November 9, 2004

Extended Warranty Income:

If comparing extended warranty to net income is misleading, then let's correct the record by comparing apples to apples: warranty claims paid to recognized revenue over the past two years.

Reaction to the Oct. 26 edition of Warranty Week was decidedly negative. In that edition, we compared the recognition of extended warranty revenue to net income at eight well-known companies.

They're totally different things, one subscriber said. It's not even like comparing apples to oranges. It's more like comparing apples to applesauce.

What we were attempting to show was how profitable extended warranty sales are, and how extended warranties account for a significant portion of certain manufacturers' net income. But it's not as simple as computing extended warranty recognized revenue as a percentage of net income. First of all, recognized revenue is pre-tax and net income is after-tax. Even if pre-tax operating income is used instead, as it was for a few of the eight examples in the Oct. 26 edition, it's still not proper accounting, the subscriber said.

Another subscriber called to say that in his opinion, extended warranties couldn't be that profitable. They couldn't be that big a source of profits for most companies because if they were, everybody would be selling them. How could some companies keep it secret for so long that they're making more money off service contracts for the products they sell than they are on the products themselves? If this were true, one would assume that all the hordes of stock analysts following these manufacturers would have picked up on this. Yes, one would assume. The sad fact is that nobody has, except the people selling extended warranties, and they're a bit camera shy.

A longtime reader at one of the eight subject companies actually cancelled his subscription last week. Perhaps it was a signal of protest? If it was, we're going to send him this edition, apologize for making an inappropriate comparison last time, and try again to make the point using the same data in a different way. The data wasn't untrue, but the comparisons were perhaps a bit unfair. And perhaps the tone of the article suggested that extended warranty profits were somehow embarrassing. It's not embarrassing. But it is surprising.

Importance of Extended Warranty Revenue

The point of the Oct. 26 edition was to show how important extended warranties have become to some of the manufacturers who sell them. There are other ways to do that than to compare revenues to profits. For one thing, several of the companies mentioned in that article were unprofitable over some segment of the last 21 months, so the comparison didn't work. For another thing, profits fluctuate at rates much greater than anything seen in warranty. So perhaps net income was the wrong choice.

This time around, we're going to make the same point about the importance of extended warranties to OEMs by comparing the amount of revenue recognized from the sale of service contracts to the amount of reported warranty claims. Granted, there's even problems with this approach, because some companies don't separate claims into two components as perhaps they should: one for product warranty claims and another for extended warranty claims. But the last thing we want to do is conclude that analysis is impossible because the data isn't perfect.

So let's take a second look at four companies: Apple Computer Inc.; Dell Inc.; Gateway Inc.; and Eastman Kodak Co. And let's compare product warranty and extended warranty in two ways for each. In the first chart for each company, we'll simply list the reported dollar amounts for warranty claims (in red) and extended warranty recognized revenue (in blue). In the second chart, we'll put those reported dollar amounts on a scale of 100%, where a reading of 50% for each would result if the dollar amounts were exactly equal.

Outflows vs. Inflows

What we're doing is comparing the outflow of funds used to pay claims to the inflow of funds derived from extended warranty policy premiums. For some companies, they're roughly equal, meaning essentially that extended warranty buyers are financing warranty claims, more or less. For other companies, they're radically out of equilibrium, suggesting perhaps that either a company is pushing too hard or not hard enough when it comes to offering extended warranties.

Let's start with Dell Inc. As the chart below suggests, the company is spending roughly as much on product warranty (red) as it sells in extended warranties (blue). HTML Edition readers who want the data in tabular form can click here to request the Plain Text Edition of this week's column. Plain Text Edition readers who want to see the graphs are directed to http://www.warrantyweek.com/newsarchive/ww20041109.html for an online version of this article.