Thursday, July 29, 2010

Extended Warranties Considered Harmful

Back when I was a young pup working my way through school, I had a job at an electronics store.  For many of the gadgets that we sold, we offered consumers to opportunity to buy extended warranties for them.  In order to give we salespeople an incentive to sell these warranties, we were given a 6% commission for every plan that we sold.  In addition, the salesperson who sold the most during the course of a month would get some sort of a bonus on top of the commission.  This brings me to my rule of thumb when it comes to commissioned salespeople:

If a business provides an incentive for its salespeople to sell something, it must be a moneymaker for the business.  The bigger the incentive, the more of a moneymaker it is.

Obviously, a business is not going to give salespeople an incentive to sell something that loses money for them (unless they don't want to stay in business for very long).  I can tell you from first hand experience that businesses make a lot of money off of extended warranties.

Why are extended warranties such a good deal for stores and a bad deal for customers?  Consider the following example...

You purchase a digital camera for $200.  The manufacturer's warranty is for 1 year, but the store offers to extend the warranty to 2 years for $40.  Are you really getting a 2 year warranty for $40?  Not exactly.  If the camera breaks during the first year, you are covered by the manufacturer's warranty regardless of whether or not you take the extended warranty.  The extended warranty only pays if the camera breaks after 1 year but before 2 years.  Essentially, you are only getting an additional 1 year of coverage.  However, by using the words "2 year extended warranty", they are tricking your mind into thinking that you are really getting 2 years of coverage. 

The question now is whether or not this extra year of coverage is worth $40.  A simple rule of thumb is to take the cost of warranty and divide it by the cost of the item.  This gives you a percentage.  If the chances of the item breaking during the extended warranty period is greater than this percentage, then the warranty is a good deal for you, the consumer.  If not, then it is a good deal for the store.  Usually the extended warranty is priced so that it is not just a good deal for the store, it is a GREAT deal for the store.

In my example, if you take the $40 cost of the extended warranty and divide it by the $200 cost of the camera, you get 0.2 or 20%.  If the probability that the camera will break after 1 year but before 2 years is greater than 20%, then you are getting a good deal.  Personally, if I think the camera is going to break 20% of the time, I am probably going to buy another camera instead of taking the warranty.

The only other time that an extended warranty might be a good deal for the consumer is if the cost to repair or replace the item is high.  Instead of a camera, maybe the item is a car.  Paying $400 for an extended warranty might not make sense from a pure probability standpoint.  However, the possibility of a $5,000 repair might be too much for your wallet to bear.  You might be willing to part with a sure $400 to eliminate that possibility.  However, in the case of most consumer electronics, the cost is low enough that the possibility of repairing or replacing the item is not going to keep you awake at night.

Because extended warranties are such a big profit center, salespeople employ a lot of hard-sell techniques to get you to buy them.  In a future posting, I'll give you an inside look at some of the strategies that are used and how to counter them.

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