So in this session, we're just going to be relying on the same tools that we were using previously. Using those probability distributions and incorporating them into our decision making process. I'm going to tee up a particular a business problem for you to work on today. And where we're going to depart from what we've done previously is, in each of the earlier modules we put together templates to kind of work through structuring the decision problem. And if we think about the flow of those different templates there's the piece that is uncertain to us, that random variable. In our last exercise it was how many people are not going to show up for flights, we had to take into account the different potential values that could occur of the number of no-shows. And we wanted to incorporate that into our profitability model. Well, we're going to do the same thing today in the context of product protection plans or extended warranty plans. If we think about that, if we think about these plans, they are very common. We see them across a wide range of products, if you head over to BestBuy you're buying a computer. Well things could happen with computers. We drop laptops, we break keyboards, we spill things on them, and if you buy that extended warranty coverage you're protected. At least some of the problems that you might encounter, it extends what the manufacturer offers, might provide you additional piece of mind. But that piece of mind comes at a cost. If you think about going to buy a new car, let's say you get the three year or the five year warranty as standard. Is it worth it for you to buy that extended warranty? In a lot of cases, we believe, that extended warranty might give me piece of mind. If I have any problems, I just bring it back, but let's think about what that means for a second. Is I'm paying up front for events that may or may not happen in the future. So that's the decision that consumers are ultimately making. Well, if we're in the position of the retailer and we want to offer one of these plans, what do we have to think about? We've got to think about how likely is it that consumers are going to bring these products in. We've got to think about what it's going to cost us to make these repairs. And ideally if we're going to offer these plans we'd actually like to make some money off of it. If we think about buying, you as a consumer goes into a store, you're thinking I'm going to buy a brand new refrigerator. Well, it's going to cost me $1000 for that refrigerator and it probably only comes with a one year warranty. In this case we got a one year warranty on parts, one year warranty on labor. Gee, I'm spending $1000, if it's going to break down right away I'm going to have to call a repairman and who knows what that's going to look like. So what does the retailer do in this case? He says we're going to offer you some peace of mind. We'll give you three years of coverage. We'll give you five years of coverage, but you're going to pay a little bit for it up front. Right, so we're going to figure out in this exercise how do we go about pricing these plans and doing the calculation of what's the best price for us to set? What are the best terms for those plans for us to set in order to, hopefully, deliver some value to the consumer. But also, deliver profit to the business. Now, one of the factors that may play into the decision to get an extended warranty plan is what would it cost me to get the repairs done if I don't have that warranty plan. Right so, this is pulled from a retailer's website if we look at the refrigerator. I don't buy the warranty plan, several hundred dollars. Should something happen. So $600 if it's the compressor. I spent $1,000 on a refrigerator. I'm going to spend 50% of the refrigerator's cost just on a single repair. That might be an incentive for me to spend a small amount up front so that I don't have to worry about that for the next three to five years. But that's if you're not handy. What if you could repair things yourself? What if it's a part that costs 50 bucks that you're capable of installing yourself? Well then it's a different problem. But for a lot of consumers, they don't have that skillset so they're going to call a third party to come in and do those repairs. The third parties going to charge them something. Maybe the retailer has arrangements that they can get the repairs done for less. So the cost of doing this repairs without the protection plans is going to be one of the factors. That we're going to have to take into account. Just to give you another illustration of this warranty coverage, it may not be just in terms of having the products available, it maybe that you want the convenience. That in the case of Apple offering their extended warranty plans won't stop. One of the things they advertise is, won't stop for technical support. You have a problem, you know where to take your computer. We also see these types of plans being offered by service providers like wireless service providers. In this case, AT&T's mobile insurance offered at $6.99 per month for each number. They also added a feature of for declining deductibles and we see this in auto insurance as well. The more time goes by the lower your deductible is going to be if you haven't had any claims yet. And so what they're saying is there's going to be an initial deductible. But as more time goes by, the next time that you have a claim I'm going to charge you potentially on a lower amount. Well the deductible is feature of the plan. We could say that there is no deductible. You pay up front for your warranty coverage and for let's say next one, two years. Everything is covered. No additional out of pocket cost. Another option is to say, pay a small amount upfront, but each time that you need support, each time that you take advantage of your policy you're going to pay a deductible. And if we think the auto industry, or the auto insurance industry as a context you'll think about your own auto insurance coverage. The higher you set your deductible, your premiums are typically lower. Well why are we seeing that happen because you're taking on more of the risk yourself. So there's not as much to charge you for it up front. All right, so here's the business problem that we're going to be working with. We've got an electronics retailer that's planning to offer these extended warrantees to its customers. It wants to generate profit, but it's also something that's being demanded by consumers. And we're trying to figure out what are the features of the warranty plan that are going to be best for us. All right, so were considering a couple options, but, and we want to built a decision support tool that as flexible as possible, but specifically here some options that you want to to consider. We want to offer warranty coverage from up to 2 years, so we want to offer for 1 year or for 2 years. We get to determine what the price is. So that's one of our decision variables. And we're going to offer it with no deductible. That is, you pay upfront and that's it. That's all that we're collecting from you as a consumer. All right, so that's one option that we want to consider. Another option that we want to consider is that deductible. That is, we don't want to assume zero as a deductible but we want to be able to set that as another decision variable. So not only do we set the price of the warranty, we also set the deductible. And it's going to be the same deductible every time that you need service. The last feature that we want to include is a quota. As you're buying a plan but you're only entitled to a given number of repair incidents. So now, we're saying that there are three different decision variables that we have. We as the retailer are going to set the price of the plan, we're going to set the deductible level, and we're going to set what the quota is. All right, now what's the consumers decision look like? What the consumer is going to consider is, what do I expect it to cost me over a one year or two year period under each of these warranty plans? If you offer all three of these plans to me, what's my total cost of service for using each one? What we're also going to have to consider as consumers, what would it cost me if I don't buy one of these warranty's? What if I have to go to a third party? So think of that as my outside good, right? If I can go to a third party and repair it for a lower price, well chances are that that's what I'm going to do. I'm not going to buy your warranty coverage if using that third party ends up being cheaper. And for illustration purposes, we're going to make the assumption, for now at least that consumers are perfectly rational. That is they're going to be, they can come up with what does it cost me under different warranty options. Warranty option 1, warranty option 2, warranty option 3 based on the features that the retailer set. And what does it cost me if I do the repairs myself? And they're going to choose the option that gives them the lowest expected repair costs. So if the retailer charges too much and the consumer can get it done for less. They're not going to sell any of these warranties.
