Tuesday, December 14, 2010

Warranties - Contract Warranties

A warranty is the highest level of a commitment that a Party can make. The failure to meet that commitment makes the breaching party subject to potential termination of their agreement and also subject to damages.

Warranties can be:
  • A statement of a future right or duty.
  • A statement of a fact at the time the agreement is entered into.

For example, a warranty for defects in material and workmanship provides the Buyer with the right to return defective product in accordance with the warranty term for potential repair, replacement, credit or refund.  A Supplier may want to provide a warranty to the effect that at the time of execution of the agreement, there are no claims against them.

Warranties can be
·      Express meaning that they are spelled out in the agreement. by a statement of fact which is made about the object of the contract and which forms a basis of the bargain. A warranty that says that the Product will comply with the specifications is an express warranty.
  • Implied – a warranty that is not expressly stated in the Agreement but is recognized or imposed by law based on the nature of the transaction.
    1.  Implied Warranty of fitness for a particular purpose – an implied warranty that the item being sold is fit for the purpose for which  BUYER is purchasing it.
    2. Warranty of merchantability – an implied warranty that the item being sold is merchantable (of the quality that is generally acceptable in the line of trade).
·      Affirmative – a warranty stating that a fact or condition is true.
·      Promissory – a warranty stating that a fact or condition is and will remain true.

Warranties have two main purposes in contracts:
  1. Their breach (such as with a fact not being true) can allow the buyer the right to terminate for cause and sue for damages.
  2. They can be intended to drive the warrantor’s behavior by making warranties of future duties during the course of a contract. The incentive that drives the behavior is the threat of the potential breach, termination and damages.

Some companies are “warranty happy” wanting the Suppliers to provide a number of different types of warranties.  For example, every time there is a new governmental action or program there’s a push to add a warranty. I know, I worked for one of those companies. Many focus their warranties on managing several key things such as ensuring you get value for your purchases and you are protected against government and third party claims that could cause you damages or penalties or impact the right to use the purchases.

For the most part when Buyer’s think about warranties they do so in the context of the right to return the defective material for repair or replacement, and these types of warranties are traditional the warranties against defects in material or workmanship that are provided for a specific term. In negotiating these types of warranties and the duration, the Supplier’s motivation may be one of either managing risk or generating revenue. If the warranties will be provided at Suppliers expense, the shorter the warranty period, the fewer the expected failures and the less the financial risk they have in providing the warranty. For products that have on-going maintenance or service contracts, the Suppliers want to negotiate short warranty terms so they can sell those maintenance or service contracts. If you are negotiating a warranty on a product where the Supplier’s main motivation is management of the financial risk, one of the best tools to help with the negotiation is the Supplier’s own data about their product’s reliability. If a product is marketed to have a mean time between failures of 100,000 hours, that means it shouldn’t fail for over 12 years on average. If the Supplier is trying to offer only a one year warranty, use their reliability figures against them. The argument is simple. If they really have a product with 100,000 hours, the incidence (and resulting cost) of failures that would occur in a year 2 or 3 are minimal, so the two are inconsistent.

Exclusions to warranties are important as they can dramatically impact your coverage or cost. For example, some Suppliers may provide a ‘parts only” warranty when the real cost of a problem is the labor it takes to correct it. Other exclusions can be so broad that almost anything will negate it. When you agree to exclusions, they should be limited to only those damages that have been caused by parties other than the Supplier, such as Buyer or Buyer’s customer’s abuse or mishandling of the product and they should be for damage that occurs outside what would be the ordinary or expected use for the product.

Standard Contracts also contain a number of legal warranties such as:
  • Right to enter the contract
  • Performance will comply with contract, laws, regulations, etc.
  • No claims or liens threatened
  • Product or Service doesn’t infringe the IP rights of a 3rd party
  • The Product or Service conforms to warranties and specifications of the contract
  • Free of defects in design and safe for use
  • The Product is new, and not re-conditioned
All of these warranties are there to create obligations on the part of the Supplier to manage against specific risks which could impact the Buyer or Buyer’s Customer’s ability to use the product. The failure to meet these warranties will provide the Buyer with remedies for breach of the warranties under the Contract in which the Buyer could pursue appropriate damages. Because of the criticality of many of these terms any negotiation should be done with the involvement of your legal counsel.

