To many, car dealerships appear as profit making machines. Most people fear that when they go to buy a car they’ll get taken advantage of, and that the dealer will be making thousands upon thousands of dollars off of them. The reality is that car dealerships are actually a lot like grocery stores — they rely heavily on volume to make money, and they don’t actually make much on each individual sale.
Car dealerships make money from three primary areas of their operation; Sales, Service, and the Finance and Insurance (F&I) departments.
If you’re in the market for a new car, simply interested in learning more about how car dealerships operate, or ended up here by accident, you’re in luck! After spending 42 years in the car business, I know a thing or two about how car dealers make money, and below I’ll walk you through how they do it.
Let’s start by debunking one of the biggest myths of car dealerships…
Car dealers don’t make money from selling cars
It seems counter-intuitive to suggest that car dealerships don’t make money selling cars. Why be in the car business if you don’t make money from selling your namesake product?
This is a valid question, and unless you really understand how car dealerships operate, its answer is shrouded in secrecy. The reality is, most car dealerships don’t make much of any profit from selling cars. Some do (and we’ll discuss how), but most don’t, or at least car sales don’t make up the majority of profit generated at a dealership. Let’s explore why.
Car sales can be broken into two categories; new car and used car sales. Regardless of selling a new car or a used car, there are two seperate areas of a car deal where the dealer can make money. They are referred to as the “frontend” and the “backend”.
The frontend of the deal is everything that happens when you are working with the salesperson. The backend of the deal is everything that happens after the salesperson is out of the picture, and the Finance Manager steps into the picture.
In theory, you can have a used car sale with no frontend profit and a lot of backend profit. Or you could have a new car deal with a lot of frontend profit and no backend profit. Or, vice versa.
If you hear a dealer say, “we are taking a huge loss on the frontend, you better make up for it on the backend of the deal,” you know that means they aren’t making much (or any) money on the sale of the car, and that they need (or at least want to) make money in the F&I part of the sale.
During this section of the guide, we’re going to focus on frontend profit. Backend profit is covered below in the F&I section. As you’re about to learn, selling cars is simply a means to sell other things.
Again, to level set, car dealers generally don’t make much of any profit on the frontend of their car deals. It’s no secret that dealers markup their inventory, but even with this markup, margins are slim. Manufacturer’s, the companies that produce the vehicles you see at the dealership, set suggested retail prices for each vehicle they produce. This is what we commonly refer to as MSRP, the manufacturer’s suggested retail price.
The MSRP of a car, as well as any applicable charges and fees (i.e. destination charges) are listed on every new vehicle’s Monroney sticker. The Monroney sticker provides you with a line-by-line overview of what is included on every new car sold in the United States. In addition to the window sticker, you may also see an addendum sticker placed on the car if the dealer has added additional accessories or charges.
At the end of the day, the window sticker, and the price you see listed on it, has some built in profit for the dealer. Why then am I suggesting that dealers don’t really make money from selling new and used cars? It’s because most dealers don’t sell their cars at its list price. Most car deals are negotiated to a lower sale price.
As a general rule of thumb, the mark up on a new car can range from as little as 2 or 3% for your economy brands (Kia, Hyundai, etc.), to more than 10% for luxury vehicles (Mercedes-Benz, BMW, etc.). The more luxurious and expensive the car, the more margin built into the MSRP price.
That means if you’re looking to buy a new Kia, and the total price listed on the window sticker is $18,000, there may only be $360 in profit built into the sale of that car. However, on the other end of the spectrum, a $150,000 Mercedes-Benz could have upwards of $15,000+ profit built into its list price.
Used cars follow this pattern as well. The cheaper the car, the less margin built into its list price. The more expensive the car, the more potential for markup. However, with used cars there is no Monroney sticker (except for the original one that the car received) to outline exactly why the car is priced the way it is. With used cars, dealers have to base their pricing on what the market is willing to pay (a novel concept that didn’t exist 40 years ago when I started in the business!), and that means that there is typically not a lot of margin built into used car prices either. Most dealers use a software like vAuto to set their used car prices.
On average, there is typically somewhere between $1,500 and $3,000 of margin built into used cars prices. If you want to learn more about how much dealers markup used cars, you should read this in depth blog post, or watch the video below.
So do dealers make a killing selling new and used cars? 99% of the time the answer is no. Do some people overpay for a car, and the dealer makes a lot of frontend profit, yes. Does that happen often? No.
During my career, I sold cars where we lost thousands of dollars on the frontend. Why did I let the customer get such a good deal? We did it in order to hit our monthly volume sales objectives from the manufacturer. Remember what I said before? Car dealerships are a lot like grocery stores, they depend on volume. That reality couldn’t be more true when dealers are incentivized to sell more cars with less profit built into each sale by the manufacturer.
Manufacturer incentives can affect both the customer and the dealer. Rebates, special financing, and specific programs for new college graduates are all examples of manufacturer incentives aimed at consumers. Their goal is simple, to sell more cars. The manufacturer will subsidize these types of incentives to entice consumers to buy more cars.
