If you are serious about building and running a service department that is a profit center for your company and not merely a necessary evil to support your installation work, there are business tools you can use to help ensure your success. One of these tools is called a warranty reserve. A warranty reserve is a like bank account or a fund that you create so your service department is paid when it does warranty work. The warranty reserve account is funded by deposits you make into it as you invoice installation, restoration or retrofit work your company has done. When your service department performs a warranty repair, the invoice for the repair is billed at your normal service rates and paid for by the warranty reserve account.
In other words, you make withdrawals from the warranty reserve account as you provide warranty service. It works like this: You choose a percentage, typically 1 percent to 2 percent of every new installation job sale price and deposit that money into the warranty reserve account. Over time it grows into a sizeable pool of money to pay your service department for the warranty services they provide. Because the 1 percent or 2 percent is a cost which is chargeable against the job, you are funding the warranty reserve account with pre-tax dollars. If you do not currently have a warranty reserve system in place, then there is a good chance your service department is only getting paid for chargeable repair work and actually losing money when it does your warranty repair work. Not a good way to run a business. However, once implemented, your service department will be getting paid for all the services it provides, warranty and non-warranty, giving it a chance to be profitable. And, as I keep saying, a well-run service department can easily be the most profitable department in your company.
Furthermore, you will have a tax-deferred pool of money to pay for warranty expenses. Notice that I said, “tax-deferred.” The reason it is tax deferred is that, eventually, you may want to start moving some of the unspent money out of the warranty reserve account and to your bottom line. Of course it will become taxable, but whatever is left over is yours to spend anyway you want to. Managed correctly, it is like finding “free money” at the end of the year. Some companies reduce or increase the 1 percent or 2 percent figure to match the true cost of providing warranty service. Personally, I like to keep it a fixed number. If we start spending more than the 1 percent or 2 percent, we take a hard look at our installations and look for patterns. Why are we doing warranty repairs on certain jobs? It is a useful management tool that shows us where we may need some training and/or jobs we need to avoid.
Setting up a warranty reserve account and managing it also protects you in the event of an IRS audit. It is one more way that you can show the IRS that you know how to run your business and play by the rules. The same is true if you sell your business. Most buyers will want a “warranty holdback.” This is a fund that comes out of the sale price. What I mean by that is it’s customary for the buyer to hold back a percentage of the agreed upon sale price, for a certain period of time, to pay for any warranty issues that may come up after they become the owners of the business. Warranty holdbacks create one more variable that can make selling your business difficult. A warranty reserve eliminates this obstacle.
Where else does a warranty reserve help you run your business? When you have to provide labor to redo work because a component failed on a job. Typically the manufacturer does not reimburse you for your labor (unless of course a full warranty was included in the price you paid the manufacturer). They expect to replace the failed products at no charge to you. You as the contractor provide the labor to repair the job. Naturally most contractors want to be paid for the replacement labor, but they understand that in most cases they provide the labor and the manufacturer provides the products. It is a part of the partnership manufacturers, distributors and contractors have when they decide to go into business - and it works. If you have a warranty reserve account, it makes this financial blow easier to absorb. If you do not, you are “working for free.”
What if you pay your salesperson a bonus based on the profitability of the job? There can be hard feelings if their jobs are well planed, thought out and generally problem free, but automatically charged the 1 percent or 2 percent warranty reserve fee. I have always found that this situation is easily remedied if you include them in the design of the warranty reserve system. I find that good salespeople are also good businesspeople. Let them help you design it. Remember, this is a self-funded insurance policy that protects them, too. Even the best job can have problems, and if the problems are catastrophic, it will seem like a bargain to all.
My final word on warranty reserve accounts is this: Talk to your accountant and ask him or her to help you design the financial side of the system or recommend someone who can. How beneficial can a warranty reserve account be for you? A good friend of mine who was an excellent contractor sold his business a few years ago. He had over $1 million in his company’s warranty reserve account. The majority of it came back to him at closing in the form of a cashier’s check - another compelling reason for running your business like a businessman.