Traditionally, warranty expense has been

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1 Warranty A Neglected Source of Competitive Advantage BY SHRUTI MANDANA AND MERAJ MOHAMMAD Warranty management is the next frontier in the ongoing battle to cut costs. Companies that use a best-practice approach to warranty management can provide better value to customers while improving the bottom line. Traditionally, warranty expense has been regarded as a cost of doing business and its magnitude has been rising. A 2008 study by Warranty Week estimated that the top 50 U.S.-based manufacturers spend more than $28 billion annually on warranty expense. For some of these manufacturers, warranty costs represent as much as 5% of total revenue. Best-run companies, however, have learned how to leverage warranty management as a significant source of cost competitiveness. PRTM research and experience shows that companies that have mastered the discipline of warranty management not only reduce costs but also increase customer satisfaction and service revenue. Take the high-technology industry as an example. Our research shows that total warranty and maintenance service costs of top performers are almost 60% lower than those of other companies. Why Are Warranty Costs Rising? All manufacturers feel the pain of warranty costs to some extent, but technologybased companies such as automotive, computers, medical equipment, electronics, and telecommunication bear the brunt of it. Four trends coalesce to increase the pressure on warranty costs. First, rapidly declining product prices, especially in the electronics and high-tech industries, are eroding profit margins. Second, ever-rising product complexity increases the number of potential problems with the product. Third, heightened expectations from consumers, who expect flawless product performance, place additional pressures on companies to provide robust after-sale services. Fourth, decreasing product lifecycles are forcing companies to introduce more reliable products to the market from the start. Fewer companies can now afford a warranty hiccup in the early stages of product introduction, expecting to recover the margins during the rest of the long product life. The increasing magnitude of warranty costs has not gone unnoticed by the Securities and Exchange Commission (SEC). Filing regulations and Sarbanes- Oxley compliance requirements now obligate companies to report costs associated with their warranty obligations. However, many financial managers still complain that they lack clear definitions for measuring warranty costs. In fact, warranty management remains an uncharted territory for many organizations as they struggle to understand, communicate, and analyze their warranty performance. This situation is exacerbated by the lack of a cross-industry warranty management framework that defines warranty elements and costs. As a result, most companies tend to use ad hoc approaches to measuring and managing this performance PRTM 1

2 Drawing on our research and client experience, the following discussion explains how companies can achieve best-in-class warranty cost performance. This approach entails understanding the primary drivers, measuring and managing warranty costs, and aligning the decision making across different functions. Figure 1: Warranty Cost Drivers Total Warranty Cost Understanding the Primary Drivers of Warranty Costs 1. Warranty Terms and Conditions 3. Service Delivery 2. Product Reliability and Maintainability Warranty costs are determined by three key factors: warranty terms and conditions (Ts&Cs), product reliability and maintainability, and service delivery. Understanding their impact as well as their relationship to each other is an important first step in controlling warranty costs. Together, Ts&Cs and product reliability determine the ultimate service-delivery costs. For example, a company with poor product reliability that goes to market with an aggressive warranty offering will likely face debilitating service-delivery costs. Since each of these three cost drivers is controlled by a different function, making optimal warranty decisions is no small feat. 1. Warranty terms and conditions. Ts&Cs depend on the length of the warranty period and the breadth of the warranty program. Companies that face rising warranty costs typically adjust the warranty period by reducing the length of standard service coverage. However, they often neglect to adjust the breadth of their program Standard Warranty Cost Drivers by tailoring such variables as service response time or the type of support (on-site versus remote). This rigid one size fits all approach to service coverage prevents companies from using it as a competitive lever. For example, in some situations, a company may want to tailor its standard warranty program in order to win a contract or generate incremental revenue through up-selling. In fact, leading warranty programs support a tiered service model (e.g., preferred, silver, gold ) by tailoring warranty services to the key customer segments. Best performers have taken this a step further by offering carefully controlled custom services that address the specific needs of each customer segment. Having a range of well-managed warranty options gives the sales staff flexibility to negotiate effectively in competitive situations by selecting, Standard Warranty and Maintenance Cost Drivers as well as bundling together, the right warranty services. 2. Product reliability and maintainability. Since product failures and, consequently, the probability that the warranty will be invoked stem directly from poor product quality, rigorous pre-release testing can help avoid expensive product recalls later. But it is equally important to design products that are easy to maintain and repair. This allows customers to service the product themselves, using tools provided by the company, such as downloadable software patches. In addition, a modular product design goes a long way toward allowing an easy replacement of defective components. For example, in the case of Dell s laptop battery recall in 2005, the company simply mailed new batteries to its customers to replace the old ones PRTM 2

