A company sold 10,000 units with a one-year warranty. Past experience shows that 80% of units will need no repairs, 15% will need minor repairs costing $20 per unit, and 5% will need major repairs costing $150 per unit. What warranty provision should be recognised?

Correct answer: A) $105,000

Explanation

For a large population of items the provision is measured using expected values. Expected cost per unit = (80% x $0) + (15% x $20) + (5% x $150) = $0 + $3 + $7.50 = $10.50. Provision = 10,000 x $10.50 = $105,000. Applying a simple average repair cost of ($20 + $150) / 2 = $85 to the 20% needing repair (2,000 x $85) gives $170,000, which ignores the different probabilities. Taking only the minor repairs gives $30,000 and only the major repairs gives $75,000.