Manufacturers also incentivize dealers to sell more cars too. How? By setting lofty monthly, quarterly, and annual sales volume goals (sometimes referred to as “stairstep objectives”), that if attained (and surpassed), result in hundreds of thousands, if not millions of dollars for the dealership.
It is in attaining these monthly, quarterly, and annual sales objectives that car dealers can make money from selling cars. Crazy, isn’t it?
Why do manufacturers wave millions of dollars in front of dealerships to get them to take losing deals to hit their volume objectives? As with all “goals” or incentive plans, there is a psychological answer and a practical answer.
Manufacturers, many of which are publicly traded companies that have shareholders to please, need to show growth. How do you show growth? You sell more cars. How do you sell more cars? You incentivize your dealer network to sell more cars by losing money on the sale of each car.
Why does this work? Because investors and shareholders are more excited by growth (selling more cars), than by profits (actually making money on each car sold). In my estimation, these practices (waving millions of dollars in the face of dealerships to sell more cars) won’t last forever. It cheapens the brand, it’s “smoke and mirrors,” and it’s simply not sustainable. But, for now, that’s the way the car business works.
Many dealerships will take losses on deals (especially towards the end of a month) in order to hit their factory incentive threshold. If a dealership doesn’t hit their goal set from the factory, they risk not making any money that month.
If you’re thinking about buying a car, you might enjoy this article: 3 Ways to Know How Much Can You Negotiate on a New Car
In my career I’ve seen manufacturer incentives that pay dealerships based on what percentage of goal they attain. For example, let’s say a dealership has a goal of selling 100 new cars in June. If they attain 95 percent to 105 percent of that goal (95 to 105 cars sold), the factory will pay them $1,000 per car sold. If the dealership is able to attain between 105 and 115 percent of their goal the factory will pay $1,250 per car. If they achieve more than 115 percent of their goal, they’ll receive $1,750 per car.
Do the math. Not only is it financially viable to take a loss on a deal to hit your “goal,” it’s a savvy investment.
Even with all this money being thrown around, new and used car sales still represent a very small (if any) profit generating segment of the dealership. At the end of the day new and used car sales exist to facilitate the other revenue generating areas of the dealership, the F&I office (aka the backend), and the Parts and Service department.
Finance and Insurance (aka the backend)
A growing area of importance for car dealerships is in the Finance and Insurance office. F&I, as it’s affectionately referred to, has always been an important revenue generator for car dealers, but now more than ever it’s becoming a major driver of profit.
If you’ve ever bought a car before, you’re very aware of the paperwork you need to sign before the car is officially yours. It’s a lot, and it can be quite intimidating. The process you went through was probably something like this:
- Test drive a car;
- Haggle on price with the salesperson;
- Agree to a price;
- Determine how you’re paying for the car (finance, lease, paying in cash);
- Salesperson hands you off to the Finance Manager;
- You spend hours reading through (or more accurately glancing at) hundreds of pages of documents;
- You purchase an extended warranty because you think you might need it and the Finance Manager suggested it;
- You drive home in your new car.
Yea, I know, buying a car is a real pain in the…
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Once you are “handed off” to the Finance Manager, you begin the second sales process. You thought that now that the salesperson was gone the sales process was over? No way!
Car dealerships make money in F&I in a few different ways.
Car dealerships markup loans
First, it’s important to understand that if you finance your purchase through a dealership they will make money on the loan. Don’t get too upset about this.
Car dealerships offer something to lending institutions that you and I can’t; volume. Generally speaking, car dealerships get access to loans at rates that individual consumers can’t. Dealers then mark up these loans and resell them to customers.
Keep in mind that you don’t have to get your car financed through a dealership. The next time you buy a car, you should consider getting a pre-approval on a loan from another lender, in addition to seeing what the dealer is able to quote you.
Car dealerships markup the money factor on leases
If you don’t buy a car, and instead you lease it, dealers have a way to make some profit there too. Dealers make money by marking up the money factor on a lease. The lender charges the dealer a money factor of say, .00125, and the dealer marks it up 50, 75 or even 100 basis points. The difference between the buy rate (what the lender charges the dealer) and the marked up rate (what you’re quoted) is additional backend profit on the lease for the dealer.
Car dealerships make money selling warranties and more
In addition to profit generated from financing or leasing a car, dealers make money from selling different insurance packages or warranties: extended warranties, tire and wheel protection, so on and so forth. With each sale of an additional item, the dealer is making some profit.
Good finance managers are like gold in the car business, and dealerships like to keep them around. Dealerships are also keen to invest in technology and software that increase their F&I margins.
Currently in the industry, a lot of dealers are investing in third party vendors to make the F&I process more pleasant for the customer. Solutions like docuPAD have been able to make the F&I process easier for the customer while simultaneously increasing the gross profit dealers receive. By empowering the customer to self select which warranties, protections, and plans they want, dealerships are realizing that they are able to sell even more products during the F&I process than ever before.
