annual report. Suddenly, there's a billion-dollar warranty expense and there's no explanation at all anywhere in the document.
Other times, a major safety recall or some other big event makes the news, and inevitably it gets reduced into a major escalation in a company's warranty expenses. For these, we don't need any additional explanations, but we never do find out exactly how much it costs.
In a few weeks we'll be marking a very important anniversary in the service contract industry. Just as the holiday shopping season of 2006 was getting under way, a major consumer product ratings publisher told shoppers that extended warranties were a waste of money. On Tuesday morning, November 14, 2006, the USA Today newspaper carried on the back page of the "Money" section (page 10B), the following full-page ad placed by Consumer Reports magazine:
Reaction was swift. Some said both the frequency of breakdowns and the average cost of repair was higher than Consumer Reports was calculating, making service contracts a better value than was admitted. Others said it was simply a matter of price, in that nobody would deny the value of a service contract priced at 0% of the product's price (in other words, free).
At Volkswagen AG, the world's largest passenger car manufacturer, and the world's largest warranty provider, with some of the industry's highest warranty expense rates, things just went from bad to worst. The company, which spent 7 billion euro (US$7.9 billion) last year on warranty claims, could end up paying an additional US$3.6 billion in claims and fines to fix a major problem with almost half a million diesel cars that have been found to be illegally polluting the air.
It all started last May, when the International Council on Clean Transportation, a small nonprofit organization focused on the reduction of vehicle emissions, and a research team at the Center for Alternative Fuels Engines and Emissions within West Virginia University, documented the discrepancy between test levels and real world nitrogen oxide (NOx) emissions levels from new passenger cars equipped with diesel engines.
After news broke last month about the plans of General Electric Company and Johnson & Johnson to break themselves into three and two companies, respectively, it made us recall the break-ups of last year, when United Technologies Corp. and Ingersoll-Rand plc reorganized themselves into three and two units.
As we wrote about in the May 28, 2020 newsletter, our main interest in the break-ups of these conglomerates was how their subsequent financial statements would allow us to get a much clearer view of their warranty expenses, since the aerospace claims and accruals would no longer be blended with those of the air conditioning or industrial/building products lines of business. And now, with nearly two years of separate data in hand, that clearer picture has emerged.
Extended warranties are a huge business in the U.S. Last year, consumers spent an estimated $17 billion on vehicle service contracts, and roughly $23 billion on protection plans for their appliances, electronics, computers, and mobile phones.
A huge chunk of that money is going to the people that sell them: the dealers and retailers who collect very healthy sales commissions and move on. But the rest is going to a long list of service contract administrators and insurance underwriters who seem to retain the risk and do all the work.