How Auto Dealers Operate
In TV ads, new car dealers are relentlessly cheerful. Off screen they have a good deal to worry about. Dealers work in volume and carry large overhead costs. Day by day, interest charges on the automobiles on the dealer’s lot eat potential profit. Buyers like you have more leverage than you think.
Knowing how the typical dealership works makes it easier to negotiate for a new car, especially after you have removed the financing hassles by arranging a pre-approved new car loan with your Credit Union (MAFCU).
THE FLOOR PLAN – Dealers own the cars on their lot in the same way that you own a house with a mortgage. New cars on the dealer’s lot are financed under arrangements called floor-plans. Most floor-plan lenders are commercial banks and manufacturer owned finance companies. Floor-plan interest has a wholesale rate which is typically one point over the prime rate. In return dealers agree to direct a certain portion of consumer financing to the floor-plan lenders.
Floor-plan interest is an overhead expense the dealer must recoup. It grows rapidly. Bobby Medow, a former car salesman in a family business, estimates that a dealer holds each car for an average of 60 days. With floor-plan interest financing at 7% APR, an $18,000 car sitting on the lot for two months creates an added expense of $211. Multiply that by an average inventory of 120 cars, and you can understand why dealers are aggressive marketers.
HOLDBACK – Manufacturers provide dealers with some business support. This includes the slick national ad campaigns that whet consumer appetites. Automakers also give dealers an annual payment called holdback. This is a rebate of approximately 3% of the factory invoice for domestic cars sold. Holdback is not given for foreign cars. Buyers, who are aware of holdback, assume the holdback will give the dealer extra negotiating room. Although the annual holdback payment can be large, dealers don’t regard it as profit. Instead, they count on holdback to help defray the fixed costs of doing business – utilities, salaries, taxes and so on. Rather than rely on holdback, the dealer plans to profit elsewhere.
RESERVE – This is a payment from a lender that is similar to a manufac turer’s holdback. Retail lenders pay a reserve on each loan the dealer writes for them. The reserve may depend on the “buy rate” or interest rate charged to the dealer. The dealer is free to finance at a higher rate and pocket the difference when the lender buys back the loan. Or the reserve may be a flat loan processing fee.
DEALER DISCOUNT FINANCING PROGRAMS – This is a special case. Here, an automaker and often its dealers, pay the financing company to lower the interest rate on new car loans. The dealer then pays a subsidy to the financing company. The dealer recoups this subsidy by increasing the price of the car. Dealers like subsidized financing, or “subvention” campaigns because the programs sell cars. Keep in mind that discount rate financing often means a higher price for the car. With pre-arranged financing from MAFCU, the dealer will often give you a better deal since the cost of the car won’t have to be adjusted to compensate for the discount financing program.
CALLING ALL CARS – The manufacturer promises each dealer a fair number and reasonable variety of cars. In reality, dealers often settle for less than the best selections. That’s because manufacturers can misjudge demand and suffer lag time before production catches up on popular vehicles. Since dealers often can’t get enough of the hottest sellers, they push to make maximum profit from the remaining cars on their lot. Customers special order only 10% to 15% of new cars to their specifications. Dealers order the rest based on what the manufacturer offers and what dealers predict their market area wants. Dealers will estimate how many cars they need “stripped” or with few options. But they order most cars with various option packages.
You can alter option packages, but you give up any package discount in the process. Some options, such as wheel covers, can be changed. However, many options are built in and cannot be removed. Experience has shown dealers that most customers buy cars on impulse. Dealers also know that the desire to drive a new car the same day can often outweigh the buyer’s resistance to unwanted options.
Dealers are not limited to selling from their own stock or ordering from the factory. Dealers can also trade cars among themselves. If the cars traded are not of equal value, one dealer (and then you) will pay the difference.
SALES HIERARCHY – Staff positions depend upon the dealership size. In all cases, the dealer sits at the top of the hierarchy responsible for major business decisions. At large dealerships the general manager is second in command. Then managers of various operations such as sales, service, body shop, leasing and finance all report to the general manager. Salespeople occupy an unusual position. They negotiate the terms of every deal, but they cannot approve a sale. Remar Sutton, a consumer advocate and former car dealer, writes in his book “Don’t get Taken Every Time”: “car salespeople don’t know anything about the dealership. It’s the sales manager, working behind the scenes, who has authority over each transaction”. This setup, says Sutton, allows salespeople to side with the customer against the dealership. Salespeople know buyers like to hear them say, “I’ll see if they will accept our offer.” Of course, salespeople have the same motive as the dealer – maximum profit. New car salespeople earn about a 25% commission of gross profit on their sales.
