Rafi Mohammed

What are Consumers Craving in this Economic Climate? An Extended Warranty… of course!

Posted on September 2nd, 2009 (0 Comments)

With consumers scrutinizing their budgets, fear (as well as the pain) of an unexpected expenditure is on the uptick. Due to this sentiment, extended service contract warranties (abbreviated term: ESC) are more attractive to consumers. Analysts estimate that sales of ESCs have increased by 10% during the recent economic downturn.

Tao Chen, Ajay Kalra, and Baohong Sun recently published an excellent academic article in the Journal of Consumer Research titled “Why Do Consumers Buy Extended Service Contracts?” Analyzing extended service contract data for electronics from a major retailer, the authors arrived at several interesting conclusions. First, lower income consumers, as well as those who have previously purchased ESCs, have a higher propensity to purchase ESCs. Makes sense, right? They also find that more ESCs are purchased when a product is on sale (the bump in ESC purchases is even more pronounced when a sale price is unadvertised – leading to unexpected savings). These results are in line with Richard Thaler’s mental accounting theory, which I have previously written about. One final conclusion is that consumers have a higher inclination to purchase ESCs for fun products (the authors’ technical term is higher “hedonic value”) such as iPods and DVD players (as opposed to, say, printers and landline phones). They claim that interest in ESCs increases because consumers would be more upset if these fun products go kaput. While an interesting thought, I am on the fence about this conclusion. Their empirical findings could just be revealing that fun products are technically advanced and used more often – which could lead to a higher chance of breakage.

As has been long rumored, new warranties can be extremely profitable. The authors cite a BusinessWeek article which asserts that profits from ESCs accounted for more than 50% of Best Buy’s profit and almost 100% of Circuit City’s (now defunct) profits.

Most consumer trade organizations have determined that extended warranties are unnecessary and overpriced. “Almost all of it (the additional premium) will be money down the drain” is Consumer Reports’ opinion. It may make financial sense to self-insure, but extended warranties do offer additional value including eliminating anxiety over unexpectedly high repair bills, guaranteeing next day service, an immediate exchange for a new product if necessary, and the convenience of not having to shop around for service or worrying about being taken advantage of when a repair is made.

So yes, in actuarial terms, Consumer Reports is probably correct. However, value to customers involves more than a financial calculation.

Offering consumers the option of purchasing an ESC is win-win. Consumers are better served and companies earn additional profits from these ESCs (typical margin is 50% to 60%), as well as attract new customers (seeking ESCs).

Enjoy your Labor Day weekend...

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