After seeing our analysis of the OEM vs. supplier split in the automotive industry in last week's newsletter, a subscriber asked if the same thing happens in the aerospace industry?

His company happens to be a major supplier in both industries, so we reran the numbers for aerospace, formatted the results into the same charts, and found that they're nothing alike.

First, while the recession hit everyone, it struck only a glancing blow on most of the aerospace industry. Second, the aerospace OEMs and suppliers share warranty expenses much more equally than do the automotive OEMs and suppliers. Third, they pay close to the same percentage of revenue for their warranty expenses.

In short, there is no story here. And that in itself is the story. Because of the way the aerospace industry is set up, there is no radical split between OEMs and suppliers. In fact, in a way they're all suppliers. Some supply the fuselage, so we call them the OEMs. But their warranties cover just the fuselage. The avionics suppliers provide warranties directly to the buyer, as do the engine manufacturers, the interior manufacturers, and many of the other manufacturers.

As a result, the buyer gets a book filled with warranty terms and conditions for each of the major components. And when something goes wrong, the buyer deals with the makers of the component, not the fuselage manufacturer. As a result, there is no struggle between OEM and supplier over blame and reimbursements.

In that way, it's more like the trucking industry than the passenger car industry. In aerospace, the OEMs are responsible for the airframe, but not for the entire system. Suppliers take responsibility for the major components, and the buyer has to deal with a collection of warranties as a result.

Flight Safety Record

However, there's another major difference. The aerospace industry strives for zero failures while the unit is in the air, and it does so with a program of preventative maintenance and extensive paperwork that accounts for a major share of the warranty expense. And because some of the best maintenance crews work for the airlines, the customer may actually do its own warranty work, and bill the manufacturer for it.

It's entirely possible that an airline will remove a system from a jet, and install a replacement, before knowing if the system needs a repair. And it may repair that system before it knows if it's still under warranty. So the claims paperwork will typically be a back-office afterthought, because keeping the plane in the air is the priority.

In the figures below, one can see some of this stability and parity in the shape of the data. We're tracking nine OEMs and 82 suppliers, though some of the suppliers, such as United Technologies Corp., could also be classified as OEMs. We should also note that some of the companies we have listed as suppliers, such as United Technologies and Harris Corp., are predominantly paying claims in other industries besides aerospace. And so, for that reason, the totals and averages we've outlined below will be slightly different and more inclusive than the annual figures provided in the March 29 newsletter.

In Figure 1, two things are clear. First, there was no dip in claims in 2007-2010. In fact, claims were lower in the second quarter of 2012 than at any time since 2006. Second, there is more of a rough balance between the claims paid by the OEMs and suppliers -- certainly nothing approaching the 9:1 ratio seen in the automotive industry.

In fact, though we won't publish it, the ratio between OEM claims and supplier claims has usually been between 30% and 40% OEM and between 60% and 70% supplier. The OEMs dropped to 26% at one point in 2008, and in the most recent quarter of 2012 their share rose slightly above 40% for the first and only time.

Therefore, aerospace is an industry where the suppliers apparently pay most of the warranty claims. And aerospace is an industry where claims were paid at more or less the same rate during the recent recession as they were both before and after it.

Accrual Data

Much the same pattern can be seen in the accrual data in Figure 2, with a few differences. First, while the peak in accruals was at the very end of 2007 (right on schedule for the recession), the industry total almost surpassed that peak at the end of 2011. Second, because of a recent rise in accruals by the OEMs and a fall in accruals by the suppliers, the balance in accruals has been much closer to 50/50 in the last three quarters.

The recent increase in accruals seems to be almost totally caused by Boeing Co., which more than tripled its warranty accruals in the fourth quarter of 2011, and has allowed them to remain at an elevated level for the first half of 2012.

The irony is that Boeing's claims rate actually dropped in the first half of 2012 to its lowest level since early 2007. So the justification for the increased accruals has yet to show itself in the form of increased claims. However, for many years Boeing has kept its accrual rate much lower than its claims rate, which allowed its reserves to deplete over time. Perhaps this is the beginning of an effort to make sure there's more money coming in than going out?

Warranty Reserves

Our third metric is the combined warranty reserve fund balance of the 91 companies we're tracking in this sector. The OEMs do indeed show a recent increase in their collective balance, thanks to Boeing. But the suppliers actually had more reserves last year than they do this year. Therefore, the combined balance for both suppliers and OEMs is down a bit from 2011 levels.

The OEMs now have $1.85 billion in their reserve funds -- more than ever before. But the suppliers kept as much as $2.7 billion in their reserve funds last year. And they allowed their reserves to shrink to less than $2.2 billion by June 2012 -- less than at any time since early 2005.

The good news is that the reason might be found in Figure 4. When we take the claims and accrual data of Figures 1 and 2 and divide them by sales figures, we get a series of percentages. And as can be seen below, the percentages for at least the suppliers seems to be trending downwards.

Back in 2003, the suppliers set aside as much as 1.5% of their revenue to pay warranty expenses. By 2006 that expense rate was generally below one percent. And by 2012, it was under 0.8%.

For the OEMs, meanwhile, the trend has been either up or down, depending upon how far back you look, and what you look at. Compared to 2003-2004, warranty expenses are radically lower. But compared to 2005-2008, they're trending upwards again.

Then again, average claims rates are lower in 2012 for the OEMs than they were last year. As of June 2012 they're back to 2008 levels again. However, the average accrual rate (again, thanks to Boeing) is at the highest level in 2012 that it's been since 2003. So at best, it's a mixture of good and bad news for the OEMs.

Remember, however, that the original prompting for this week's newsletter was a subscriber's question whether things were the same in the aerospace industry. In the automotive industry, there is a large gap between the average expense rates of the OEMs and the suppliers. In the aerospace industry, there really is no gap, and the rates for the two groups are very close together, as can be seen in Figure 4.

The Boeing Effect

We said we wouldn't publish a chart showing the OEM/supplier split for claims, because it showed so little change over the past decade. However, the Boeing-caused rise in OEM accruals, and the reductions by the suppliers, have changed the balance on the accrual side. So that's a chart that we will include this week.

In Figure 5, we've taken the quarterly totals from Figure 2 and set them to equal 100%. In other words, if the OEMs and the suppliers each made a total of $200 million in accruals in a given quarter, for a total of $400 million, the percentage split would be exactly 50/50 between them.

In practical terms, the ratio has never reached 50/50. But as can be seen in the chart above, it came awfully close to doing so in the final quarter of 2011. The ratio has since then fallen back to 44/56%, but even this is closer to a 50/50 balance than any of the 35 quarters that came before the most recent three.

When Boeing used to allow its claims to exceed its accruals, it periodically fixed things by making special adjustments to its warranty reserves. For instance, in 2009 it added $110 million to its reserves in addition to $167 million in regular accruals. In 2010 it added an extra $170 million to supplement its $141 million in regular accruals. But last year, there was no big adjustment. Instead, there was $232 million in regular accruals.

So what we're seeing in Figures 2 and 5, rather than being an early warning of trouble ahead, may be nothing more than a major player learning how to strike a better and more timely balance between claims and accruals. And that major player is so large a part of the industry that its adjustments can easily move the totals and averages.