There are several implied warranties that suppliers traditionally want to exclude/
Warranties of Merchantability the Fitness for a Particular Purpose and the Warranty of Title and Non-infringement.

Under the Uniform Commercial Code (UCC) goods must be of “merchantable” quality meaning they:
  • are of fair average quality within the description or are are fit for the ordinary purposes for which goods of that type are used;
  • are of equal kind, quality, and quantity within each unit and among all units involved;
  • are adequately contained, packaged, and labeled
  • conform to any promises or affirmations of fact made on the container or label.
  • may have other implied warranties from course of dealing or usage of trade.
Also under the UCC an Implied warranty of fitness for a particular purpose will apply If the Seller has reason to know of any particular purpose for which the goods are required and that the Buyer is relying on the Supplier's skill or judgment to select or furnish suitable goods.
To exclude the warranty of merchantability the language must mention "merchantability", be by a writing, and be conspicuous. To exclude or modify any implied warranty of fitness the exclusion must be by a writing and be conspicuous.  Language to exclude all implied warranties of fitness is sufficient if it is in writing, is conspicuous and states, for example, "There is no warranty that the goods will be fit for a particular purpose".
All implied warranties are excluded by expressions like "as is," or "with all faults," or by other language that in common understanding calls the Buyer’s attention to the exclusion of warranties and makes plain that there is no implied warranty.

It is important to understand that these implied warranties are provided to a Buyer under the Uniform Commercial Code which really applies only to the United States, which means that in other locations of you need these warranties they would need to be expressly spelled out in your agreement as they will not be implied.  Other Jurisdictions may have other warranties that are implied by law.

In deciding whether they are required you need to look at the circumstances of the purchase,

The implied warranty of merchantability is a form of quality warranty.  It says that the goods must be of "merchantable" quality or simply of good enough quality to re-sell. If you have an agreement that
Disclaims that warranty the expectation is that the purchases will have higher quality requirements than it just be merchantable and that is managed by both the Specifications for the Product and all the Quality Documents that are made part of the Specifications or agreement.  In that situation a warranty that the Product complies with the Specifications or Agreement provides the same protection. 

The implied warranty of fitness for a particular purpose requires that the Supplier must know the purpose and the product will work under that purpose. This warranty may be disclaimed by Buyers when at the time of the agreement is executed the Buyer either does not know or want to share the specific purpose or the Buyer is not relying upon that Supplier’s skill or judgment.

If your agreement is silent as to the implied warranties and would be subject to interpretation under the UCC most of the time the Supplier will propose that the implied warranties be excluded.  Whether you should agree to that is dependent upon the circumstances of the purchase.

Here’s a few questions to help decide if they apply:
  1. Will the Product being purchased be resold as is?
    1. If yes, you may need the warranty of merchantability. If no you may not.
  2. Does the agreement have specifications and quality documents that clearly describe the required quality and/or workmanship?
    1. If yes, you probably don’t need the warranty of merchantability. If no and the answer to 1 was yes, you should have it.
  3. Do you intend to disclose the purpose for which you are buying the product to the Supplier?
    1. If yes, you may need the warranty of fitness for a particular purpose. If no it would not apply,
  4. If you are disclosing the purpose, have you made it clear to the Supplier that you are relying on them to select a product that meets that specific purpose?
    1. If yes, you need the warranty. If no or you are not relying on their skill or expertise you probably don’t need it.

In negotiating it as part of a standard agreement that will be used for the purchase of multiple items over time, you can have situations where it may not be needed for some products and it may be needed for others.  This means that if you disclaim them in the master agreement that you use, you may need to add them for any product specific document and ensure that has priority because it will conflict with the master or vice versa.

The Warranty of Title and Against Infringement;  Buyer's Obligation Against Infringement provides that “the title conveyed shall be good and its transfer rightful and shall not unreasonably expose the buyer to litigation because of any colorable claim to or interest in the goods; and “the goods shall be delivered free from any security interest or other lien or encumbrance of which the buyer at the time of contracting has no knowledge”.
If further provides that if buyer that furnishes specifications to the seller must hold the seller harmless against any such claim that arises out of compliance with the specifications.

