Toyota's much publicized recalls in 2010 have brought up an important question: How much do auto recalls actually affect companies? After all, recalls aren't just on consumers' minds right now - they're at the forefront of investors' minds too. As a result, Toyota's share prices have seen a double-digit decline year-to-date. But is the dip justified, or is it an investor overreaction?

The Truth About Recalls
In general, recalls aren't a big deal - they're actually quite common. Since 1967, the National Highway Traffic Safety Administration has recorded 8,759 safety related and compliance recalls as of March 2008. That's more than 200 recalls every year. (Find out what to consider before taking a ride with stocks from this industry in Analyzing Auto Stocks.)

For the most part, those recalls go unnoticed by investors because they're minor and relatively inexpensive fixes. Occasionally, however, an auto recall becomes a serious issue for an automaker - such has been the case with Toyota.

Toyota's recalls have been a big deal because the defects have been serious enough to cause deaths, the defects affected multiple systems in the vehicles and because the defects affected such a large number of popular vehicles worldwide. But that said, how much could a major recall really affect a company?

Repair Costs
The most direct costs to consider are the financial costs of a recall to the automaker. The most obvious one is the cost of the fix. Obviously, repair costs for a car manufacturer are significantly lower than they would be for consumers given the lower part costs and labor expenses that the automakers enjoy. That usually makes a recall's cost per vehicle relatively low - but far from immaterial.

A major recall that affects a large number of cars can create huge expenses in the aggregate. According to Toyota's Q3 conference call, they have set aside 100 billion yen (approximately $1.12 billion) for these "quality-related expenses" which will be allocated between the third and fourth quarters. (Some products were announced with great hype, only to be pulled from shelves. Find out more in A Year In Product Recalls.)

Legal Costs
Another big cost for a major recall is legal liabilities. With class action lawsuits popping up quickly right now, it's likely that Toyota's legal expenses - and potential damages - will be severe. Luckily for investors, the company carries liability insurance that should bear the brunt of the expense, but it's still unclear just how much the lawsuits could impact share prices.

Finally, the company will have to spend cash to fix the blemishes to its formerly solid image. Worldwide, Toyota has already publicly apologized for its past quality shortcomings through television commercials, print ads, and PR blitzes - each of which carries a hefty price tag.

Image Costs
Automakers also face a number of other, less tangible, expenses. For Toyota, one of the biggest costs will be the blow to its brand - one that the Kelley Blue Book estimates trimmed the value of Toyota vehicles by an extra 3% this year.

That brand damage equates to a serious opportunity cost and lost sales. In the highly competitive auto industry, where manufacturers battle hard to convince consumers to spend significant amounts of money on their products, the blemishes of a recall can be enough to shift fence-sitters, the consumers who are in the middle of making a car buying decision, to the other side.

That translates into significant sales losses - Toyota estimates lost sales at 70 to 80 billion yen (roughly $770 to $880 million) because of the recalls. (It's the key to any market economy, so investors need to learn the measures and how to analyze them in Consumer Confidence: A Killer Statistic.)

Can a Recall Ever Be Good?
But with all of that bad, don't forget that quite a bit of good can come of a recall - if it's executed correctly. One of the most famous examples is Johnson & Johnson's (JNJ) Tylenol recall in 1982 following a series of deaths due to tablets intentionally laced with cyanide. The public applauded the company's quick action to keep them safe - and Johnson & Johnson saw its brand equity improve.

If the public sees a company taking on extra costs to protect consumers – and not just its own sales - the implications can actually be positive. That said, with all of the negative publicity Toyota's recalls have received in 2010, it's nearly impossible for another automaker to announce a major recall without taking a similar blow.

The Bottom Line
Ultimately, whether the decline in Toyota's share price has been justified has yet to be seen - the true effects of the recall won't be known for some time. What is undeniable though is the fact that a major auto recall can have serious consequences for manufacturers; it's something that already troubled car companies will avoid at all costs in 2010.

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