Sometimes, warranty expense rates get too low to be sustainable. And sure enough, when General Motors Co. recently saw its warranty accrual rate dip below two percent, and when Ford Motor Co. saw its accrual rate fall to 1.5%, you could almost see it coming.

Both companies are now revising their accruals by adding in extra funds to pay for safety recalls and unexpected warranty work. And while that doesn't impact their traditional accrual rates, it has a massive effect on their actual accrual rates, in terms of how much they're actually paying. And that, in turn, is cutting into profits.

It all started earlier this year. GM began differentiating between warranty accruals and recall expenses in the warranty expense table it published for the first quarter of 2014. Until that point, the company had provided just one unified figure for warranty accruals and recall expenses, which it called "Warranties issued and assumed in period." So while it has always included recall costs in its warranty expenses, now it's identifying them separately.

Beginning with its financial report for the quarter ended March 31, 2014, there have been two separate lines for accruals: "Warranties issued and assumed in period -- policy and warranty," and "Warranties issued and assumed in period -- recall campaigns and courtesy transportation."

The first of these we're going to call regular warranty accruals. The second and new one, we'll just call recalls. GM now lists them separately. And when it began doing so this year, it also provided year-ago figures that detailed how much of the 2013 warranty accruals went towards recalls vs. regular warranty.

Massive Recalls

The recalls have been all over the news this year. As those headlines have highlighted, GM is now reacting to defects in its ignition switches and power steering systems that have caused crashes, injuries and even deaths. Now it's setting aside money to pay for repairs. Here's GM's explanation:

In the three months ended March 31, 2014 we recorded charges of approximately $1.3 billion comprising: (1) approximately $680 million for 2.6 million vehicles to repair ignition switches that could result in a loss of electrical power under certain circumstances that may prevent front airbags from deploying in the event of a crash; to fix ignition lock cylinders that could allow removal of the ignition key while the engine is running, leading to possible rollaway or crash; and to provide courtesy transportation to owners of affected vehicles; (2) approximately $340 million for 1.9 million vehicles to replace either the power steering motor, the steering column, the power steering motor control unit or a combination of the steering column and the power steering motor control unit as the electric power steering could fail under certain circumstances; (3) approximately $185 million for 1.3 million vehicles prone to non-deployment of the side impact restraints if vehicles are not serviced when the Service Air Bag warning light is illuminated; and (4) approximately $70 million for 1.2 million vehicles for other matters.

In other words, while the regular and usual warranty accruals continue to be made, the company allocated additional funds for these four additional reasons. And the bill for these additional reasons topped $1.3 billion, which was far more than was set aside for the regular and usual warranty accruals.

In the second quarter of 2014, GM also began to ramp up the size of its adjustments for pre-existing warranties, correcting for under-accruals made in previous years. Typically, these adjustments are much smaller than the regular and usual warranty accruals. But they because unusually large in the second quarter.

Warranty Claims

These recalls and adjustments didn't affect claims by much. Payments are payments, whether they're for brand new cars or older cars, and whether the repair is part of a recall or not. There's just one figure for claims payments, not separate figures for recall claims and non-recall claims. But as can be seen in Figure 1 below, claims payments have increased noticeably in the second and third quarters of this year.

In the second quarter of 2014, GM paid out more than $1 billion in warranty claims per quarter for the first time since the end of 2009. In the months of July, August and September, it paid out more than $1.3 billion in claims, which as can be seen in the chart above is not far below the heights reached in 2008 and 2009.

Most manufacturers use the accrual method to pay their warranty expenses. When they sell a product, they estimate how much its warranty will cost, and they set that amount aside in a reserve fund as an accrual. Then, as the actual bills come due, they take money out of this fund and use it to pay for warranty claims. If at some point they discover that they didn't set enough aside when the product was sold, they make an adjustment. And if they eventually see that not all the money they set aside was actually spent on claims, they take the excess out of the reserve fund with an adjustment.

