Category: Business

In Part I of Dealership Economics, we looked at the financial reasons the car sales process is so perplexing.  In this (shorter) post, we'll look at where the service department fits in to the business.

When someone buys a new car, there is a widely-held myth that they are required to return to the dealer for service to keep their warranty valid.  In fact, you can service your car elsewhere, and the warranty still holds — and there is a section of your owner's manual which should state this fact.  But the superstition persists, and is often reinforced (or, at least, not refuted) during the sales process…. Why is this?

I think it goes back to the economics of the dealership.  As I looked over the financial statements of the dealership company, I saw one set of statistics which really jumped out at me:

• 85% of a dealer's sales is generated from car sales (58% from new cars, 24% used cars, and the rest from finance, insurance, and "other").
• The remaining 15% of sales comes from the service department.

That might not be so surprising… But here's where it gets interesting:

• The service department generates almost half (45%) of the dealer's profit

The cars are expensive, but contribute relatively little profit to the business.  The service department is relatively small, but generates huge profits for the dealer…

It is to the dealer's benefit to maintain the warranty myth, and keep as much of that service business to themselves as possible. 

If you have a relatively new Toyota, Lexus, or Scion, and would like to service it at Lowell's, you shouldn't let concerns about the warranty hold you back. 

I hate going to the dealership to buy a car.  I don't like the haggling over the price, and I don't like the games they play (like "I'll have to run that by my manager…").  While there are a few dealers who are "up-front" on prices (for example, I shopped at CarMax for my last vehicle), most are less-than-forthright when it comes to pricing.  Why can't they just tell you what the price is? 

For fun, I like to look over financial statements for different kinds of companies (I know… I need to get a new hobby).  This weekend, I was looking over a the earnings for a company that owns several dealerships, and I learned some really surprising things about the economics of dealerships which helps me understand why the purchase process is so convoluted.

This particular company sold new cars for an average of about $30,000.  Out of that $30,000, it paid the car manufacturer (Toyota, GM, Ford, etc.) an average of $28,000.  Out of the $2,000 that was left, about $1,500 per vehicle goes to things like rent, salaries and commissions, and advertising. 

That means that when this company sells a new car, it will make only $500 in profit for its owners.  I say "only" because they have to buy a car for $28,000 and keep it on the lot and hope that it does eventually sell…  That's a pretty big risk to get less than 2% in return.

This helps me better understand three distinct behaviors I've noticed at dealerships:

1. Vague Pricing: The dealer can take advantage of a customer's lack of knowledge about pricing to generate much higher profits.  If, for instance, they could convince an uninformed customer to pay $1,000 over what other customers would pay — $31,000 — then most of that extra $1,000 is profit and the dealer stands to make about $1,500.  So, by getting the customer to pay just 3% more, the dealer can triple its profit.  Being vague pays off.
2. Needless Add-ons: I remember shopping for a new Accord in Lexington many years ago (this was before I met Lowell), and not being able to find one without pin-striping.  There were usually a host of other add-ons — special floor mats, trunk liners, wheel locks, etc. — as well.  I knew I didn't want to pay $150 for $5 worth of colored tape, but a "plain" Accord didn't seem to be an option.  But if the dealer gets customers to pay a few hundred dollars for some cheap "special" options, then they significantly boost their profit.
3. Pushing Insurance: When the deal was closing, I always wondered why the dealers would push insurance so hard — openly questioning the quality of their product by telling us all of the things that could go wrong with the car.  Well, it turns out that the company I looked at made nearly as much by selling financing and insurance for the car as they did from selling the car itself.  Much like the add-ons, this is where the dealers can really grow their profits. 

So, the next time you are looking to purchase a car, don't be surprised if you see these strange, infuriating tactics. 

In Part II of Dealership Economics, we'll look at how the service department fits into the business.