The Dark Side of Warranties

Many companies sell their products under quality assurance warranties, which typically cover the cost of repair or replacement of malfunctioning products and the cost of refund for defective products. While warranties help consumers reduce purchase risk, they may cost firms a ton. Consider Tesla, whose stock price dropped significantly after an article in?Consumer Reports?highlighted the widespread quality issues with Model?X?and raised questions about the company’s large warranty payments. However, it is unclear what managers could do to attenuate the potential harm from bad warranty news (or how they could successfully benefit from good warranty news). For instance, when facing unanticipated increases in warranty payments, should managers boost advertising spending (to counter with positive information) or R&D spending (to help overcome quality concerns by placing greater emphasis on innovation)?

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Our paper in the best international journal in marketing answers these questions.

First, we show that higher warranty payments indeed indicate product quality issues. Second, we propose a contingency stock market response model incorporating both internal and external product market signals. Our thesis is that changes in warranty payments are timely and informative signals for investors, and that they consider this signal in conjunction with other product market signals when forming their expectations about product quality and its impact on firm value.

Warranty payment information is especially important to investors when other quality signals are lacking––most likely in industries such as machinery or electronic equipment manufacturing. We compiled a large data set of warranty payments for the period 2010–2016 using information obtained from public firms’ annual reports filed with the Securities and Exchange Commission (SEC). Among our sample firms with the highest warranty payments are Motorcar Parts America Inc., Standard Motor Products Inc., Overland Storage Inc., Netgear Inc., and Thor Industries Inc. Several web sources and articles discuss significant quality issues experienced by these firms. For instance, Thor Industries, a large U.S. manufacturer of recreational vehicles, recalled different types of motor homes in 2015.?The company has also been involved in various ongoing litigation cases based on state “lemon laws” and customer warranty claims. Similarly, Netgear was sued in 2017 for selling defective cable modems.?As all of these firms offer some type of warranty for their products, warranty coverage does not necessarily imply product quality.

Changes in firms’ warranty payments are informative signals that enable investors to form timely expectations about potential changes in product quality. We show that warranty payments affect potential investors’ product quality assessments and stock investment. Our quantitative analysis reveals an asymmetric stock market reaction: unanticipated increases in warranty payments (which signal quality losses) lower stock returns but unanticipated decreases do not affect stock returns. Two important factors moderate this relationship. First, boosting advertising spending attenuates the negative stock return effect of unanticipated increases in warranty payments. Second, unanticipated decreases in warranty payments, which signal quality gains, translate into higher stock returns when the industry has become less concentrated. Interestingly, changes in R&D spending do not moderate investors’ response to unanticipated increases or decreases in warranty payments. We advise firms to use advertising to lessen the harm from warranty payment increases and to strongly communicate warranty payment decreases in the face of intensified competition. The below figure visualizes the interaction of increasing warranty payments and advertising intensity, with advertising changes at respectively 1 standard deviation (SD) above versus below the industry mean. In the face of an unexpected warranty payment increase, annual stock returns are stable when the firm advertises a lot, but decrease a lot when when advertising intensity is low.

?Our findings are relevant to production, marketing, and finance managers as well as to the C-suite. We document evidence suggesting that preserving and enhancing firm value in relation to warranty programs and related product quality issues requires a coordinated effort among managers from different business functions. Cost efficiency through cost-cutting tactics, such as using cheaper material and labor, is likely to increase defective product rates and lead to unanticipated increases in warranty payments, which translate into lower firm value. However, overinvestment in quality improvement efforts may not result in higher firm value as investors do not react positively to unanticipated decreases in warranty payments. Therefore, managers need to carefully consider the cost and benefits of allocating resources away from and to product quality investment.