When a Supplier wants to disclaim this implied warranty what they are effectivly saying is they want to sell only the right or title as the seller or a third person may have (which shouldn’t really apply to OEM’s that produce a product, or that the seller is selling subject to any claims of infringement which would greatly reduce the potential value to the Buyer. They may also want to take the position on infringement that all the want to provide is the indemnification. There’s several problems with that. Once you eliminate the warranty, especially if you had these as express warranties, if the provide the remedies under the indemnification you would not be able to terminate the agreement nor would you be able to recover damages. Not all remedies in most Intelllectual Property indemnification sections are not cost neutral to the Buyer, and giving up the warranty can force you into having to continue to purchase from the Supplier with a much more expensive solution.

Warranty Redemption

In negotiating warranty redemption provisions, just as Buyer’s are concerned about the Supplier’s quality checks prior to shipping parts, Suppliers are concerned that Buyers have a similar quality process in managing returns to screen out non-defective items and items that would not be covered under warranty such as out of warranty items or damages excluded from warranty. Since many Suppliers are concerned about this they may want samples of the defects to be provided so they can verify the defect prior to issuing a return material authorization to return a larger quantity. Supplier’s may also want to negotiate in no-defect found or no-problem found charges for those situations where the Buyer returns good Product to cover their costs of checking inspecting and testing those returns. Suppliers may also want for the parties to split the cost of the returns with the Buyer paying for the return to the Supplier and the Supplier paying for the return back to the Buyer. For the Buyer, the primary concern is the speed in which the repair or replacement will be performed, as that impacts inventory levels, and anything that delay the replacement forces an increased inventory or longer downtime. Issues like No-Problem found requests can easily be dealt with by offering the Supplier to agree to pay that, if they pay you for all your costs every time they send you a defective product, which is a proposition I’ve never had a Supplier accept. On the issue of time, the Supplier requests are really cumulative. First they want a time to verify the defect, then they want a time to issue an RMA, then they will want time to provide a replacement of perform the repair, the total of which can be substantial and the impact to you is it drives your investment in inventories up. The higher the value of the product, the greater the investment in inventory and the more quickly you need to have the repair or replacement of the product turned around and can’t wait for a serial process to occur.  Any time the Supplier wants to include a conditional step prior to your return, if you are going to agree to that step, you should include a timeframe they have to perform it. As part of the warranty many provisions will also include a form remedy should the Supplier fail to perform such as being able to procure it elsewhere and charge the Supplier the difference. That may not be practical as other Suppliers may not be able to repair replace it and, you may be better off negotiating different performance such as being able to pull new parts from an existing VMI hub. As to the cost of the shipping, my position has always been that we paid for the Supplier to provide a high quality, high reliability product. We also, in many cases paid to have that product shipped to us. Since we paid once, we shouldn’t have to pay again.   

Out of Warranty Service And Support

If you have on-going support commitments to your customers or you are buying a product that will need to be maintained, serviced, repaired or supported, the best time to negotiate those Supplier obligations is before you agree to make the purchases that will need them. If all you do is buy maintenance agreements to meet those needs, your primary concerns in the negotiation are cost, the length of the support commitment and the scope of the services (what they will do, when, how, the response times, and how problems will be managed and escalated etc).  If you do self maintenance or perform service and support for others, as a minimum you need to be able to purchase Field Replaceable Units (FRU’s) and out of warranty repairs. If you will do lower level support you may need to purchase of spare parts, training, tools, test equipment or programs and possibly back up support. The most important things you negotiate in all of this is the term and the cost. The term is how long you can count of the Supplier to provide what you need. The cost is important because if you don’t have control over that in the future, the Supplier could price the support items where it is cost prohibitive to continue with them thereby avoiding all the other commitments, or they can use the fact that you are locked into them to substantially improve their profit at your cost. Once these two things are locking in, the next most important thing is to negotiate response times and escalation processes to assure you get what you need when you need it and that you get the appropriate response when problems arise. Since out of warranty service and support is a great profit generator for Supplier and provides them with a revenue stream year after year, when you negotiate the cost you need to be aggressive. Back in the 60’s when a car cost $3,000, if you purchased all of the spare parts to make that car it would cost well over $20,000 and I’m sure that the situation hasn’t gotten any better. Spare parts, and FRU’s will cost more than the production piece if for nothing more than the fact that they must be individually tested, inspected and packaged so an old rule of thumb was that there shouldn’t be any more than a 30% price premium. The other thing that you clearly need to be aware of is that Suppliers will probably have the tendency of trying to charge more for the items that will need replacement more frequently and may try to charge less for those that have substantially less of a probability to fail just to make the overall cost look better. Consumable supplies clearly fall into the category of things you need to closely watch the pricing on to make sure it is competitive.