As a rule of thumb, dealerships can traditionally make much more profit on the backend of a car deal than on the frontend. Depending on the dealership, a “healthy” deal for the car dealer will result in $2,500 to $3,500 in frontend and backend gross profit combined. Remember very little of that will come from the actual sale of the vehicle.
Parts & Service are the real money makers
By now you are starting to see how car dealerships truly make their money. Selling cars is simply a means to sell other products and services, and it’s through those other products and services that dealers make their money.
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As far as products and services a car dealership has to offer, look no further than their parts and service department for a plethora of options. For all car dealerships, their primary revenue generator (and profit center) is the Parts and Service department.
Let’s start with the Parts department. The parts department at any car dealership keeps in stock a variety of relevant items that go towards fixing, maintaining, or upgrading a vehicle. From tires to shocks, a dealership’s parts department will have hundreds, if not thousands of unique items stocked at any given moment.
The Parts department sells these parts to three customers:
- Other dealerships; and
- Their own Service department.
Customer #1 is easy to understand. Let’s say you blow a tire in your Mazda 3 and you show up at the local Mazda dealer to get it fixed. The parts department will happily sell you a replacement tire, and in this instance the dealership makes money off of selling you the marked up tire.
Customer #2 is also easy to understand. Let’s use the same example as above, but this time, when you get to the dealership, they tell you they don’t have the specific tire you need. Instead of running around town to find it, you ask the dealership to call another local dealer and buy the tire from them. In this case, the dealership that sold the tire made some money by selling it to another dealer.
Customer #3 is less obvious to someone who isn’t in the business, but it represents the most common customer of the Parts department; the dealership’s Service department. To keep using our example, instead of buying the tire outright from the dealer, and then going to an independent tire shop, you decide to simply let the dealership mount the new tire for you. In this case, on your invoice you’ll see charges for parts (the tire) and labor (mounting the tire). Yes, you, the customer are still paying for the tire, however the dealer was able to bundle together the parts and the service into one transaction. In these instances, the Service department is “buying” the part from the Parts department, and then charging you, the customer for both the parts and the labor.
For car dealers, it’s all about service absorption
The Service department is where car dealerships make most all of their money. In the business there is a concept called “service absorption.” Service absorption is the percentage that the Parts, Service and Body Shop operating gross covers of the total of its own entire combined department operating expenses PLUS the total of fixed expenses and dealer salary.
Car dealers aspire for 100% (or higher) service absorption, although most reach 70%. If a dealer attains 100% service absorption that means that their Parts, Service, and Body Shop make enough profit to pay for all the dealerships expenses. Let that sink in for a moment…
How do dealers make money in the Service department then? By beating the book time associated with every vehicle that comes through the service lane.
For a Service department, it doesn’t matter if a vehicle is under warranty or not (dealers will happily send invoices to manufacturer’s for cars under warranty), what is most important is that their mechanics can beat the book times stipulated for each job.
Auto repairs are charged based on how long a job should take, multiplied by a shop’s hourly rate. If a certain job should take four hours, and a mechanic can get it done in two, guess what the dealer is going to charge you for? Four hours of work. And, they’ll bill you at their hourly rate (which is generally going to be quite high).
This is how car dealerships make their money, by processing repairs, maintenance, and more through their service drive efficiently. Now here’s a fun thought experiment for you… What happens when a new brand launches in an area, and there are no cars to service?
MINI is a perfect case study for this. In 2002, the BMW owned brand launched in the United States, and immediately there was a problem for the first few MINI dealers: there were very few opportunities for parts and service sales.
The Service department is dependent on vehicles in operation, i.e. cars needing repairs or maintenance. When a new brand launches there are no vehicles in operation, making the entire Service and Parts department nearly obsolete.
At launch, the Parts and Service department can help boost profits a tiny bit by accessorizing cars that the new car department sells, but this is peanuts compared to the revenue they usually bring in. For MINI, just like any other brand that is new to a market, it takes years to get enough vehicles in operation to build up a dealership’s Service and Parts departments to where they should be.
In MINI’s case, they recognized this, and for years dealers were subsidized by BMW for opening MINI dealerships. Today, more than 800,000 MINI’s are on the road in the United States, and MINI dealerships are thriving because of it (MINI’s aren’t particularly reliable cars).
Have you ever seen a car dealership without a service drive? Now you know why.
Other ways dealerships can make money
Up to now we’ve covered the traditional ways car dealers make money. There are a few nontraditional ways dealers (and more appropriately, their owners), can make money.
Savvy dealers make money from their dealership by owning the real estate that the dealership sits on. This is another way dealers can make a lot of money. Many dealers own the land they build their dealerships on, and then the dealership pays them rent each month to operate there. In my 42 years in the car business, I’ve seen dealers of all sizes make money from paying themselves rent.
I’m even aware of dealers who have repurposed an existing facility and rented it out to a competitor to sell a different brand. You can’t underestimate the value of the real estate that a dealership sits upon, that land is a veritable gold mine.
So there you have it, those are the myriad ways car dealerships make money. If you’re in the market for a car, or simply have a question about the car buying process, don’t hesitate to get in touch. Call or email me today.