Question

A company estimates that 0.7% of their products will fail after the original warranty period but within 2 years of the purchase, with a replacement cost of $350. If they offer a 2 year extended warranty for $48, what is the company's expected value of each warranty sold?

Answer 1

$44.90

Explanation:

The resulting value for the company of replacing a failed product is given by the price of the warranty minus the cost of replacement:

F = $47-$300=-$253

This event has a 0.7% chance of happening.

The resulting value for selling extended warranty to a product that does not fail is given by the price of the warranty:

W = $47

This event has a 99.3% chance of happening.

The expected value is:

EV = $44 * 0.993 + ($47-$300) *0.007

EV = $44.90

The expected value for each warranty sold is $44.90.