Designing and pricing menus of extended warranty contracts

Extended warranties provide ‘peace of mind’ to a consumer in that product failures which occur after the base warranty expires are rectified at little or no cost. They also provide an additional source of revenue for manufacturers or third-party providers, such as retailers or insurance providers, and help cultivate consumer loyalty. In this article, we analyze a number of extended warranty contracts which differ in design, including restrictions on deferrals and renewals. With the use of dynamic programming, we compute the optimal strategy for a consumer with perfect information and determine the optimal pricing policy for the provider given the consumer's risk characterization. We also provide insight into when different contracts should be issued. Finally, we illustrate how profits can be dramatically increased by offering menus of warranty contracts, as opposed to stand alone contracts, with the use of integer programming. Surprisingly, risk-taking consumers provide the greatest benefit to offering menus. These insights can help a company develop a comprehensive warranty planning strategy for given products or product lines.