The Biz of Pacelinebiz

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Extended Warranties

with one comment

Roll the dice!

Roll the dice!

Should you offer extended warranties or other insurances or “protection” against an unlikely event?  Should you take advantage of an extended warranty as a consumer?  Let’s take a look at the second question.

The reason I thought of this idea is I recently experienced something that made me consider extended warranties.  The event was an unfortunate one that I have not yet resolved.  I bought a de-humidifier on June 27, 2013 at a large, big-box home improvement store and it has not worked since I turned it on this spring.  It came with a 1 year limited warranty which expired last summer.  This unit was designed for basement use and can de-humidify down to a temperature of 41 degrees.  I paid $200 plus tax and I believe a 2 year extended warranty was $25. I lost my bet this time.  The lesson today is I had really bad luck with this de-humidifier.

If you do some quick math, to break even on the deal for the big box store they must have placed a 16.5% chance of it going bad over the 2 year period covered.   Let’s assume the cost of the unit to them is $150 then I arrive at about a 16.5% chance – this would mean that if they sold 6 warranties 1 would be used and the 6 warranties at $25 each would cover the $150 cost they have in the unit.

But wait a minute.  They are not in business to break even; they are in it to make money.  So, we need to re-visit the numbers.  Let’s assume that extended warranties are a good margin business.  For this hypothetical example, let’s assume a “good margin” is 50%.   If they want to make 50% on the extended warranty; that means the chance must be half of the breakeven of 16.5%.  So, 1 In 12 would be redeemed NOT 1 in 6.  To re-cap, this is how the math would work.  12 sold at $25 yields $300 and the cost to replace the 1 bad unit in 12 is $150 so they make $150 on $300 in sales – 50%.  I suspect the margins are higher than 50% but even still I was the 1 person out of 12 who picked a loser unit off the shelf.

But wait another minute.  If the failure rate is 1 out of 12 that means 8.3% would need replaced in 2 years.  Let’s be realistic, the big box store would not do business with a company that had a rate that high.   Manufacturing standards used by a big box retailer would require a failure rate of something in the low single digits – maybe 2 or 3%.  If that is the case, I was the one out of 50 that picked a bad unit.  This also means that their margins are higher than 50%.  A question you need to ask yourself is this; if the warranty is such a good deal for me, why would they try so hard to sell it to me?

So what does this mean to you and your business?  It means if you know your product and its reliability you should offer a warranty and price it as an additional revenue stream.  In some situations, even a service provider can off “protection” to their customer.  When I was working in a CPA firm, I can recall one firm in the market offering IRS “audit protection” on 1040’s.   This firm knew that the IRS audit rate was under 3% and they also knew what their own experiences with audits were – which was much less than 3%.  For $25 they offered this and it gave peace of mind to clients and made enough money to have a nice after tax season party each year.

Have a great week exploring new ways to get more revenue while providing extra value to your customers.

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Written by pacelinebiz

April 6, 2015 at 8:01 am

One Response

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  1. This reminds me of a time I was in a car dealership. A door to the employee-only area was open. From the showroom floor, I could see the dealership’s sales board tracking the salespersons’ stats. There were two sets of columns to record sales – one set for car sales/leases and another set for extended warranties. This reinforced the idea that extended warranties are a profit center for the seller more than a way to protect the consumer.

    Matthew Macy

    April 6, 2015 at 9:26 am


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