Il

Warranty
Policies For
Non-Repairable
Items Under
Risk Aversion
Technical Memorandum 551
by
Peter H.
Ritchken
Department
of
Operations
Research
Case Western Reserve
University
Weatherhead School of
Management
Cleveland,
Ohio 44106
September 1984
Warranty Policies For Non-Repairable Items Under
Risk Aversion
Key
Words: Warranty, Renewable Warranty, Warranty Design.

Purpose: Present corrections, extensions, and examples of renewable

warranty problems.
Abstract:
An approach is presented for analyzing warranty policies for items
receiving renewable warranties when failure occurs during the warranty
interval. The model presented corrects a model of Thomas and then
extends the methodology by describing how sellers' risk aversity
linear rebate policies are more attractive to risk averse sellers than
influences the
policy. It is shown that for exponential failures,
shorter term full rebate policies that result in the same expected
Cost.
I i'
"
1.0 Introduction
Consider a non-repairable item that is sold with a
warranty. Upon
any failure within the warranty period, the item is replaced and the
warranty
renewed. Once a given amount of time expires with no
failure, the manufacturer is relieved of all
responsibility.
Let $
denote the class of warranty failures that provide a total rebate over
a given period of
time. The cost of a failure to the manufacturer is
given by
I (X.) =
C 0 < X. < W
$1 0 -1-0
otherwise
(1)
where X. is the time between failures, C is the cost of replacement 1
and wO is the length of the warranty. Let $ denote the class of
prorated policies. Following Thomas [2], we shall consider policies
that provide full compensation up to time wl and prorated compensation
thereafter up to time w2. The cost of a failure for such a rebate
scheme is:
I*(Xi) =
C
0 < X. < w (2)
0 - 1- 1
=
CO(W2-Xi)/(w2-wl)
Wl S Xi S w2
=0 otherwise
-- L6-E V--be arandom vari-ble Yepre-enting--Ee -tot a-1-warranty -- - --
expenses accumulated per item
sold. That is
8 -
n
V=E
I(Xi)
(3)
i=1
-
where n is the number of failures that occur until a failure time
-1-
:
exceeds the prescribed warranty period.
Thomas has studied policies, 0, and has established cost
equivalent policies, 0
[2].
Since errors occur in his Proposition 1
(See page 283 [2]), all his following propositions and examples are
incorrect. This article corrects these errors and provides extensions
to the theory. Specifically", the design
of warranty
design
under risk
aversion is considered.
2.0 Proposition 1
The expected warranty cost for an item under policy, 0, is given
by
F(w2) W2
E(V ) = C " f F(u)du/(w -w ) (4)
li
0 0
R(w2) Wl
2 1
where F( ) is the cumulative distribution of Xi and R( ) is the

reliability. (R( ) =1-F( )).

Proof: The expected warranty cost per item sold is given by:
n
E(V*) = E[ECE I*(Xi)1
i=1
1 -
Since n is a stopping time,
E(V 111) =
E(n)E(I*(Xi))
(5)
Since n is geometric,
-
Pr(n k) =
R(w2)F(w2)k
k =
0,1,2... (6)
and
E(n) F(w )/R(w ) (7)
22
-2-
:
B
Moreover, from Thomas [2]:
il
C W
02
(W2-Wl) Wl
E(I(X)) =
-
S F(u)du (8)
The product of (7) and (8) yields the
result. Notice that this
result differs from that derived in Proposition 1 of Thomas
[2].
For
the special case of a linear prorated policy, with wl = 0, equation
(4) reduces to
C F(w )
E(V ) =0 2
F(2)(w2)
(9)
0 w R(w )
2 2
W
(2)
where F (w2) = /2 F(x)dx
0
With Proposition 1 corrected, Proposition 2 (page 284 of [2]) is
given as follows.
Proposition 2
For each policy, 0, there is a policy,
0,
that yields the same
expected cost. This policy must be chosen such that w satisfies the
following condition:
-F(wi) -- FC-w2) -f2F(u)du/w2-wl) -(10) -- -- - R
(wO) R(w2)
wl