In negotiation of repair pricing you need to remember that repairs are just another manufacturing process in which tasks are performed and materials are consumed, so the cost you pay for repairs should be based on the competitive cost of those elements plus a reasonable contribution to their overhead and profit consistent with the industry.

Maintenance contracts also need to be looked upon as just another service. There are planned maintenance calls which have certain labor and materials associated with them and there are break-fix maintenance calls in which there is labor and in most cases the swap out of FRU’s that may need to be repaired.  In negotiating maintenance agreements the biggest unknown is the frequency of the amount of break fix activity. If you can estimate what the planned maintenance portion of the cost is, it’s then easy to back into what the Supplier has allotted for break fix as part of their annual fee to determine whether it is better to have an all inclusive maintenance agreement or pay on a per call basis. Since most Suppliers don’t want you to buy maintenance on a per call basis, they will usually overprice the per call rates and they may also use a connection between contract status and service call priority to try to drive you to a maintenance agreement where the odds are great that it will be more profitable for them. As long as you negotiate all of this before you make the initial commitment to purchase the product you have the leverage to negotiate a better deal. If the nature of the business is really structured in a way where the Supplier is dependent on the annuity stream that on-going support provides, always use that to 1) get the best deal you can on support, and 2) use any reluctance you have with them on giving you what you want for support is leverage to drive the initial purchase price down further.

Warranties – How Long Should The Last

How long should a warranty last ? The answer really depends upon what is being warranted.  In negotiations I’ve seen Lawyers want to have all warranties expire when the warranty against defects in material and workmanship expires. The problem with that is when a warranty relates to a potential third party claim, in many cases the typical warranty period for defects in material and workmanship is far less than the statute of limitations provides for the third party to make a claim.

For example assume that you have a 3 year warranty for defects in material in workmanship but your agreement also has the Supplier warrant that the product is safe.
The Product is purchased on January 1, 2011. The warranty against defects would expire on January 1, 2014. On January 1, 2013 the customer is injured.  If the Customer lived in New York, the Statute of Limitations for tort claims (claims for personal injury or property damage) is three years from the date of the injury.  This means that injured party must make a claim by January 1, 2016.  This also means that since the Buyer is potentially liable on that claim as a reseller of the item, their potential liability would not extinguish until January 1, 2016 on that potential claim. If you allowed the Suppliers warranty to co-terminate with the warranty against defects in material and workmanship, you would create the situation where the Supplier is no longer liable to you, but you could still be liable to the injured party.

Many times Buyer’s will refer to their warranties as on-going. Suppliers may view that as them having potential liability forever. It’s really not forever as the potential liability will at some point cease as a result of the Statute of Limitations. What you need and should require is that as long as you could be liable to a third party, you need the Supplier to be continuing to provide you protection.

One of the keys in maintaining that protection is to make sure that the Warranties, and other key terms that are intended to provide protection against third party claims, such as Indemnities and Insurances, are included in the Survival section of your Agreement so those obligations do in fact survive the termination or expiration of the contract.    

Negotiating product warranty

(Defects in material and workmanship).

The two factors drive a supplier's behavior regarding warranty for defects in material and workmanship. They are the potential financial exposure from the warranty and the potential of additional revenue generation. In reducing the potential financial exposure, Suppliers know that the shorter the warranty period, the lower the probability of claims against the warranty. The fewer claims, the smaller the supplier's warranty cost.

