When a consumer purchases a new automobile, the overall experience is never complete without a trip to the finance manager’s office where all types of additional products and services are offered including pre-paid maintenance, rust proofing and extended warranties.  By this stage of the process, the price has usually been negotiated with the salesperson and the consumer just wants to get out of the showroom and on the road.

The typical sales pitch will consist of enthusiastically congratulating the proud new owner while beverages are provided.  The finance manager will comment on how the customer must obviously be a very intelligent individual to have purchased such a fine automobile.  Now, surely it would be wise to invest some additional money today (“We can even finance it!”) in exchange for the peace of mind of having protection in the long run?

Of course, informed consumers know that such warranties are almost always a poor deal, but apparently many opt to pay a significant percentage of the purchase price for extended protection.  Why is this?

Amazingly Profitable Cash Cow

According to an article published in The Economist, warranties generate over $16 billion annually for American retailers.  This is despite the fact that few products appear to break during the warranty period which minimizes warranty service costs.  Consumers who are in a good mood or feel like they have secured a great deal on the purchase often opt to spend that savings on a warranty.

Shoppers typically pay 10-50% of the cost of a product to insure it beyond the term covered by the manufacturer’s guarantee. The terms of these deals vary (and there is often a great deal of fine print), but they usually promise to repair or replace a faulty device for between one and four years. Yet products rarely break within the period covered, and repairs tend to cost no more than the warranty itself. That makes warranties amazingly profitable: they generate over $16 billion annually for American retailers, according to Warranty Week, a trade journal.

Psychological Tricks

There are other underlying psychological tendencies at work that are exploited by retailers.  Obviously, excessive risk aversion could prompt a consumer to purchase an overpriced warranty if the probability of encountering a failure is mentally miscalculated.  However, prompts for the impulse buy go beyond this.  For example:

• Exploiting Reciprocity. When the sales person or finance manager offers a cup of coffee or a soda along with a wall calendar or other trinket, the consumer is being cleverly manipulated.  The tendency for people to want to reciprocate is extremely powerful.  Even when provided with a small token such as a soda, most customers will feel an unconscious need to reciprocate.
• Projecting Authority. The reason the finance manager makes the pitch is because he or she has the aura of authority in the dealership compared to the sales person who has been working with the customer throughout the sales process.  For “difficult” customers, the finance manager is often brought out to negotiate pricing as well.
• Social Proof. The sales process will directly state or imply that the vast majority of smart consumers will take the extended warranty.  The implication:  If the customer refuses, he or she is less savvy than all of the others who have had to make the same decision.

Of course, there are other tricks that are routinely used in order to convince customers to purchase warranties on unfavorable terms.  These are by no means restricted to extended warranties.  Car dealerships are virtual laboratories of psychological manipulation.

An Alternative

Consumers who are tempted to purchase extended warranties should instead adopt the following strategy:  Take the funds that would have been spent on the warranty and simply put it in a bank account that will serve as a fund to replace merchandise that breaks prematurely.  Over many years, it is very likely that this “self insurance” program will result in a lower total cost of ownership than purchasing extended warranties on unfavorable terms.  With many extended warranties priced at 10-50% of the cost of the product, it would not be difficult to build up a sizable fund.