Tuesday, December 14, 2010

Warranty – Financial aspects of warranties.

Accounting rules require companies to recognize sales and the related expenses in the same period. When products are warrantied for a period that extends beyond the current accounting periods, companies will estimate the future warranty expense and charge the estimated amount when the sale is made. When there are warranty costs, as long as those costs do not exceed the amount of the reserve, they will accounted for against the warranty reserve and not have an affect on the current Profit & Loss. If costs exceeded the amount of the reserve they would become a current expense that impacts the current Profit and Loss.

If the warranty reserve estimate turns out to be incorrect the amount reserved is adjusted in future periods when necessary. For example, if there are inadequate reserves for meeting warranty obligations, additional contributions to the warranty reserve could be required. Similarly, if the reserves were far more than what’s needed, the adjustment would occur by including reduced or no contribution to the reserve in the current year.  Since this would impact the expenses that are offset against current sales in determining the profit made in the year, this also impact taxes a company will pay.

Companies try to manage their warranty expenses a number of ways. 
  • One is by getting their suppliers to provide them with warranties that will match their warranty period and commitments to their Customer. For example, if the Buyer provided the Customer with a 3 year warranty and the Supplier only provided them with a one year warranty, any costs of replacement or correction after that first year would need to be charged against the warranty expense. 
  • A second way is to seek protection for what is called “epidemic defects” where the Supplier assumes greater responsibility for sharing in Buyer’s warranty costs because of the abnormal number of defects in the Supplier’s products.
  • A third way is to seek a sharing of certain expenses when they become excessive.
Suppliers are reluctant to assume responsibility for epidemic defects as it could wipe out their warranty reserves, or it could be an expense against current sales, impacting their profit.  The key in negotiating warranty issues is what party has the greatest ability to manage the risk?

Many Suppliers want to avoid warranty risk and cost for two reasons:
1.     Competitiveness. The lower their warranty risk, the less they need to include as warranty reserves. The less the warranty reserves, the lower the price they can charge without it impacting their profit.
2.     Profit. The lower the warranty risk, the less reserves they need to contribute, the higher the profit.  Which would you rather have, $1.00 in expenses or a $1.00 more in profit.
Buyer’s have exactly the same reasons in wanting to manage their risk.

Many Suppliers will argue that their price takes into account the allocation of the risks such as warranty risks.  Maybe it does. The more leverage you have with competitive sources that you can benchmark against, the more you can disarm that argument into one where its no different than having to ante up in a poker game. If you want to play, it’s the cost to get into the game.

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