Budgeting for Warranty Expense

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Simplifying a Complex Process with Built-In Business Logic

Manufacturing companies are obligated by law to repair or replace defective products under warranty. Customers who buy products for personal or business use rely on this obligation when making their purchases. In fulfilling these obligations, manufacturers incur expenses associated with their customer warranty claim activities. These expenses include the cost of parts, labor, freight, and administration of the warranty program.

Although cash is spent on warranty work during the actual warranty activities or shortly thereafter, according to US GAAP’s accrual accounting rules, the warranty expense occurs when a product is shipped, or revenue is recognized for completing all sales contract obligations to the customer. The manufacturer is required to maintain a warranty reserve (a current liability) and charge actual warranty expenses at the time they are incurred to this reserve. As revenue is recognized, a percentage of this revenue must be recorded to the warranty expense account while the reserve account is credited.

Just how much of the sales revenue to expense to warranty is a function of analyzing historical warranty claims and their expenses in the various product categories or in actual products within those categories. After a certain amount of time a product or product line has been on the market, a manufacturer can develop a financial model showing the historic cost of warranty expense as a function of product sales. This model will allow the manufacturer to record warranty expense in the accounting periods the products were sold in as required by GAAP.

Budgeting Warranty Expenses

The same principles apply to budgeting warranty expense and the warranty reserve account balance. If you have a dedicated planning and budgeting software solution where you can perform allocations and have dependencies set up in the application (for example, expenses that are linked to revenue items in the budget), then you can set up your budgeted warranty expense to be dependent on revenue. As revenue changes, reflected in the amount spread among the budget periods, warranty expense will accurately track these revenue values.

Using Intelligent Planning and Budgeting, currently available to SMBs, one can set up a warranty expense budget using the built-in business logic that allows establishing dependencies without using a single formula, function, or link to another worksheet as in traditional spreadsheet-based budgets. The budgeted warranty expense is simply the sum of all the forecasted warranty expenses derived from all products or product lines that are included in the budget and use these intelligent dependencies.

Simple Example

Here’s a simple example:

Assume there are two product sales, A and B, each budgeted on a separate line. Each product historically exhibited a different historical warranty cost due to different actual customer warranty claims. Let’s assume that the actual warranty expense relates to historic gross sales of these products at a rate of: Product A 1.5% and Product B 2.1%. Now you can establish a separate warranty expense dependency for each product sale.

You do that by creating a warranty expense record under Operating Expenses, a module of the planning and budgeting software. You also set up a data link in each expense record representing a revenue line, A and B in our example. For each revenue line, A and B in our example, or group of revenue lines (e.g. product line) that have distinct warranty expense characteristics, a unique driver is set up driving the warranty expense for that revenue record or an entire product line consisting of several or many revenue records.

Then the payment method for the revenue expense record is set to Non-Cash with a default credit to the Warranty Reserve account (current liability) to allow crediting this liability as the warranty expense is recorded. To record the forecasted actual warranty expenditures incurred for customer claims (always trailing behind forecasted sales), an adjustment entry is set up driven by the warranty expense but automatically delayed a certain number of periods since warranty claims always follow sales by a certain amount of time which vary by industry but must be taken into account in the plan and budget.

Results

When the revenue model is built, edited, and finalized, warranty expense is created following the logic described above, perfectly tracking the revenue plan. The income statement and balance sheet will accurately reflect this through the automated system entry of: Debit Warranty Expense, Credit Warranty Reserve. This occurs in every warranty expense record in every budget period (month) and is identical to the method used to record it in the actual accounting system.

The actual warranty claims, which only affect the balance sheet, are automatically recorded in each budget period following the logic set up in the adjustments module. Now both the forecasted income statement and forecasted balance sheet reflect all activities related to GAAP-compliant warranty expense and the adjustments to the required warranty reserve account. As is usual with Intelligent Planning, for all changes to these revenue lines (e.g. annual amount, product price, period spread pattern, increases/decreases, etc.), total budgeted warranty expense and the warranty reserve will perfectly track these revenue line changes.

Conclusion

Now imagine doing all this in a spreadsheet or having to program all this logic in a typical, purpose-designed planning and budgeting application where there is little or no built-in logic and accounting rules. You’d have to agree that this is a futile endeavor, which is why such new intelligent planning solutions are starting to replace traditional systems and processes. Warranty expense and warranty reserve planning and budgeting are only an example of what can be accomplished using an intelligent planning and budgeting software solution. The principles described above can be applied to many areas of the plan, thus automating the generation of complete and accurate forward-looking synchronized financial statements.

‍Alan Hart, MBA, is Principal Consultant at Pacific Shine Group in Portland, Oregon, with responsibility for client business development and hands-on client project implementations. Prior to starting Pacific Shine Group, he worked in various executive accounting and finance positions with technology and growth companies. Notable is his 18 years in the hi-tech manufacturing industry where he served as Controller, Vice President of Finance and CFO of several privately as well as publicly held companies in the Hi-Tech industry, such as Hybrid Arts, Inc. Hamilton Bay Associates and Syncronys Software. In his role in management consulting, Alan has worked in diverse industries and with a variety of clients, including fortune 1000 companies such as Boeing, Delta Airlines, Intel, Wyndham Worldwide and others, as well as many mid-market organizations such as Guitar Center, Ducommun AeroStructures, Cypress Semiconductor, TriQuint Semiconductor and others.

Combining his skills and experience in engineering with deep understanding of technical accounting, he is able to assist small and medium-size manufacturing companies establish GAAP compliant accounting and reporting systems.