By: Rajiv K. Sinha
Warranties have traditionally been used as a means to signal to potential customers that the product is high-quality and to allay customers’ anxiety over purchasing a new product of unknown reliability. However, given large increases in reliability as well as the level of commoditization in consumer electronics markets, the value of warranties as a signaling tool is questionable. Adapting to market forces and to managerial concerns, the duration of warranties and the extent of coverage have been rapidly declining. This change has led many firms to switch their focus from offering free base warranties to offering optional extended warranties, or extended service contract warranties (ESC warranties), which consumers must opt into and pay for themselves. In fact, firms have grasped the financial reality that offering extended service contract warranties is extremely profitable. These ESC warranties are lucrative for firms as they all but eliminate the firm’s commitment to free base warranties and essentially allow the firm to profit by making wary consumers share in the risk of product failure. The profitability of these warranties is striking- firms such as Best Buy and Circuit City generated nearly 50% and 100%, respectively, of their annual profits from warranty sales in 2004. Moreover, the extended warranty industry generated almost $25 billion in sales in 2011 alone.
Given that the financial benefits accrue principally for the seller, it is unclear what benefits these ESC warranties could possibly provide to consumers. On the one hand, the traditional warranty literature indicates that warranties are primarily used by consumers as a signal of product quality. Producers with more reliable products have an incentive to provide extensive warranty coverage as a means of signaling quality to consumers. On the other hand, the insurance literature is based on protecting manufacturers from assuming the product failure costs caused by heavy users. Essentially, manufacturers view ESC warranties as a means of signaling low customer quality; those customers who purchase ESC warranties are more likely to overuse or misuse the product.
Thus, the warranty literature generally treats warranties as a signaling tool to reduce overall perceptions of risk by assuaging customer concerns of product quality in uncertain markets while the insurance literature views warranties as a means of screening out heavy users of a product who will likely generate warranty costs for the manufacturer. Given that individuals are unlikely to purchase an ESC warranty unless they can easily imagine something going wrong with the core product, it is difficult to envision ESC warranties as a signal of quality.
Clearly, these different perspectives raise some interesting questions.
- First, if traditional warranties signal value, then what do ESC warranties, which increase the up-front cost to consumers and assume that something can go wrong, signal to consumers?
- Second, to what extent does the nature of the product affect willingness to pay for these ESC warranties?
For example, past research has suggested that people are more likely to purchase an ESC warranty for a hedonic than a utilitarian product. This raises the question of why this is the case, particularly when the potential loss of use of a utilitarian product is likely to result in more economic loss than the loss of use of a hedonic product. Moreover, utilitarian products, relative to hedonic products, are more likely to need to be replaced, as they generally serve functions which must be performed as part of a quotidian routine.
Recent research supports the assertion that perceived risk is a very important factor in the decision process, and that it is the consumer’s perceptions of risk that are driving the decision process. However, this relationship is influenced by the nature of the product– for a hedonic product, consumers really want to minimize their exposure to risk and risk-related concerns.
Interestingly, the perceptions of risk engendered by an unfamiliar brand can be mitigated by offering an ESC warranty if the warranty is from a known retailer and is offered before the purchase decision is made. Additionally, if the same offer is made by the manufacturer of an unknown brand it only serves to further highlight the risk associated with purchasing an unknown product leading to a reduction in the perceived value of the product.
In contrast, people who buy extended warranties for durable and utilitarian products (like refrigerators, which rarely fail) are buying a different kind of an insurance policy: they want to avoid feelings of guilt and regret in case of product failure and the subsequent consequences of not having coverage. This is quite different from protecting from product failure itself and may well explain the reasons for ESC coverage, despite the fact that that is seems like an irrational decision at first glance, particularly from a purely economic perspective.
Dr. Rajiv K. Sinha (Ph. D., Penn State) is a Professor of Marketing and the Lonnie Ostrom Chair in Business at the W.P. Carey School of Business, Arizona State University. His research interests include new product development, technology diffusion, software and music piracy, product pricing, public policy issues related to tobacco and alcohol addiction, Internet based brand communities and marketing strategies for digital products.
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