3 What Are Warranty and Maintenance Costs? While warranty-and-maintenance services are often lumped together and considered synonymous with after-sales support, it is important to distinguish between the two. Warranty services are associated with products that are under the standard, or base, warranty included the product s original price. Extended warranty (or contracted maintenance) services, on the other hand, are revenue-generating service agreements that have been purchased by the customer, over and above the standard warranty coverage terms. For example, when purchasing a television set, a buyer may get a one-year standard warranty and an option to buy an extended warranty for three additional years. Alternatively, a manufacturing company may attempt to contain its warranty costs by sliding back the standard warranty to only 90 days. This approach incurs greater maintenance costs, which are then covered under revenue-generating extended warranty contracts. Figure 2: Standard versus Extended Warranty Sidebar 1 3. Service delivery. Measuring and managing total warranty cost depends on measuring and managing service-delivery costs. These costs can be effectively managed internally, unlike other cost drivers such as warranty period. For example, if customers expect a three-year standard car warranty, it would be difficult to sell cars with a shorter standard warranty. How do leading companies distinguish themselves in service delivery? They can provide warranty services more efficiently and cost-effectively than others because they have optimized their service supply chain processes, such as repair, material parts usage, and reverse logistics. Standard Warranty Extended Warranty Measuring and Managing Warranty Costs Warranty Costs Maintenance Costs Companies often account for service expenses rendered to support a product under standard warranty as a budgeted cost, while revenues and expenses associated with servicing products under extended warranty or maintenance agreements are treated as a profit center. This classification has important implications for cost allocation and accounting practices. If the services organization is treated as a stand-alone profit center, it may be less likely to allocate costs to the profit-center side of the ledger relative to the standard warranty cost center, which is often charged back to the product business unit. Therefore, while it is important to measure and track standard and extended warranty costs separately, an aggregated metric provides a more complete view and allows a more consistent cross-company comparison of warranty performance. It s no coincidence that companies that excel at tracking and reporting warranty costs are also better able to control them. To track costs correctly, it is important to clearly distinguish between the warranty and maintenance categories. Warranty costs, in essence, are service-delivery costs associated with products under standard warranty (see Sidebar 1 for definitions). The effectiveness of a company s service-delivery operations depends largely on how well the company manages four cost areas: repair, material parts usage, reverse logistics processes, and overhead costs. Repairs usually account for more than half of total warranty costs. Given this liability, leading organizations focus on proactive cost avoidance and preventive 2008 PRTM 3

4 maintenance. They also reduce costs by adopting appropriate service strategies, such as encouraging customer self-help and repair services guided by a call center. This strategy is particularly important for mission critical facilities or equipment for which remote diagnostic capabilities can identify potential service problems, preventing the prohibitive costs of system downtime. Material parts, which represent about 15% of total warranty costs, are calculated net of supplier redemptions, either in the form of charge-backs or as credits for part replacement. An effective supplier costrecovery program, where suppliers are charged back for warranty claims related to faulty components, can significantly improve warranty cost performance. Companies that establish clear supplier accountability are more likely to improve overall product quality in the long run. When calculating the overall costs of material parts usage, best performers include inventory carrying costs and obsolescence costs related to service parts. Service logistics include warehousing and transportation costs associated with moving the defective part from the customer to the repair center or the supplier, and then shipping the repaired/replacement part back to the customer. Leading companies develop strategies to optimize these reverse logistics network operations. For example, they cut costs by minimizing the number of touch points (staging locations or central sorting operations) and by shipping the parts directly to Customer Self-Help Remote Repair Repair Profile On-Site Repair the nearest supplier warranty-redemption center. General overhead includes the costs of managing a warranty program, as well as all finance, planning, and information technology costs that support the service organization. These costs must be captured to provide a complete view of operational warranty efficiency. Aligning Decision Making across Functions Since warranty management typically lies at the intersection of three functions product development, sales and product management, and service and supply chain Figure 3: Service Delivery Cost Pyramid Material Parts Usage Warranty Redemption Efficiency 1. Warranty Terms and Conditions Total Warranty Cost Scrap/ Obsolescence Reserves 3. Service Delivery Material Inventory Carrying Costs 2. Product Reliability and Maintainability Warranty-Related Service Delivery Costs Service Logistics Inbound/ Outbound Distribution/ Freight Warehousing Warranty Cost Drivers Level 1 Cost General Overhead Finance, Planning, IT Costs Level 2 Cost Elements Level 3 Cost Elements management who owns it is a critical issue. Best companies coordinate the actions and decisions of different functions for the most effective warranty management. The product development group owns the overall design and quality of the product. It s important to ensure that the product is designed in a way that facilitates its future use. For example, if a company wants to encourage customer self-service, then those serviceability specifications should be an integral part of the product design. The development team faces the conflicting pressures of meeting its time-to-market and cost goals while at the same time ensuring high product quality and serviceability PRTM 4