Therefore, if we look at the warranty reserve fund like a savings account, we have two types of deposits: regular accruals and adjustments. And we have two types of withdrawals: regular claims and adjustments. But since the adjustments can be both positive and negative, most manufacturers usually list only the net amount, upwards or downwards.

Separating Recall Expenses

What GM has done is to create a third type of accrual, for recalls. Therefore, in order to get a true picture of the company's deposits into its warranty reserve fund, we have to look at regular accruals, adjustments, and recall expenses.

In Figure 2, we're tracking all three types of expenses separately. The dark green represents GM's regular accruals, which by the way always included recall expenses from 2003 to 2012. The bright green represents the recall expenses that GM has recently begun to identify separately. And the yellow represents all the other adjustments made to pre-existing warranties.

It becomes immediately clear that the warranty accruals for current sales haven't really changed that much. It's the recalls and the other adjustments that are running up the bill in recent quarters.

Notice that in previous years, the other adjustments have been comparatively small in relation to the regular warranty accruals. And since GM always bundled its accruals and recalls together before 2013, we have no historical data for that metric. But the point is that the sheer size of the recall expenses and other adjustments has been much larger than usual in recent quarters.

The problem is, those expenses are rising precipitously. This really is unusual. And that money really needs to be set aside. And it comes straight out of profits, whether it's a regular expense or an adjustment.

Rapidly Rising Recall Costs

Normally, we look at just the regular expenses (in the dark green). But in GM's case, the unusual expenses have become so large that they can't be ignored. In the first quarter of 2014, for instance, GM had to set aside more than $2 billion, which was more than twice as much as it did during the same period of 2013.

The irony is, the amounts that we're calling the regular accruals actually fell year over year, from $705 million in the first quarter of 2013 to $634 million in the first quarter of 2014. But then the company had to also set aside extra money for the unexpected recalls this year, which sent the total quarterly outlays above $2 billion for the first time ever. The previous high was $1.65 billion in the spring of 2005.

In the spring of 2014, GM had to set aside a little less for recalls than it did in the previous quarter. However, it still had to add in $889 million in other adjustments, sending the quarterly total over $2.6 billion. So even though both accruals and recall expenses were falling, the total for accruals plus recalls plus adjustments hit yet another new high.

And then finally, in the third quarter of 2014, things began to calm down a bit. Regular accruals fell below $600 million, and both recall expenses and other adjustments fell to around $200 million each. And the quarterly total for all three together fell below $1 billion once again.

This doesn't mean the crisis has passed. What it means is that GM has by now set aside all it needs to pay all the claims it expects, given what it knows now. Claims are likely to remain elevated, because it takes time to get to all the affected customers. And further adjustments are still possible. But regular accruals and recall expenses have probably peaked.

Meanwhile, GM's warranty reserve fund balance has also peaked. After all these deposits have been made, and before all the withdrawals will be made, at the end of September 2014 the balance rose above $10 billion for the first time ever. But as more claims are paid and less accruals are added, it's likely to slip below that level by year's end. Before this recall crisis began, GM's reserve balance was around $7.2 billion.

Expense Rates Compared to Sales

The missing metric is product sales revenue. When GM had to set aside more than $2 billion in the first quarter, it had to do so against $36.3 billion in product sales revenue, meaning it was setting aside almost 5.6% of its sales to repair its products. That's relatively high, even for the automotive industry, where warranty expense rates tend to be elevated compared to most other industries.

By June, the warranty & recall bill was up to nearly $4.7 billion for the first six months of the year, meaning GM had to set aside nearly 6.3% of its $74.8 billion in product revenue. By September, the total cost of all three types of accrual was up to $5.65 billion, but that was only 5% of its $112.8 billion in product revenue.

In Figure 3, we've charted both the "regular" claims and accrual rates and a new third line representing the unified bill for accruals, recalls, and other adjustments. Notice that the red line representing "regular" claims has turned upward in 2014, while the line for "regular" accruals is lower. It's the new accrual rate, representing accruals, recalls, and other adjustments, that's really soared. But even that metric is now down from its peak.