Warranty claims result from problems that usually occur in two distinct stages. The first stage of failures is what is referred to as "infant mortality", where the failure occurs early in the use of the product. This problem usually results from either defects in the material or the production process. To reduce the amount of infant mortality failures, companies would "burn in" the item by running it for some period. The more reliable the product proves to be, that period may be reduced or eliminated. Suppliers may also use pre-tested or "pre-conditioned" parts where the testing for infant mortality has already been performed.

The other stage of failures is those that will normally occur randomly during the life of the product. In understanding the potential warranty cost to a supplier, they will consider the average life or "reliability" of the product. Product reliability is usually expressed in a quantitative measure that is a statistical average of all projected failures. That statistical average or mean is called Mean Time Between Failures. For things like semiconductors and other electrical devices it may be expressed as “FIT” meaning Failures In Time in which one FIT equals one failure per billion hours where the rate is statistically projected by results of accellerated failure testing. The longer a product is used, or the more a product is used, the higher the potential incidence of failure. 

As warranty repairs, on-site calls and product returns may, under the terms of the warranty, be paid for by the Supplier, their goal is to reduce the period of the warranty which reduces their financial exposure to those costs.

A short warranty period also means that the supplier can sell you service or maintenance contracts sooner. The sooner they sell the service or maintenance contract the more money they stand to make. For example if one Supplier had a 12 month warranty and another had a 90 day warranty, you would need to add 75% of the annual service contract cost to the Supplier with the 90 day warranty to have equivalent warranty terms.

Warranties can be expressed in terms of time (days, months, years), or a function of usage (number of operating hours,  volume of production). For example a toolmaker may warrant their tool for a certain number of "hits" or times in which the tool is used. In addition to the actual term of the warranty there are other factors that affect the cost of warranty.
- Delivery terms may impact when the warranty starts
- The time required to inspect and accept an item may reduce the effective warranty period if warranty starts before then, such as with the shipment.
- What's covered by the warranty (does it include materials only or             labor
  and materials).
- Certain warranty language can have sufficient exclusions that the
  value of the warranty may be substantially diminished.
- Systems required to track and manage any warranty related claims
  can add to the cost.
- Requirements such as who pays for shipping of warranty returns can significantly add to the cost.
- As a buyer the quality and reliability impact the cost of the item.
  Low quality items mean more problems and greater inspection and acceptance costs.
- Low reliability items require more frequent replacement
- Reliability also impacts any strategies you may have for stocking of spare or replacement items.

In negotiating warranty provisions:
1) The period of the warranty should be long enough for the item to operate at full capacity under all required operating conditions. For example, if you replaced an air conditioning system in October, you would want at least a 9 month warranty so that it could be tested during the heat of July and August. If you purchase an item designed for a specific volume production, you would want the warranty to go past the
point at which you will achieve that volume. Many problems aren't seen until an item is functioning at its peak levels.

2) There should be a relationship between the warranty period and the reliability. Products that have high MTBF specifications should not have short warranties. If the vendor is pushing for a short warranty one of two things is happening: 1) they have a lack of confidence in the reliability of the product, or 2) they want to increase revenues by starting the service or maintenance agreement sooner.

3) In most companies maintenance, service contracts, spare parts and repairs are high profit margin, annuity businesses. The less self sufficient you are in supporting the item or the fewer alternatives you have for support, the more you need to protect yourself against the future cost of those items. The best time to negotiate them is when you have the greatest leverage that is before you purchase item.

4) How you use the item may be different from other customers, so you may need to tailor the warranty and follow on maintenance services to your specific needs. Items you may want to address are emergency contacts, response times, spare parts inventory required to be carried, problems escalation requirements, and preventative maintenance requirements. The more critical an item is to your operation, the tighter your requirements should be. Response times can be tailored to both performance and needs. For example, the greater the number of failures the faster the response you may require. If there are times at which you have significantly greater volumes, where the impact of being down is significantly greater,  you may require a faster response during those periods.

5). To do things right from the beginning may require some assistance from the supplier. With any major piece of equipment you would want
a complete set of operating manuals, recommended preventative maintenance requirements and schedules, training on the operation and maintenance of the equipment including replacement of high wear or consumable items and customer intended trouble shooting activities which can be performed. Items such as software applications require many of the same types of assistance.

