How firm innovativeness and unexpected product reliability failures affect profitability

Abstract

This study examines relationships among a firm’s innovativeness, its unexpected product failure costs, and financial performance. When a firm chooses to develop more innovative products and processes, product reliability outcomes become more uncertain. These uncertainties in turn may lead to unexpected warranty claims costs, as well as other costs that can erode the advantages of an innovation leadership position. This study empirically tests these propositions using publically reported warranty and financial data from 2003 to 2013, representing 482 unique firms. Consistent with prior studies, our estimation of the direct effects of firm innovativeness on financial performance shows an inverted–u–shaped relationship. Importantly, we find that more innovative firms also experience more unexpected product failure costs, and, consistent with organizational information processing theory, the negative impacts of these costs on financial performance extend well beyond the direct costs associated with remediating warranty claims. Further, we find that this relationship is robust to differing levels of industry innovativeness. Hence, our study suggests that product failure risks associated with firm innovativeness are significant, and act to at least partially offset the financial benefits of innovation leadership. In addition, standard accounting for product warranty claims may substantially understate the true costs associated with product failures, which appear to generate significant SG&A, fixed asset, and inventory costs above and beyond direct warranty processing costs. Our study also demonstrates a novel usage of warranty claims data. We discuss the implications of these findings for both managers and researchers.