Design and pricing of extended warranty menus based on the multinomial logit choice model

Abstract

This paper studies the design and pricing of an extended warranty menu, which offers multiple options with differentiated lengths and prices. The power law process is used to model product failures and evaluate warranty costs. The multinomial logit model is adopted to describe customer choice behaviors. From a warrantor’s perspective, the design and pricing problem is to determine which candidate options to offer and the associated prices so as to maximize the expected warranty profit. We show that the optimal strategy is to offer all candidate options associated with a cost-plus-margin pricing policy, with the same profit margins for all options. If only a limited number of options can be offered, then the options with the highest valuation margins should be selected. In addition, we present three extended models by incorporating heterogeneous warranty breadths, free preventive maintenance programs, and customers with heterogeneous perceptions of product failure probability. Major findings in the extended models include: (i) a free preventive maintenance program should be attached to a warranty option only when it is feasible for that option; and (ii) when the customer population is heterogeneous, the equal-margin pricing policy is no longer optimal. Overall, this work will equip practitioners with a quantitative tool to design and price extended warranty menus in various practical scenarios.