6) When you consider a warranty you also have to consider how much the item costs and what it will cost to enforce the warranty? In some instances it may be worth negotiating a discount for no warranty.  In other situations it may make sense to have a system where you get a credit for a failure but don't have to return it, or can consolidate returns
to reduce shipping costs.

7) Warranties sometimes need to be looked at not by what is included, but what has been deliberately excluded. Does it include parts only where the greater expense will be labor? Does it provide free labor, when there is minimal labor content?

8) Another portion of warranty discussions, mostly from an OEM perspective, is "no problem found charges". The concept behind a no problem found charge is material returned for repair under warranty should be failed material. If the material isn't defective, the argument goes that you haven't done your job at screening the material and hence
you should pay for the supplier incremental costs to receive and re-test the material. The easiest way to may this go away is to offer to accept the no problem found charge if the supplier accepts all your costs every time they ship any bad material.

9) If the item has a long useful life, in addition to all other requirements you may want to include an "end of life" purchase option, where if the supplier elects not to make the product or parts any longer, they provide you with an option to make a one time "end of life" purchase of critical materials you feel are needed to continue to use and maintain the equipment.

10) The channel you buy from has a major impact on your ability to negotiate warranty provisions. While certain distributors or re-sellers may perform warranty services, a distributor or re-seller cannot bind the OEM. Without the OEM's express consent, any changes to the warranty or unique warranty terms you negotiate would have to be provided from the resources of the distributor or re-seller. Most distributors or re-sellers support is usually limited and focuses on "tier 1" support where they have the capability to fix common problems and the OEM is available to support the more complex "tier 2" problems.

11. Service warranties normally address the standard to which the service is being provided (e.g. Conform to the specification; Good. work person like manner; comply to certain professional standards). It will also address the responsibility of the supplier to correct any problems or errors (e.g. full conformance, substantial conformance, conformance to material requirements). It will also address the timing
for the correction (e.g. within X hours or days, immediately, within pre-defined response times).

12. Software warranties normally address the standard to which the software is being provided (e.g. Conform to the specification). It will also address the responsibility of the supplier to correct any problems or errors (e.g. It may have different tiers of importance with different requirements for each and also address providing an initial "work around"  and a later revision to correct the item and may also address the degree to which each will be performed (full conformance, substantial conformance, conformance to material requirements). It will also address the timing for the correction (e.g. within X hours or days, immediately, within pre-defined response times and with pre-agreed escalation processes).

13. One of the important things to consider when negotiating warranty is how you will be able to track and manage the warranty period. For single purchases it may be easily tied to the delivery date. You may allow the it to be tracked from the supplier's shipping date as long as the in-transit and inspection and acceptance time is added to the warranty period. For higher volume purchases a simpler method or tracking may be required such as date coding the items.

14. As with other terms, what you negotiate for warranty provisions needs to drive the right behavior on the part of both parties. For example the period to do warranty repairs may be set at one time (assuming that there will be minimal problems) and have a much shorter, more aggressive requirement in the event there are substantial numbers of warranty problems. While I don't think a buyer should ever pay to return an item
for warranty repairs, if you do agree to pay it should be based upon a small number of returns, and if the number is exceeded the Supplier should pay.

The whole issue of warranty is who should bear the costs in the event of a problem with the product. The attitude you should have is that the party who has the greatest ability to manage against that risk is the one who should bear the majority of the costs associated with the problem. The supplier is the one who has the greatest ability to manage the product's quality by its design, materials used, processes, inspections, etc. When there are quality problems that result in warranty claims, they should bear the biggest financial burden.

Should the length and extent of a supplier warranty impact what’s required for Supplier quality management? The answer is easy. Under a traditional warranty scenario, the warranty responsibility is to repair or replace athe defective product and that may cover only a small portion of the costs. That commitment may be further reduced by exclusions to the warranty:
·      The definitions of what is warranted. Not all problems may be covered. For example: Contract Manufacturers may warrant their workmanship, but may exclude any warranties on the materials you specify.
·      How long a period the warranty runs and what starts it. E.g. 12 months from shipment.
·      Specific exclusions such as environment use with other products, misuse, Damage from electrical surges, static discharge.
·      The supplier’s responsibilities in the event of a covered failure. E.g. Repair, replace, credit.
·      The supplier’s responsibilities for consequential damaged that accrue. E.g. Do they pay for the cost re-work, repair or replace or do they just give you the part?

