U.S.-based product manufacturers incur annual warranty management-related expenditures, as a percentage of profit before tax, of as much as 20 percent. The warranty accrual incremental budgeting process faces challenges when new products are introduced. Zero-based budgeting better addresses new product introductions because budget inputs are completely reset every budget cycle, with new inputs captured to reflect a changing business environment.
Warranty driven expenditures, reported on financial statements, can include the following, though the Securities and Exchange Commission (SEC) reporting requirements are vague:
- Upgrade/modification programs employed when product performance guarantees are not met.
- Voluntary/mandated recall programs.
- Goodwill initiatives (e.g. key customer’s product is warranted an additional six months due to ongoing reliability problems).
The most popular budget technique employed for warranty claim accruals is the incremental budget, which typically encompasses the following:
- Engages readily available analytic tools like Excel.
- Applies inputs from historical data sets such as claim settlement expenses.
- Uses independent-demand forecasting techniques like weighted averaging and trend.
- Does not consider that a black swan event may occur and assumes the existence of a relatively stable business environment.
- Efficiently manages the budget process and minimizes levels of granularity to do so.
- Delivers a reasonable level of accuracy.
- Passes the muster of internal/external auditors.
But this budgeting process faces challenges when newly-designed products (NDPs) are introduced as part of the mix of warranted products. NDPs are always defined as being recently delivered for the first time to the marketplace. NDPs also contain a combination of the following elements that differentiate them from warranty cost drivers of previously designed products (PDPs):
- Product design (e.g. new capabilities, and more reliability, maintainability and capacity).
- Different terms and conditions meeting product owner expectations (e.g. NDP warranty duration of four years versus two years for PDPs).
- Volatility of warranty claim settlements, driven by the production learning curve slope (e.g. warranty accruals are 8 percent of revenues for the first 50 units of NDPs manufactured due to quality and engineering issues, and then will decline to 2 percent starting at unit 200, which then aligns with that of PDPs). If learning-curve projections are wrong, warranty claim settlements may be dramatically affected.
- Relationship changes between the manufacturing organization of NDPs and its suppliers.
The aforementioned may rule that the employment of the incremental budgeting process is problematic for budgeting warranty claim accruals, but a product manufacturer should first understand the financial materiality of those accruals. For example, leadership and/or auditors may define the materiality threshold level as being triggered when 20 percent of all warranted units are NDP units, and/or when 30 percent of all warranty expenditures are driven by NDP units. Note that a unit of warranted NDP can incur warranty claim settlement costs that are 25 percent to 100 percent higher than that of a unit of warranted PDP.
Once materiality levels are developed, the warranty budgeting technique chosen can embrace one of the following four scenarios:
- If warranted NDPs do not meet the financial materiality test, incremental budgeting can be continued to be solely employed for both PDPs and NDPs, with an understanding that the budgeting of accruals might be slightly inaccurate compared to that of claim settlements.
- If warranted NDPs do meet the financial materiality test, an alternative should be chosen to replace incremental budgeting in order to be more adaptive to a variety of cost drivers and a more volatile business environment.
- A manufacturer can select to retain the incremental budgeting process for warranted PDPs and employ an alternative budget technique exclusively for warranted NDPs.
- If warranted NDPs do not meet the financial materiality test, leadership may nonetheless seek an alternative budget technique for the combination of all warranted products.
One alternative budget technique to that of incremental budgeting for warranted NDP is zero-based budgeting (ZBB), a technique in which budget inputs are completely reset every budget cycle, with new inputs captured to reflect a changing business environment. Note that ZBB requires that a working business model, with simulation capabilities, drives the selection of all its budget inputs. The abandonment of all analytics that were performed in the last budget cycle and starting from scratch in the next budget cycle is not the modus operandi of ZBB.
There are several advantages to ZBB:
- Greater accuracy. Besides anecdotal experience, the use of a significant number of budget inputs tangentially invokes the Law of Large Numbers of probability theory. Also, operational personnel from the real world are involved and are accountable for the validation of the inputted data sets.
- Greater adaptability. Easily enables changes to a variety of inputs during multiple budget cycles and non-stable business environments.
- Greater granularity. Imparts a higher level of understanding as to the complexity of a warranty program and its financial impact. Often an “awakening” for leadership to dedicate greater resources in this area to improve the efficiency and effectiveness of the processes.
- Greater action orientation. Increases the ability of an organization to identify unfavorable warranty cost trends and engage in targeted changes, sooner rather than later.
The business model driving zero-based warranty budgeting includes such inputs as:
- Products/models types that will be warranted during the forecasted period.
- Population size and value of warranted units.
- Customer solutions required to meet obligations of the warranty terms and conditions.
- Processes and their activities required in delivering customer solutions.
- Direct and indirect resources employed in each of the solution-driven processes.
- Quantity requirements for each resource.
- Cost-estimating relationships.
The clarity and adaptability of a zero-based warranty budgeting initiative creates a standard of excellence that is hard to surpass. But a ZBWB project is not an easy endeavor to undertake. It can be extremely inefficient and even ineffective when the following are lacking:
- A detailed business model driving the budget.
- Analytical software with simulation capabilities.
- Oversight by seasoned operational and financial professionals knowledgeable in warranty management.
- Support from leadership.
Despite these challenges, ZBWB should be considered as the budgeting process of choice for product warranty accruals, regardless of financial materiality.
Ron Giuntini is principal with Giuntini & Company Inc.
A longer version of this article appears in the July/August edition of AFP Exchange.