Extend Warranty

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Design of Extended Warranties in Supply Chains
Kunpeng Li
University of Illinois at Urbana−Champaign, College of Business

Dilip Chhajed
University of Illinois at Urbana−Champaign, College of Business

Suman Mallik
University of Illinois at Urbana−Champaign, College of Business

Abstract
Consider a supply chain involving an independent retailer and an independent manufacturer. The manufacturer produces a single product and sells it exclusively through the retailer. Using this supply chain framework, we develop a game theoretic model to study two commonly observed practices of selling extended warranties: the manufacturer offers the extended warranty directly to the end consumer, and the retailer selling the product offers extended warranty. We show that, of the two decentralized systems, when the retailer offers an extended warranty, it is for a longer duration and generates more system profit. We compare and contrast the two decentralized models with a centralized system where a single party manufactures the product, sells to the consumer and offers the extended warranty. We identify the different causes of inefficiencies in each of the two decentralized models and propose coordination mechanisms that eliminate the inefficiencies. We also provide contracts to achieve both coordination and a Pareto improvement over a wholesale price contract.

Published: September 2005 URL: http://www.business.uiuc.edu/Working_Papers/papers/05−0128.pdf

Design of Extended Warranties in Supply Chains

Kunpeng Li kli@uiuc.edu

Dilip Chhajed chhajed@uiuc.edu

Suman Mallik mallik@uiuc.edu

Department of Business Administration University of Illinois at Urbana-Champaign 350 Wohlers Hall 1206 South Sixth Street Champaign, IL 61820 September 2005

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Design of Extended Warranties in Supply Chains

Abstract
Consider a supply chain involving an independent retailer and an independent manufacturer. The manufacturer produces a single product and sells it exclusively through the retailer. Using this supply chain framework, we develop a game theoretic model to study two commonly observed practices of selling extended warranties: the manufacturer offers the extended warranty directly to the end consumer, and the retailer selling the product offers extended warranty. We show that, of the two decentralized systems, when the retailer offers an extended warranty, it is for a longer duration and generates more system profit. We compare and contrast the two decentralized models with a centralized system where a single party manufactures the product, sells to the consumer and offers the extended warranty. We identify the different causes of

inefficiencies in each of the two decentralized models and propose coordination mechanisms that eliminate the inefficiencies. We also provide contracts to achieve both coordination and a Pareto improvement over a wholesale price contract. Key words: supply chain management, extended warranty, game theory

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1. INTRODUCTION Selling extended warranties on products is a rapidly expanding business. During the 1980s, extended warranties were offered only on large, expensive items. Now, extended warranties are offered on almost all consumer electronics and domestic appliances ranging from laptop computers to simple sewing machines. An extended warranty is actually a service plan under which the provider promises to repair, replace, or maintain the product for free or at a lower price over a certain period of time after the manufacturer’s original warranty expires. The extended warranty may also offer additional benefits (such as return and/or exchange privileges) that are not provided by the manufacturer’s original warranty. Extended warranties are sold separately from the products and usually cost extra money. Generally, an extended warranty is offered by a manufacturer, a retailer, or by a third party (Publication 153, Best Business Bureau). The terms of a typical extended warranty...
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