proof:
Under a total rebate policy, the expected cost of a failure is
given by:
E(I*(Xi)) =
COF(w)
(11)
Hence, from equation (3), we have
-3-
E(V0) = E(n)E(I*(Xi))
and from equation (7) we obtain:
COF (wl) 2
E(V ) (12)
$ R(w )
0
For the expected costs to be identical, we require:
C F(w )2 C F(w ) w
0
.0
0 2
R(w )
R(w2) /2 F(u)du/(w2-wl) (13)
1 0
1
Notice that for the special case of a linear warranty, equation (10)
reduces to:
F(w )
F(w2)
F
(W2)
2 (2)
0 - (14)
R(wO - R (w2) w 2
Example
To illustrate this result, consider Example 1 of Thomas (page 284
[2]). Given the cost of replacement, C, is $100, failures
exponential with expectation 50 months, wl six months, and w2 36
months, we have from equation (4):
100 (1-ex_R(-36/50) )
36
-- E (V-*) -=- 3 0 e x p
( -3 6/5 0)
f -(1-ex-p(-x-/50)-)-d-x
6
= $35.13
Hence wQ must satisfy the condition:
F(w o) 2
=
0.3 5 1 3(1 - F (wl))
That is:
8
-4-
exp(-wO/25) - 2.3513exp(-wQ/50) +1=0
The solution to this quadratic is:
wl = 29.22 months
For the linear prorated policy with w2 = 36, the expected cost,
given by (9), is
E(V ) = 30.28
111
and w, satisfying equation (14), is given by:
w = 27.18 months
il
Proposition 3
The expected time to a failure at which point the manufacturer
incurs no warranty cost is given by:
ECT) = E(Xi)/R(w2) (15)

Proof: Let T be the earliest occurrence for which the time between
failures exceeds the warranty period w2. That is:
I -
n+1
T = E X.
i=1
1
-
Then E(T) = E(Xi)E(n+1)
Now, using equation (7), we obtain
E(T) = E(Xi)/R(w2)
It is of interest to note that if F( ) is exponential, then the
distribution of T is also exponential.
Example. 1 .(continued)
For Example 1, the expected total warranty coverage period per
-5-
orginal sale for the policy 0, with w2 = 36, is given by
ECT ) =
50e = 102.72
36/50
$
and for the policy $, with w = 26.18, we have
27/50
0
E(T ) =
50e = 86.11
$
Policies $ and $ are only equivalent in expectations.
The actual
distribution of costs is quite
distinct. Unless the seller is risk
neutral, Proposition 2 may not be that
useful.
In the next section,
we compare these two equivalent expected cost policies under the
assumption of quadratic utility.
3.0 Policy Evaluation Under Quadratic Utility
Under quadratic utility, decisions can be based on means and
variances [1].
To compare policy, 4, with its equivalent expected
cost policy, 0, we require expressions for variances of cost.
Pro posi-tip-n 4
For the two warranty policies, the variance of total costs is
given by:
F (w21- 2-
-- C re) -
- vtv, ) 2 (6*R(w2)-+ E(I4(Xi))2-)
R(w )
2
Var(V$) = 0 2 (aR(w) + E(I*(Xi))2) (17)
F(w )
R(wO)
where 04 = Var(I (X.) and 02 = Var(I*(Xi)). 0 1

