Pricing of the option to delay the purchase of extended service contracts

Abstract

Extended service contracts (ESCs) can be purchased at the same time as the product they cover or at some point afterward. We believe that the option to delay the purchase of an ESC until after the customer ‘gets to know’ the product should be reflected in the pricing of the ESC. However, through field interviews in the automotive industry, we found that the price charged for an ESC to someone buying a new car is typically identical to the price charged for the same ESC to someone purchasing it at the end of the base warranty period. This results in an implicit loss to the retail establishment that sells the ESC. The current method for pricing ESCs ignores the fact that the option to delay the purchase of an ESC to the end of the base warranty period carries an implicit cost that the retailer must bear. We feel that the price should reflect this cost. Using methodology that is similar to stock option pricing techniques, we develop a model to find the true value of the option to delay the purchase of an ESC. When implemented, our model will allow retail firms to gauge more accurately the true value of their ESCs.