How Do Car Dealerships Make Money?
Most consumers believe car dealerships make their money off new car sales. In reality, the balance sheet is much more complicated.
New vehicles are the shiny, big-ticket items that get the most attention, but they are also the least profitable part of the business. Few dealerships can survive on new car sales alone. A successful dealership business requires a mix of sales from new vehicles, used vehicles, finance and insurance (F&I), and the services department.
Which segment is most profitable? That answer might surprise you. Let’s look at each category and break down the sales, costs, and profits.
New Vehicles: The Loss Leader
New cars are the best-selling items for dealers, but they also have the lowest profit margins. They are considered a loss leader product because they bring customers through the door without generating much profit on their own. According to NADA, net profit margins for new vehicles dropped to 2.3% in 2017, down from 2.7% in 2015 (These numbers include F&I).
The problem is that dealers have to work within the confines of the original equipment manufacturer (OEM), the maker of the vehicle. The OEM— like Honda, Ford, or Subaru—sets the minimum retail price for new vehicles, also known as the MSRP. Dealerships can’t price much higher than the MSRP or their customers will simply find a better deal.
Of course, OEMs set the wholesale price for new vehicles as well, leaving dealerships with little wiggle room to improve their margins. Luxury brands offer higher profit margins than less expensive new vehicles, but they also have higher wholesale costs.
New vehicles also have a shorter shelf life than used vehicles. At most, dealerships have less than one year to move all their new inventory before the new models come out. In reality, the window is even smaller. If dealers don’t sell new inventory within the first 6 months, they will be hard-pressed to find a buyer, who would rather wait for the newest models coming out in the fall.
To compensate, dealers will often sell new vehicles at a steep discount—even at a loss—if the inventory sits for too long.
But as well see in the sections below, even new vehicles sold at a loss can make a dealership money. First, let’s break down the economics behind used cars.
Used Cars: Less Volume, Higher Profit Margins
The used vehicle market is considerably different than the new market. According to NADA, used vehicles make up only 30% of sales for dealerships, but almost 25% of the gross profit. By comparison, new vehicles make up almost 60% of sales, but only 26% of gross profit (These numbers include F&I).
In other words, used vehicles are almost twice as profitable as new vehicles.
Why is this the case? First, dealers have more control over the pricing of used vehicles. Used vehicles have no MSRP, so dealers can sell them for as much or as little as they want. They can also increase the value of a used vehicle by spending money on reconditioning.
Dealers also have more control over how much they pay for used cars. Whether at auction or through trade-ins, dealers can look for good deals on popular cars. They use car appraisal tools to make sure they’re buying winners and not duds.
Amazingly, used cars are not the most profitable product for dealerships, either.
Where is the Real Profit Generated
The sale of new and used vehicles brings in a collected 50% of profits for a dealership. What brings in the rest?
Dealers know they cannot survive on vehicle sales alone, so they use them as a gateway to upsell products from the services, parts, and body shop department.
Many stores encourage their salespeople to close as many deals as possible, even if they have cut into their profit margins. That’s because the services department, which only generates 13% of revenue, accounts for 49% of gross profit in a dealership.
Dealers know when they sell a vehicle, whether new or used, they are earning a customer for the real moneymaker in their business: the body shop.
The finance and insurance department is another profit generator for dealerships. NADA data shows us that on average, the F&I products yielded 2.8% net profit for new cars and 3.7% for used car. That’s a higher net profit than both new and used car sales.
F&I tacks on additional profit for the vast majority of vehicle sales. 85.1% of new car buyers use some form of financing versus just 53.8% for used car dealers. Extended warranties are also becoming more popular, adding even more profit to each deal.
Dealerships: Selling Cars, Profiting on Service
Dealerships are complex businesses where each department relies on the others.
New car sales could never sustain a business on their own, but they bring in customers for more profitable departments. Service departments would also struggle to survive on their own, but the used car department supplies a steady stream of customers.
Dealers may sell cars, but they are really in the business of servicing and financing. As a dealership’s largest profit centers, these departments have become an essential part of the business.