Proof:
By the law of iterated variance, we have:
-6-
V a r (V) = E (V a r (V I n) ) + V a r (E (V I n) )
1 Now,
E (VIn)
=
n E(I(Xi))
n
V a r (V I n) = V a r ( E I (X i) ) = n V a r (I(X) )
i=1
E -
Now, since n is geometric, we have:
-
Var(n) = F (w2)/R(w2) 2
Hence
Var(E(VIn)) = E(I(X)) Var(n)
2
-
=
E(I(X))2F(w2)/(R(w2))2
(18)
-
a n d E (V a r (V I n) ) = E (n V a r (I (X) ) )
= Var(I(X))E(n)
= Var(I(X))
F(w2)/R(w2)
(19)
Combining (18) and (19), we obtain the result.
For warranty 0, equation (16) simplifies. Specifically, the
variance of a cost of failure, a, is given by:
- -- 0 2 =-E (I -CX)2) -E (I (X)) 2 - - -- - -- -
0 0 0
= c02F(wO) - C02F(wO)2
Hence:
00 = CO2F(w)R(w) (20)
Substituting this result into equation (17), we obtain:
-7-
22
Cn F(wO)
Var (V* ) =U . .2 [R (wO) 2 + F (w l) ] (2 1)
R(wO)
For warranty
4, equation (16)
also
simplifies. For simplicity, we
shall consider linear warranty policies only.
Hence:
I*(Xi) = CO(w2-Xi)/w2 0 .1 Xi S w2
(22)
=0 otherwise
For this case, the expected cost is given by
i
E ( I ( X) ) = f I ( x ) d F ( x )
111 0
I
C W
0 2
=- f (w -x)d F(x)
W2 0
2
which, upon integrating by parts, yields:
ECI*(X)) = CF(2)(w )/w (23)
2 2
Moreover, the variance of cost, c2, can also be computed:
2 2 2
0 = E(I (X) ) - E(I (X)) (24)
8
0 0 111
C W
2 0 2 2
and E(I (X) ) = - f (w2-x)
dF(x) (25)
w 2 0
2
--
Expanding-and integrating by-parts-, equation_-(24)reduces_to- __
2 2 (3) 2
E(I (X) ) = 2C
F
(W2)/W2
(26)
0 0
(3)
W2 (2)
where F
(w2)
=I F
(x)dx
0
Substituting equation (26) into equation (24), and simplifying, we
-8-
obtain:
2
C
2 0
(3) (2) 2
c = -
(2 F (w) -F (W ) ) (27)
42 2 2
1 w2
Finally, substituting this equation into equation (16) yields:
c02F(w2) (3) (2) 2
Var(V )
=
2 - [2R(w2)F
(w) +F (w ) F(w )] (28)
$ 2 2 2 2
w2 R (w2)
As an example of equation (25), consider the case of exponential
failures. For this case:
1 F
(w) =1-e
-XW
F(2)
(w) = (Aw - F(w))/A
(3) 2 2 2
F
(w) = ( A w - 2 A w + 2 F ( w) ) /2 1
= [(Aw - 1)2 + 2F(w) - 1]/212
Substituting these expressions into equation (28), we obtain:
l
C F(w )
(Aw2R(w2))
Var (V*) = 0 2 2 [(Aw2-1)2
+
2F(w2)-1]R(w2) + [Aw2 - F(w2)]2F(w2) (29)
A comparison of equation (21) and (29) for policies having the
same expected cost will indicate which policy has the smallest
:
variance and, hence, which policy is the most desirable.
Example
For the linear prorated policy, wl = 0, w2 = 36, we have seen that
E(V*) = 30.28. The expected cost for the full rebate model with w =
27.18 is also 30.28. Computing the standard deviations of these two
-9-
policies, using equations (29) and (21), we obtain:
Var(V ) = 55.23
111

and
Var(V ) = 62.81
$
Hence if the seller is risk averse, then the linear rebate policy
over 36 months is more desirable than a full rebate policy over 27.18
months that has the same expected cost.
Exhibit 1 illustrates that, in general, linear rebate policies
will always be preferred to full rebate policies having the same
expected
cost.
Notice that as the average time between failures
increases, the expected warranty cost decreases, and the time of the
equivalent full rebate policy decreases. As product reliability
increases, the standard deviation of costs decreases.
From Exhibit 1,
it can be seen that the standard deviation of the full rebate policy
is larger than the linear rebate policy.
Conclusion
This article has investigated optimum warranty policies for
non-repairable
items. It has corrected errors in the Thomas article
and has extended the results to take into account risk aversion
factors of the seller.
It has been shown that, for exponential
failures, risk averse sellers will prefer to issue longer linear
prorated warranties to shorter full rebate warranties which have the
same expected cost.
-10-
REFERENCES

Ill Markowitz, H. Portfolio

Selection.
Yale University Press: New
Haven, 1959.
[2] Thomas, M.
U.
"Optimum Warranty Policies For Non-repairable
Items," IEEE Transactions on Reliability, Vol. R-32, No. 3,
August 1983, pp. 282 - 287.
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