How Smart Dealerships Make Their - Money

At first, sales would appear to make up the majority of profits at a typial new car dealership. However, appearances can be deceiving. Car dealerships make money in several ways beyond simply making sales. One component of any dealership's earnings is trade-ins. Dealership's make money selling service contracts, customer fees, manufacturers holdbacks and then there's financing.  These revenues are classified as front-end and back-end earnings.

Mark-Up

One of the most obvious ways a dealership makes money is how much the dealership marks up the manufacturer's suggested retail price (MSRP). When it comes to selling cars, the dealership's invoice price for a particular vehicle does not reflect the true cost to the dealer. The invoice price has typically been marked up five to ten percent over the MSRP for that vehicle. This is an example of front-end profits.

Undervaluing - Trade-Ins

One of the most lucrative parts of the car dealership's business is trade-ins. It's also a very gray area, and a cash cow for the car dealerships. The used-car manager normally oversees appraising trade-ins from new-car customers.

When you trade your car in on a new or even used car, the dealer's used car department always and I repeat always undervalues trade-in's. Nothing personal. Its their job. Its how they make their living.

When customers do trade-in (Colossal Mistake)their used cars the dealership has an opportunity to make some additional profits, by undervaluing the price of the trade-in. Presume the customer's trade-in's real TMV (True Market Value) is $4,500. The dealer quotes the customer at $3,500, thus realizing an immediate $1,000 profit when the customer accepts the deal.

Shortly, after the deals done and sometimes even before, the dealer will clean the car a bit, make sure its safe to drive and as fast as they can, sell the vehicle at $4,500 it's True Market Value or more. With one trade-in, the dealer has made $1,000 from undervaluing the trade-in, and another $1,000 from selling it at it's TMV price to another customer or wholesaler, taking in $2,000 total.

This money, in most cases could have gone in the buyers pocket - towards the price of the new car.

The dealership can also make an additional profit by booking the car at a higher price. Lenders will finance more than 100 percent of the car's value if the new buyer has good credit, giving the dealership an additional profit besides the $2,000 they've already churned, I mean earned!

Car dealerships use many sources, including the National Automobile Dealers Association (NADA) to track the prices on different cars. They use the NADA prices to determine if they can book out the car at a higher price and get away with it. If they can, they usually do, taking the profits if the car sells. This is a back-end profit.

Service Contracts

After the customer agrees to purchase a new or used vehicle, they go to the Finance & Insurance (F&I) office. F&I represents another opportunity for the dealership to make money. In the F&I office, the customer signs all of the legal documents that finalize the deal. During this process, the dealership stands to make some money by selling extended service contracts. These contracts cover items that will, in all likelihood, never need to be repaired. Additionally, an extended contract requires the customer to pay a deductible every time they use the contract.

The customer can avoid this undesirable outcome by purchasing a certified pre-owned car. This is backed by the manufacturer and not the dealership. An extended service contract is backed by the dealership, which does not have the reputation at stake that the manufacturer does. These contracts represent back-end profits.

Holdbacks

A holdback is a percentage of either the MSRP or the invoice that is paid to the dealer by the manufacturer. Holdbacks are designed to increase the dealership's cash flow and not to pay sales commissions. The holdback artificially inflates the dealership's paper cost.

The car dealership must maintain an inventory on-hand to display to potential customers. When they purchase and replenish this inventory from the manufacturer, the price for each vehicle is reflected on the manufacturer's invoice. The "invoice price" is inflated by the manufacturer by around 2 to 3 percent on average. The dealership pays this inflated price to the manufacturer. However, the manufacturer later reimburses the dealership at predetermined times, usually on a quarterly basis.

This seems like an unusual sleight-of-hand trick, but it accomplishes three goals. Dealerships borrow money based on the invoice price. A higher invoice price including a holdback allows the dealership to borrow more money. Sales commissions are calculated on the basis of gross profit. Holdbacks lower the gross profit, which results in lower sales commissions and greater profits for the dealership. Finally, holdbacks let the dealership advertise at invoice prices and still make a tidy profit on every transaction. Holdbacks are front-end profits.