Can Sharing Warranty Costs Lead to Better Products?

New research shows that product quality and safety improves when suppliers bear equal responsibility for warranty costs.
June 24, 2011 | Opinion
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The slew of product-safety recalls in recent years has put consumers and manufacturers on high alert. In 2010 alone, the Food and Drug Administration issued more than 235 recalls for food products contaminated by bacteria or allergens, including the largest recall of table eggs in US history after a salmonella e. outbreak infected at least 1,900 people. At least 81 deaths were linked to contaminated heparin in 2007, a blood-thinning drug manufactured in China by the Baxter Healthcare Corporation. That same year, toymaker Mattel issued a massive recall of more than 10 million Chinese-made toys, including popular Barbie and Fisher-Price items that contained lead paint and tiny magnets.

In an international manufacturing process incorporating a global supply chain with many different players, tracing a potentially dangerous problem back to its source can be exceptionally challenging. This is especially true because even a single part can have multiple suppliers. While many companies have implemented tracking systems to identify the supply-side source of quality breakdowns, tracing a problem to its source is not only impossible for some products, but not always the best way to maximize product quality or profit, according to Professor Fangruo Chen.

“Manufacturers cannot police where the raw materials come from,” Chen says. “Often, companies will relax their standards and source from unconventional channels, which opens the process up to problems.”

Working with Lijian Lu and Hanqin Zhang of the Chinese Academy of Sciences, Chen first examined the value of installing a tracking system to trace a quality problem back to its source. This led to larger questions: How can manufacturers incentivize suppliers to invest in quality improvement? When quality problems arise that incur warranty costs, who pays for the mistakes? Who takes responsibility for product improvements to address previous failures?

Chen and his co-researchers found their answers by looking at how warranty costs are shared among suppliers and manufacturers. Currently, many manufacturers choose to use a target-sharing system, where tracing is used to track which supplier created each component. One of the best examples of this system is the building of a car, where different suppliers often make individual parts.

Common practice is for the manufacturer to shoulder 85 percent of warranty costs for a defect, with the at-fault supplier responsible for 15 percent. A bar code or other mechanism is placed on physical components to track the parts so that quality issues can be traced back to the supplier at fault, who then pays its share of the warranty costs as dictated in the agreement with the manufacturer. If a supplier creates a faulty brake pad, for example, that supplier pays for 15 percent of the warranty costs for that defect.

Another way of allocating warranty costs is equal sharing, in which the manufacturer agrees to pay a percentage of the warranty costs while the remainder is divided evenly among all suppliers for a product. In this system, tracing is not necessary, because the manufacturer and all suppliers split the costs of fixing a problem without assigning blame to any single supplier.

In practice, target sharing is the more common method of distributing warranty costs, Chen says. But by creating a theoretical model that compared the quality-improvement outcomes of target sharing with those of equal sharing, Chen and his colleagues came to a surprising conclusion: sometimes equal sharing not only improved quality by increasing competition among all suppliers, but increased profits for all parties on the supply chain since fewer warranty-related costs were incurred.

“That’s counterintuitive,” Chen says. “But we found that under equal sharing, suppliers have a greater incentive to improve quality than under target sharing because every supplier is held accountable for other suppliers’ mistakes. The only way for a single supplier to reduce its own warranty costs is to grab market share from the other lower-quality suppliers by increasing the quality of its own products.”

Chen suggests that equal sharing could be particularly helpful in identifying problems with the food supply in which tracing is difficult, with potential to prevent events such as the recent outbreak of the deadly E. coli bacteria in Europe, where officials originally attributed the outbreak to cucumbers, then sprouts. While Chen is conducting more research on incentivizing food suppliers to improve quality, the current findings already point toward a path to safer, higher-quality products for manufacturers that use multiple suppliers in all industries.

“To get suppliers to improve quality, you have to give all suppliers incentives to reduce mistakes. Equal sharing does this by placing responsibility on all suppliers,” Chen notes. “That creates healthy tension that in the end will move all parties to produce a higher quality product.”

Fangruo Chen is the MUTB Professor of International Business in the Decision, Risk, and Operations Division and a senior scholar at the Jerome A. Chazen Institute of International Business at Columbia Business School.

Fangruo Chen

Professor Chen's main research area is supply chain management. He has published extensively in many of the field's top academic journals such as Management Science and Operations Research. His research has addressed issues in production/distribution planning, procurement auctions, supplier management, supply chain coordination, supply chain information sharing, incentive contracts, salesforce incentives, etc. Professor Chen received the prestigious CAREER Award from the...

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Fangruo Chen, Lijian Lu, Hanqin Zhang

"Warranty Cost Sharing in Supply Chains"


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