GM's claims rate is now back up to 2.75%, its highest level since the end of 2009. But remember, back then it was high because GM was fixing last year's cars with that year's money, and that year was the deepest part of the recession. Now, the claims rate is high because of all the additional recalls and repairs, while sales are flat.

Same Problem at Ford

The good news (or bad news, depending upon your point of view), is that GM is not alone. Ford also has its warranty & recall expense problems, though unlike GM it has not yet taken the extra step of separating its warranty & recall costs into two separate figures. Actually, it didn't begin to combine its warranty and recall expenses until 2011 (see the April 5, 2012 newsletter) for more. However, like GM, it is making massive and unprecedented adjustments to its accrual levels to catch up with rising costs.

In Figure 4, we're tracking Ford's quarterly claims payments from 2003 through 2014. As is obvious, claims have now risen to a level not seen since early 2008. Also, on a rolling basis, claims paid in the first nine months of 2014 topped $2.1 billion, up almost 24% from the same period in 2013. By year's end, Ford's claims total may be back up to 2011 levels, if not higher.

The accruals don't yet reflect this rising trend. But that's because as mentioned, Ford has not gone as far as GM did, and is still publishing only one all-encompassing figure for warranty accruals (including recall expenses). And so far in 2014, regular warranty accruals haven't risen all that much. For the first nine months of 2013, Ford accrued $1.47 billion. For the first nine months of 2014, it has accrued $1.51 billion, only a 2.4% increase.

However, Ford has also been making some relatively large warranty adjustments, in addition to its regular accruals. As can be seen in Figure 5, it made a $625 million adjustment in the fourth quarter of 2013. And the adjustments made so far in 2014 have also been quite large: $456 million in the first quarter, $207 million in the second quarter, and $759 million in the third quarter.

This means that in the most recent quarter, the adjustments exceeded the regular accruals for the first time ever. And while the regular accruals are down, year over year, the adjustments are way up. There were some large upwards adjustments in 2005 and 2009, but never before on this scale.

So let's do the same thing with Ford's accrual rate that we did with GM's in Figure 3. Let's add the regular accruals and the upwards adjustments together for the last four quarters, and use that total to plot a new accrual rate.

On this basis, as can be seen in Figure 6, Ford's accrual rate is also soaring. In the first nine months of 2014, the company made $1.51 billion in regular accruals and $1.52 billion in adjustments, meaning that it's set aside a total of $3.03 this year for warranty work. Against $102 billion in automotive sales, that's almost three percent of product revenue for the first nine months of the year.

Excluding these adjustments, Ford's accrual rate has remained close to 1.5% since the middle of 2012. And that's very low for an automotive OEM. But if we add in the adjustments and recalculate the accrual rate, we can see it begins to rise in 2013 and really spikes in 2014.

Of course, there have been quarters in which both GM and Ford made downwards adjustments to their warranty accruals, effectively taking money out of the reserve fund after concluding that they had overestimated the true cost of warranty in years past. GM, in fact, has withdrawn as much as $409 million per quarter from its reserve fund, while Ford has taken out as much as $268 million per quarter.

No Downward Adjustments Included

These downward adjustments aren't included in Figures 2 or 5. That's why, for instance, in Figure 2 it appears that GM made only one adjustment in the five years between 2003 and 2007. In reality, during that entire 20-quarter period, GM made 16 downward adjustments, three small ($4 to $6 million) upwards adjustments that are barely visible, and just one medium-sized ($78 million) upward adjustment, which is the only one that can be seen.

We have an alternate set of charts available that include the negative numbers. But it's even more confusing than Figures 2 or 5. Still, readers who want a copy should email the editor through the pop-up link at the top of this page: warrantyweek.com and for "Your Message," please request the alternate GM and Ford charts.

However, the omission of the negative numbers from these charts doesn't really change our conclusions. GM has made only two downward adjustments since the end of 2009. Ford has made only two downward adjustments since the end of 2007. And it's been 18 months since they made any. Therefore, those negative numbers would have no effect on the soaring accrual rates we've seen in recent months.