The key is who bears the cost? In a traditional warranty situation here’s how it would break out depending on the phase. 

Failure at Incoming. –
Buyer bears inventory costs, and management of replacement costs.
            Supplier pays for repair or replacement and some/all of the shipping.

Failure In-WIP
Buyer pays for inventory costs, re-work costs, and management of the replacement.
            Supplier pays for repair or replacement and some/all of the shipping.

Failure at the End Customer site
Buyer pays for inventory cost, service call, and management of the replacement.
            Supplier pays for repair or replacement and some/all of the shipping.

Epidemic failures
Buyer pays for inventory costs, service call costs, management of replacement costs, and deals with customer impact.
            Supplier pays for repair or replacement and some/all of the shipping and, depending upon what’s negotiated, the Supplier may reimburse Buyer for its costs, but that usually occurs only after an initial threshhold of failures has been exceeded.

Whether you rely upon their plan and warranties, or verify and pro-actively manage their quality gets down to whether you trust the Supplier and believe what they say. If you don’t, you need to independently verify that they are in fact managing the business in a sound, controlled manner that will produce high quality products. Since Buyers bear a large percentage of the total quality cost in the relationship, the concept of verifying their program and doing on-going management is something that needs to be done to manage the potential cost exposure.

The general rule with quality is that the sooner in the process you are able to catch the problem, the lower the cost impact. Once a product reaches the customer, the cost of quality problems grows exponentially so something which may only cost $1.00 to correct at the Supplier, may cost multiple hundreds of dollars to correct at the customer site.

The only risk warranties traditionally protect against is the cost of purchasing a new or repaired item. Warranties of component suppliers may not cover your costs of re-work at a Manufacturer. The real costs of quality to a Buyer is in the extra inventories they must carry, the customer shipments missed, the field repair costs, and customer satisfaction issues.

Mean time between failures
Product cost (warranty period received is LESS than that offered)
Delivery terms (Start of warranty
Product inventory
Systems (Both Buyer and Seller)
Spare parts inventory
Item cost
No problem found charges
Cost of handling
Warranty administration cost
Inspection and acceptance
Life cycle cost/ profit
Locations for returns
Competitiveness of service charge
Product inventory strategy
Reliability problems

What's covered by warranty


General thoughts on negotiating warranty terms:

  1. There should be a relationship between the warranty period and the supplier’s published reliability or Mean Time Between Failures (MTBF) data. Use the Suppliers published reliability data do achieve a longer warranty period.

  1. How much does the item cost? What will it cost to enforce the warranty? You always need to consider whether it is worth having no warranty or a system where you get a credit for failures but don't have to return it.

  1. For equipment it’s important to understand what is included in the warranty and what is its respective value? Does it include only parts where the real expense will be labor?

  1. Is the response time adequate? Have you considered requiring that the greater number of failures the faster the required response time?

  1. If the Supplier wants charge you a "no problem found" or no defect found charge for situations when good material was returned to them, have you countered by offering to accept those charges if the Supplier will accept all your costs for every time they ship you bad material? (This usually ends the discussion on no problem found charges.)

  1. If the vendor is pushing for a short warranty does that show a lack of confidence in the reliability of the product? Is the push for a short warranty tied to other goals such as the sooner the warranty expires, the sooner they can sell you a maintenance agreement.

  1. Once you buy you have lost leverage for later negotiations of service or maintenance agreements unless there are competent third party service providers who will insure that competition exists. Even then, you may still be at a competitive disadvantage as they may still need to purchase replacement parts from the original supplier.

  1. What is included in or excluded from the warranty and what is its respective value ? For example, does it include only parts where the real expense will be labor or does it include only labor where there is minimal labor content ?