5 Terms and Conditions Figure 4: Cross-Functional Nature of Warranty Sales and Product These different goals must be carefully balanced. For example, if a target launch date is too aggressive, should the team launch a product with a known defect with the expectation that it will need to be fixed later in the field? Or is it better to delay the launch date? The sales and product management teams also face conflicting pressures. On the one hand, they must provide competitive warranty Ts&Cs to make the sale. On the other hand, management must carefully weigh cost implications of its proposed Ts&Cs to ensure that the estimated warranty liability will be within the prescribed range. For example, to compete in the U.S. market, Hyundai provided a warranty with 10-year standard coverage, while its established competitors offered only three- to Product Development Warranty Service and Supply Chain Maintainability and Reliability Service Delivery Efficiency four-year warranty periods. For their part, service and supply chain managers must deliver high-quality service to customers at the lowest possible operational cost. This requires efficient execution of the repair, material parts, and logistics strategy to meet warranty terms and conditions. For example, these managers must decide how to transport replacement parts: Should they use next-day, second-day, or ground shipment options? These three functions need to work in alignment to make effective warranty management decisions in a timely manner. Since the majority of the warranty costs are locked in during the early stages of the product development cycle, this is when the company can best influence future warranty costs. The key product design decisions are made by product development, sales, and product management groups. After the launch, the service and supply chain management function is left with managing the predetermined warranty costs. Effective communication between service and supply chain managers and the product development team on warranty claim incidents is crucial to improving the quality of future products. Not surprisingly, high warranty costs can often be traced to the decisions made during early stages of product development. For example, if a company is designing a product for a short warranty period but extends the period significantly after the launch, warranty costs are sure to exceed the planned levels. Since recalls and field changes are often expensive, warranty considerations must be taken into account early on. Once a product is launched, it s up to service and supply chain managers to execute effectively on the promised warranty terms through efficient service planning and delivery practices. Finally, as a product is gradually phased out toward the end of its lifecycle, the groups responsible for all three functions must collaborate again to ensure continuity of warranty and service provision. This collaboration will help limit the overall obsolescence charges for parts inventory, both within the company and across the supply chain. So what should an ideal cross-functional warranty governance structure look like? The answer depends on many factors, including industry, type of product/serv PRTM 5

6 ice, and existing organization. The most common approach is to manage warranty as a cost center and to charge warranty costs back to sales and product P&Ls. The group primarily responsible for making decisions about product reliability design trade-offs and warranty policies should also have the corresponding accountability for warranty-related expenses. Taking Warranty to the Next Level To improve your company s warranty management performance, first assess the maturity of your current warranty strategy, policies, organization, and practices. Next, develop a practical road map for advancing to higher levels of warranty management maturity. The following best practices will help you accomplish this goal: Align warranty strategy with business and operational strategies. For example, the Briggs & Riley luggage company offers a lifetime warranty for its high-end, premium-priced products, regardless of usage. This approach is in line with the company s strategic objective of using warranty Ts&Cs and customer service as a competitive differentiator. In contrast, companies that compete in more cost-conscious market segments set their standard warranty levels low but offer many options for extended coverage. This menu of options allows them to customize their warranty offerings rather than pursue a one-size-fits-all approach. Figure 5: Ability to Influence Warranty Costs Design Development Verification Introduction Growth/ Maturity End of Life Cost Impact High High Low Medium Low Medium Influence Key Activities/ Decisions Product Development High High Medium Low Low Medium Product quality specifications Supplier selection Serviceability specifications Terms and conditions Development to specifications Influence Warranty Costs Pre-release testing Serviceability testing Engineering changes Field engineering Product Lifecycle Figure 6: Warranty Maturity Model Stable usage Software updates Manage Warranty Costs End planning Major Elements Sub-Elements Stage I Stage II Stage III Stage IV Strategy Policies Organization/ Infrastructure Practices Overall Strategy Product Strategy Operations Strategy Pricing Strategy Market Research/Analysis Terms and Conditions Internal Policies Organizational Alignment Roles and Responsibilities Measures and Metrics Accounting and Controls Service Planning Service Delivery Logistics Supplier 2008 PRTM 6

7 Establish and enforce clear warranty policies. Using research tools such as voice of the customer, identify key customer warranty requirements and integrate them into the design stage of product development. At the same time, formulate warranty policies and programs that will optimize service revenue by promoting aggressive cross-selling and up-selling opportunities. Align the governance, roles, responsibilities, and metrics. Ensure that people in product development, sales and marketing, and service management are all working toward shared goals. Align the accountability with responsibility using integrated performance metrics. This will ensure appropriate cross-functional input to manage the complex trade-off decisions. Develop effective service supply chain practices. Use top-notch logistics and planning practices to reduce cycle time in your supply chain and avoid excess parts inventory. Work collaboratively with suppliers and partners to deliver on warranty commitments. Agree on equitable warranty recovery contracts. As warranty management becomes an increasingly important factor in manufacturers cost-reduction strategies, this approach will provide better customer value at lower costs clearly a win-win proposition in today s customer-centered market. CONTACTS PRTM Manager Meraj Mohammad at mmohammad@prtm.com or PRTM Associate Shruti Mandana at smandana@prtm.com or _may PRTM 7