It goes without saying that car dealerships can't exist unless they are profitable. That's true for every business, from a neighborhood dry cleaner to a mega-retailer like Wal-Mart. At auto dealerships, the rows of shiny new cars might prompt shoppers to believe that they're where the business makes most of its money.
But that's not the case. According to the most recent data from the National Automobile Dealers Association (NADA), the new vehicle department of a car dealership accounts for about 30 percent of a dealership's gross profits. In addition to car sales, that figure also reflects profits from finance and insurance (F&I) products sold on new cars. That means such things as Gap insurance, alarm systems and, notably, extended warranties.
The used vehicle department represents nearly 26 percent of a dealership's gross profit, according to NADA. In addition to car sales, the figure also reflects profits from F&I products sold on used cars.
So where does the majority of a dealership's profit come from? It's not from car sales: at least not directly. It's from the service and parts department, which accounts for 44 percent of the dealership's gross profits, according to NADA.
Knowledge Is Powerful
What makes some shoppers wary as they enter car dealerships is the fact that they don't actually know what they're going to pay for the product. Shoppers don't expect to negotiate the cost of a quart of milk at the supermarket or the price to dry-clean a dress at the shop around the corner. We do expect to negotiate car prices, however.
An alternative to car price guesswork can be found via Edmunds Price Promise®, which gives shoppers an upfront, guaranteed price on a specific car. But until every dealership offers Price Promise, you can better navigate some of the more complex purchase negotiations by understanding some of the financial aspects of the car selling business. Here are some examples.
New Cars: Dealer Holdbacks and Dealer Cash
Car pricing is a complicated process. To simplify things, consumers learn to look at the invoice price of a car and assume that's what the dealer paid for it. They may then wonder how a dealer is making a profit if it's selling the car for the invoice price. This is where two other sources of manufacturer money come into play.
Dealer holdback: This is money the manufacturer pays to the dealer only after a car is sold. It's typically 2 or 3 percent of either the invoice or the sticker price of the car. On a $20,000 car, a holdback represents $400 to $600. The holdback allows dealers to sell a car at invoice price (or even below invoice) and still make money. Most manufacturers offer holdbacks to their brands' dealers, but not all. You can check the holdback percentage before going shopping but don't try to build it into your negotiations. Dealers consider this money off limits for the purposes of price negotiation.
Dealer cash: When a car isn't selling well, the manufacturer will sometimes offer an incentive — often as much as $2,000 — to move it off lots. That's known as dealer cash.
Dealer cash can also come into play at the end of a model year, when both the dealership and manufacturer want to clear out even popular cars to make way for the incoming new vehicles. Edmunds True Market Value Price (TMV®) includes the pass-through rate for dealer cash.
The Role of Commissions
Traditionally, a car salesperson works on commission, and maybe even "straight commission," without a base salary. The salesperson typically tries to hit sales goals in order to earn a more substantial paycheck. This can set up strains between the buyer, who wants a lower price on a car, and a salesperson, who may be paid better if the selling price is higher.
"Confessions of a Car Salesman" has an explanation of how this worked at a high-volume, high-pressure dealership in 2000. It boiled down to this: The higher the per-car profit for the dealership, the higher the commission a salesman would earn.
Today, dealerships vary in how they structure compensation for the sales staff. Some still hold to traditional commission-based plans. But in a growing number of dealerships, the push is to sell as many vehicles as possible, even if it means little or no profit per car. The bonuses are instead based on the number of cars sold, with higher percentages paid to salespeople for more cars sold above a certain goal. Bonuses based on sales volume, rather than more profit per car, have long been the model for dealership Internet departments. That's a good reason for car shoppers to work with them.
Used Cars: Trade-Ins and Purchases
Although used cars account for the smallest percent of a dealership's gross profits, the trade-ins themselves can be a "huge profit center for the dealer," says Oren Weintraub, a former general sales manager at a top Ford dealership and now president of the concierge car buying service Authority Auto in Los Angeles. And dealers really need those used cars. According to NADA, 61 percent of a dealer's used car inventory comes from trade-ins.
Used cars are far more profitable for a dealer than are new cars. For example, there's a $4,000 difference between the trade-in value of a 2010 Toyota Camry XLE (what the dealer would pay you for it) and its dealer retail price (what the dealer would sell it for). That $4,000 is essentially the dealer's expected profit. Dealers will point out that they have to recondition used cars, and that costs money. But even so, the profit margin on a used car is typically more than what a new car sale can bring. NADA reports that at the average car dealership in 2012, net profit per new vehicle retailed was $111.
On the buying side, used cars can be tricky for shoppers because they can be a "blind negotiation," Weintraub says. The car shopper doesn't know what the dealer paid for the used car and might not know its current market value. An Edmunds' True Market Value (TMV®) appraisal of a used car can help. While TMV adjusts for regions, local markets can have quirks that are difficult for the car shopper to spot. Only by researching the current market and comparing prices can you know the right price for a used car.
Finance and Insurance: More Important Than Ever
F&I is an important source of dealership income. According to NADA, nearly 37 percent of a dealership's gross profit comes from the sale of F&I products and service contracts on new and used cars. And while the gross margin on the sale of new cars and trucks fell to 4.2 percent in 2012 from 4.6 percent in 2011, aftermarket income rose, "because of increasing F&I and service contract dollars," according to NADA.
The average profit on a new car from F&I products was $804 in 2011, according to a 2012 survey of 800 subscribers to F&I and Showroom magazine. With increased training for the F&I staff, that figure can go up to $1,200 per car, according to Zurich, a company that does F&I sales training. In short, F&I sales are critical for a dealership's success.
The dealership's F&I manager is primarily there to present the dealership's pitch for financing. It's worth listening: Sometimes the interest rates are lower. But you also should arrange independent financing first.Then you'll be able to know for sure how good the deal is.
In addition to offering dealer financing, the F&I manager typically offers extended warranties (also known as extended service contracts). The pitch for extended service contracts appears to be a winning one with car buyers. In 2012, customers bought extended service contracts on 42 percent of new vehicles. That's the highest rate in the past two decades, according to Automotive News, citing NADA data.
If you do want to buy a product such as an extended warranty, it's important to remember that the price is negotiable. To get some tips on arriving at a better deal, read "How To Get the Best Price on an Extended Car Warranty."
The Service Department
In economic hard times, service bays have kept many dealerships afloat. Dealers know that there's a good chance that a car buyer will bring the vehicle in for regular service, and even if the dealership only ekes out a thin margin on a new car sale, there's the possibility of continued cash flow from a service relationship.
Commissions play a part in the service operation as well. Service advisors typically receive a commission on all the parts and services they sell. Again, the amount of sales pressure you'll experience varies widely.
Reputation, Reputation, Reputation
Now that you know more about where a dealership makes its money, you can move on to picking one that has a good track record in how it deals with customers, both as buyers and as clients of the service department. Visit Edmunds dealer ratings and reviews, where you can read about real consumer experiences.
To find a dealership that knows how to treat shoppers right, please visit Edmunds.com's Dealer Ratings and Reviews.