Salespeople are trained to determine what motivates each buyer – price, trade-in amount, interest rate, monthly payment and so on. After sizing you up, salespeople try to create an emotional attachment to a specific car. They try to get you to test drive it, feel the upholstery, admire the options or the styling. Many salespeople try to appear as your friend. By putting you at ease, negotiations often proceed to the dealership’s advantage.
TURNOVERS – If a sales person can’t bring a prospect to sign a contract, they will sometimes “TO” or turn over the consumer to another salesperson or a manager. Sometimes, the next salesperson will succeed because of more experience or simply by virtue of being a new face. Sometimes, a new salesperson can bump the buyer to a higher price vehicle. Even so, salespeople generally don’t like turnovers because it can lead to split commissions. When the salesperson leaves the closing or negotiating room, it is often to confer about your resistance and to devise tactics to overcome it. Typically, what follows is a TO or another assault on your objections. Either way, feel free to leave and visit another dealership. By the way, a good tactic used by salespeople to keep you in the negotiating room is to have you surrender your keys to your trade-in so it can be tested while you’re talking. It’s hard to get up and leave when you don’t have the keys to your car. Another tactic is to ask you to give the salesperson a “good faith” deposit such as $50. Once you hand over this money during the negotiating stage, the salesperson is certain you won’t leave without getting your money back.
INVOICE – The factory or dealer invoice is a closely guarded secret. Usually even the salespeople don’t know it. That’s to prevent them from negotiating upward from invoice. Sales managers would prefer the salespeople negotiate downward from the sticker price. The invoice is different from the manufacturer’s suggested retail price (MSRP) which is the sticker price on the window. The sticker price has been marked up well above dealer invoice. As such, the sticker price is usually well above what consumers should pay for domestic cars. Due to the strong demand for certain foreign cars, consumers may have to pay close to sticker or, sometimes, above sticker for those models. Dealer markup is generally greater for luxury cars than subcompacts. A car that has a sticker of $25,000 may have a $3,500 (14%) markup while a car that costs $12,000 may only have a 7% markup or $840. This means there is more room to negotiate when buying a bigger or luxury car.
ADD-ONS – Salespeople present these high-markup items after buyers have decided on a car. That’s when most consumers relax, assuming negotiations are over. “Dealer Preparation”, a euphemism for gas, oil and advertising, is a big money maker. Others include paint and interior protection packages. Don Wilson, a former dealer general manager who now works for a credit union, says the consumer may pay $350 or more for rustproofing, undercoating and paint protection which may cost the dealer less than $100. “Custom Striping” might cost $40 for materials and labor, yet carry a price tag of $200. Window etching is another huge profit maker – do you really need it. Another big money maker for dealers are extended warranties or service contracts. The profit margin on these is usually 50% to 60%. Be wary of buying GAP insurance – do you really need it. The profit margin on GAP insurance can be 100% or more. There is room to negotiate on dealer add-ons. Dealer “packing” or add-ons are often added before the car is put up for sale. You should not feel obligated to pay for unwanted removable add-ons.
FRONT AND BACK – Selling you a new car and handling your trade-in are often referred to as the “front end” of the transaction. Financing and credit insurance are the “back end”, and is the turf of the F & I (finance and insurance) man. Sometimes a dealer will take a close front end sale when he knows he has a good back end deal. This could happen when the salesperson is certain the customer will finance through the dealer with a lender that pays a good reserve. The F & I man is very important to a dealership. It’s his job to get the highest financing rate possible and sell you an extended service contract along with disability and loan life insurance. The F & I department can generate about 40% of the gross profit in a dealership. The F & I man will attempt to arrange loan financing at a rate guaranteed to carry a good reserve. Some dealers will actually negotiate financing rates with a customer who shows strong resistance to closing the deal due to the financing rate offered.
What can you do to persuade a dealer to sell you a car at a fair price?
See the next section to learn how you can BUY A CAR ON YOUR TERMS.