Moving 10-Year Parts Warranties In-House, Part 2
Wednesday, August 12, 2015
This is part 2 in a three part series. Part 1 can be read here.
In part 1, we introduced a new in-house parts and warranty program. We talked about how equipment fails based on a normal curve and showed how warranty dollars would be offered to the customer by incorporating the cost into the initial purchase of the equipment or by creating a premium maintenance agreement program.
Part 1 ended by saying the success of the program lies in how the money is handled, which is what we’ll focus on this month.
Step 1: Paper Trail
The beginning of the paper trail (when the income comes from the initial sale of the equipment), starts with setting up a current liabilities account (or an additional one if you already have one). Current liabilities are different from long-term Liabilities; current liabilities indicate the liability will be paid off within a shorter number of years. It is suggested the new current liability accounts be titled Current Liabilities (initial purchase) followed by the year number.
Step 2: Create a Separate Account
Step 2 is to set up a brand new, additional, checking or savings account. This separate account will “hold” all funds until they are dispersed at the end of the year. Placing funds in the separate account will reduce the possibility of spending the money during the year. Out of sight, out of mind!
Steps 3 & 4: Paper Trail
When the money for the installation (which includes the $550 for the 9-year Warranty Agreement) is received, the first step is to deposit the $550 into the new “current liabilities” account. As repairs are performed throughout the year, an invoice should be created as if any other repair performed. However, in this case, the invoice has a note added that states, “No Charge – Covered by Warranty.” Two copies are made, with one going to the homeowner, or business, and the other being filed at the office.
Transfer of Money
When repairs are being performed on warranty work, it is suggested you DO NOT transfer funds at this point. However, if cash flow is really tight, and the funds are needed, it’s ok to transfer the invoice amount from the liability account during the year. However, be sure to keep accurate records so you know which invoice dollars have been transferred and which have not. Be sure NOT to transfer more dollars than are allocated for the current year.
If funds have not been transferred during the year, year-end is simple. If they have been transferred during the year it will require a bit more math to do it properly.
Assuming no dollars have been transferred during the year, there should be $55,000 in the account. That is based on the company selling 100 units that include the $550 per unit for the warranty.
Now calculate the amount that should be transferred from the account. Notice, based on our normal distribution curve, the company should transfer 4% -- or $2,200 -- from the account into warranty income. If the actual dollars spent (from the collected warranty invoices) exceeds $2,200 for the year, the new program lost money that year. If the $2,200 exceeds the actual billed dollars, the company generated a real profit from the program that year.
The remaining $52,800 ($55,000 - $2,200 = $52,800) in the Currently Liability Account stays there, untaxed, waiting to be utilized over the coming years.
Year Two Transfer (example):
Just like year one, the company calculates what should have been spent that year based on the normal distribution. Year two should have generated repairs totaling 7% or $3,850 ($55,000 x 7% = $3,850). The $3,850 will then be transferred to warranty income. At this point 2013 Current Liability Account should have $48,950 ($55,000 less year one dollars of $2,200 and less year two dollars of $3,850 = $48,950 remaining it in for future repairs.)
How to Handle Year Two Sales
At the beginning of year two, a SECOND currently liabilities account will need to be created. Like the other the account, it needs to be accessible on line for easy transfer of funds.
Note: Each year a “new” Current Liabilities Account will need to be set up. Keep in mind all the dollars will have to be transferred out of each account at the conclusion of the nine-year warranty period. This is why each year must have its own liabilities account with money being kept separate from the other years.
What does the IRS think about this process? The IRS is actually more concerned that you have a “logical method” of dispersing funds than they are about what method you use. The worst case scenario is that they disagree with your method and make you change to another. However, the likelihood of that happening is very small.
Before implementing a program like this, be sure to check with your CPA as well as any state regulations that may be applicable within your specific state.
In part 3, we will talk about how to create the Premium Maintenance Agreement program to incorporate the nine year parts and labor warranty program.