What is Product Warranty Cost?

Product warranty cost is the charge to expense when a product is replaced under a warranty program. This amount may be charged to expense only when warranty costs are incurred, or it may be set up as an allowance, where a standard amount is charged to expense each month. The latter approach is considered to be more correct accounting, since all related costs are charged to expense when revenue is recognized, rather than at a later date. Thus, the use of an allowance for product warranty costs matches all revenues and associated expenses in the same reporting period. This matching of revenues and expenses is known as the matching principle.

Example of Product Warranty Cost

Albion Corporation, a manufacturer of laptops, offers a one-year warranty on its products covering repairs and replacements for manufacturing defects. In the current year, the company sells 10,000 laptops at $1,000 each, generating $10 million in sales revenue. Based on past experience, Albion estimates that 2% of the sales will result in warranty claims, with an average cost of $150 per claim for repairs or replacements.

To calculate the warranty cost, Albion makes the following estimation:

Estimated warranty claims: 10,000 laptops × 2% = 200 laptops.
Estimated cost per claim: $150.
Total estimated warranty cost: 200 laptops × $150 = $30,000.

Based on this information, the related journal entry is a debit to the warranty expense account for $30,000, and a credit to the warranty liability account for $30,000.

Throughout the year, as actual warranty claims are processed, Albion will reduce the warranty liability account. For instance, if $20,000 in actual repair costs is incurred, the liability would be reduced accordingly.

This example illustrates how companies estimate and recognize product warranty costs to match expenses with the related sales, ensuring that financial statements accurately reflect the anticipated costs of honoring warranty obligations.