Frequency and Severity: The Cost Impacts on Your Warranty Program Profitability

by Scott Walker on August 16, 2016
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Anytime you decide to start running, or improving, an extended warranty program cost considerations should be at the top of your list. In particular, the concepts of Frequency and Severity can deeply impact the profitability of your program.

Why Are Frequency and Severity Important to Your Bottom Line?

Frequency and Severity are important to know when trying to run a profitable warranty program because together they help you to understand the total amount of Required Reserves needed to pay for the cost of repairs. Without the knowing your Required Reserves, you may end up having insufficient funds needed to cover repairs.

What is Frequency?

Frequency is also known as “Failure Rate”. When referring to Frequency, you are talking about the average failure rate of all products covered by your warranty program, or the rate at which all covered products need to be repaired.

To understand your store’s Frequency, you should:

  • Know the failure rate (or Frequency) of every product type, so that you can accurately predict the failure rate of every product you offer whether it is appliances, televisions, tablets, cell phones, etc.
  • Complete an actuarial analysis through an independent Actuary who will validate assumptions by analyzing historical failure rates.
  • Track manufacturer recalls in order to know if there are certain product failures that will be covered through recall campaigns. By not tracking recalls, you are setting yourself up to cover epidemic failures. These failures can result in 100% failure rate across all customers with that product type.

What is Severity?

Severity, in its simplest terms, is the average cost per claim. You will also hear Severity called “Average Cost of Repair”. When you multiple Severity with Frequency you get the Pure Cost of Claims or Required Reserves (as mentioned above).

To understand your store’s Severity, you should:

  • Pre-negotiate service rates to help you control repair costs. Have an agreement that outlines labour and parts mark-up to help reduce claim costs, offer a better end user experience, and help take pressure off of your store(s).
  • Understand the cost drivers of your business. They include:
    • Parts and labour cost per repair
    • Product replacement (if it cannot be repaired)
    • Taxes, levies, and fees (and which you are responsible to pay)
    • Shipping costs
    • Travel costs if the product needs to be repaired in the customer’s home (e.g. appliances)
    • Good Will payments that are made to keep customer satisfaction high

The Warranty Cost Formula

To calculate the Required Reserves, or Pure Cost of Claims, you need to multiply Frequency and Severity.

Frequency (Failure Rate) X Severity (Average Cost of Repair) = Required Reserves (Pur Cost of Claims)

Once you have completed the The Warranty Cost Formula, you will need to begin setting up your reserves. To learn how to do this, we have published a free ebook that walks you through this process. You can download it here.10 questions to ask about your protection plan program

What other questions do you have about cost considerations for your warranty program?

Topics: Warranty program, Profit