SMITH BUSINESS Magazine
Volume 11 No. 1 SPRING 2010

Extended Service Contracts

You’ve been there: standing at the register at a big-box electronics store, waiting for your purchase to be rung up, when the checker asks if you’d like to purchase an extended service contract (ESC) to lengthen the coverage provided by the manufacturer warranty.

ESCs are extremely profitable for retailers, with an average margin of 50% to 60%--18 times the margins for the products themselves. In 2003, ESCs represented about 50% of Best Buy’s profit.

Experts recommend against buying ESCs, feeling that they provide little value; but consumer demand for them remains high. Why are people willing to shell out an extra $50 or $100 for something they may never use?

Tao Chen, assistant professor of marketing, conducted a study that examined the purchasing records for consumers from the electronics department of a retailer over the course of a year to learn why consumers are purchasing service contracts.

Product category matters. Chen found that consumers were more willing to buy ESCs for products like game consoles that were more “hedonic” (more fun), than for products that were more utilitarian, like printers. This could be due to that consumers may perceive a higher value for the fun products than the utilitarian products, even when both cost the same amount.

Price promotions also play a factor in consumer willingness to buy a service contract. “According to other research, if you buy a product on sales promotion, you know that you have saved money, and you are likely to put your savings toward the purchase of another product, ” Chen says. Chen found that this tendency held true for ESCs as well. If you purchase a product on sale, you are more likely to purchase a service contract.

The effect is even more pronounced if the product is sold through an unadvertised, in-store promotion. The unexpected savings puts consumers in a positive mood, says Chen, and this elevated mood affects their attitude toward risk. People who have a positive mood are more risk averse, and are more willing to purchase a service contract to guarantee their peace of mind.

People who have experienced product failure are also more likely to purchase a service contract. Once bitten, twice shy; people who have experienced the pain of purchasing a replacement product are more likely to think that products are inclined to break, and are thus more willing to pay for a service contract rather than experience the same aggravation again.

Lower-income consumers are more likely to purchase ESCs than higher-income consumers. Someone who can afford to replace his or her DVD player does not purchase a service contract because he or she is not as concerned about the replacement cost, says Chen. Lower-income consumers purchase ESCs because they worry about not being able to afford a new DVD player if the current one breaks. So the people who tend to purchase ESCs as product insurance are the ones who can least spare the added expense of the ESC.

Men and women may buy ESCs for different reasons. Men are more sensitive to the expected replacement cost while women are more risk averse. This may be because men are more sensitive to the cost of replacing a product than women. “Or it may be because there’s some truth to the stereotype that men are more responsible for maintaining and taking care of the family electronics and appliances,” says Chen.

What about Chen? Does she buy extended service contracts? “Personally, I do. I always did when I was a graduate student, when I knew I couldn’t afford to replace things,” she admits. “It gave me peace of mind. Now, it might be a different situation.”

“Why Do Consumers Buy Extended Service Contracts,” co-authored by Tao Chen; Ajay Kalra, Rice University; and Baohong Sun, Carnegie Mellon University; was published in the Journal of Consumer Research. To learn more about this research, contact Tao Chen

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