  1. There are other things that affect warranty and the warranty you get affects a number of other factors
Delivery terms (if delivery is linked to the start of the warranty
Systems required tp manage warranty obligations (Both Buyer and Seller)
Item cost (where warranty redemption may not be economically feasible
Cost of handling
Additional Inspection, test and acceptance costs for repaired or replaced item
Locations for returns

Product Cost for products that use the item if the warranty period received is less than the warranty period offered to customer/
Product and Spate Parts nventory levels
Life cycle cost/ profit
Competitiveness of maintenance / service charges and profit of service business

  1. Maintenance and Service revenues are extremely important to many companies. They are frequently higher margin businesses within the company and considered “annuities business” which provide on-going revenues without, in many cases, a substantial sales effort. You may not be buying just the product, you may be buying the product and a potential long term revenue steam for the Suppler. In negotiating you must consider the total cost of ownership which includes price, the cost of on-going service, maintenance, support, parts, etc.

Warranty Exclusions

Many times Suppliers try to limit their liability by trying to either exclude responsibilities from the warranty or exclude their responsibility to provide warranty coverage in certain situations.  An example of the former is when a Supplier excludes parts from the warranty but includes labor or vice versa. An example of the latter is:
“These warranties do not extend to, or apply to, any Product which has been (1) subjected to misuse, neglect, accident, improper installation, or to use in violation of instructions furnished by Supplier, (2) repaired or altered outside of Supplier’s factory by persons not expressly approved in writing by Supplier, (3) evaluated, screened, or tested by an outside testing laboratory not previously approved in writing by Supplier, or (4) based on design features provided by Buyer.” 

Let’s take a look at what’s wrong with this type of exclusion.

  1. “These warranties”. This is a very broad statement and would apply to not just the warranty against defects in material and workmanship but would apply to all of the listed warranties. If you had product impact warranties like whether the Supplier has the right to sell the product, the product doesn’t contain any liens, that the product is non-infringing? It probably does not. So if you are going to agree to an exclusion make sure it applies to the specific warranty.
  2. “subjected to misuse, neglect, accident, improper installation, or to use in violation of instructions furnished by Supplier” this is very broad and very subjective. If you are going to agree to an exclusion you want to be clear and objective.  Require the Supplier to specifically define what each means so its clear that you know what you are not supposed to do.
  3. As products are misused, neglected, have accidents occur to them, have improper installation and may still work, you also want to make sure that whatever you did or failed to do is the root cause of the problem or acceletrated the problem.
  4. “repaired or altered outside of Supplier’s factory by persons not expressly approved in writing by Supplier”. What is a repair or alteration? Some products require a form of alteration just to use them. For example electronic components on their own do nothing. They need to be placed on a circuit card to use them. Is that an alteration?  Language needs to be clear and objective and you also want to make sure that the repair or alteration was the root cause of the problem or acceletrated the problem.
  5. “evaluated, screened, or tested by an outside testing laboratory not previously approved in writing by Supplier”. This one was a little strange as evaluating, screening or testing a product should have no affect on the product unless you were doing stress testing outside the operating parameters of the Product Specification and that caused damage. Why would you ever want to effectively give up your right to have something tested for a defect because the cost of that would be the loss of warranty? I could potentially see agreeing to excusing it if, 1) the testing was done outside the operating parameters in the Specification and 2) that testing was the root cause of the problem or accelerated the problem.
  6. “based on design features provided by Buyer.”  The impact of this is if Buyer provided any design features, it would excuse the Supplier from the warranty. The only problem with that is that the design features provided by the Buyer may not be the source of the problem. A design feature should excuse a manufacturing defect that has no direct relationship with the Design.  Be clear and make sure that they would need to prove that the Buyer provided design features are the root cause of the problem or accelerated the problem. I would also be specific on what Buyer provided design features are.  For example, If the Buyer either by its specification or by written direction tells the Supplier that the product must be implemented in a particular way, that may be something that would be reasonable to excuse the Supplier from responsibility for. If on the other hand Buyer provides certain features or functionality in the product that is up to the Supplier to determine how to implement or Buyer make suggestions that they Supplier has the option of accepting or rejecting, in both those situations I would argue that those are not design features provided by Buyer. Again, be specific and make sure that what you have done is either the root cause of the problem or without those design features that you required the problem would not have existed. 

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.