How do car dealers make money? (Explained by a former car dealer) (2024)

Last updated on November 11, 2023

To many, car dealers appear as profit machines. Most people are afraid that they will be taken advantage of when they go to buy a car, and that the dealer will make thousands and thousands of dollars off it. The reality is that car dealers are basically like supermarkets: they rely heavily on volume to make money, and they don't make much on each sale.

Car dealers make money in three key areas of their business; Sales, Service and the Finance and Insurance (F&I) departments.

If you're looking for a new car, just interested in learning more about how car dealerships work, 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 show you how they do it.

Let's start by debunking one of the biggest myths about car dealers...

Car dealers don't make money selling cars

It seems counterintuitive to suggest that car dealers don't make money selling cars. Why be in the car business if you don't make money selling your product of the same name?

This is a fair question, and unless you really understand how car dealerships work, the answer is shrouded in secrecy. The reality is that most car dealers don't make a lot of money 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 the profit generated at a dealership. Let's explore why.

Car sales can be divided into two categories; sales of new and used cars. Whether you're selling a new car or a used car, there are two distinct areas in a car deal where the dealer can make money. They are called "frontend" and "backend".

The front of the agreementis all that happens when you work with the seller.The background of the agreementis everything that happens after the salesperson is out of the picture and the financial manager comes into the picture.

In theory you can sell used cars with no frontend profit and a lot of backend profit. Or you can make a new car deal with a lot of profit on the front end and no profit on the back end. Or vice versa.

When you hear a dealer say, "We're taking a huge loss on the front end, you better make it up on the back end of the deal," you know that means they're not making much (or any) money. from the sale of the car, and that they should (or at least will) make money on the R&I portion of the sale.

In this section of the guide we will focus on front-end gains.The backend profit is discussed below in the F&I section. As you're about to learn, selling cars is simply a way to sell other things.

Again, at the established level, car dealers generally don't make much profit on the front end of their car deals. It's no secret that retailers are increasing inventory, but even with this increase, margins are slim. Manufacturers, 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 call MSRP, the manufacturer's suggested retail price.

A car's MSRP and any applicable fees (i.e. destination taxes) are listed on each new vehicle's Monroney sticker. The Monroney sticker gives you a line-by-line overview of what's on every new car sold in the United States. In addition to the window sticker, you may also see an extra sticker on the car if the dealer has added extra accessories or taxes.

Ultimately, the window sticker and the price you see on it provide a built-in profit for the dealer. So why am I suggesting that dealers don't really make money selling new and used cars? This is because most dealers do not sell their cars at list price. Most car deals are negotiated at a lower sales price.

As a general rule of thumb, the price increase for a new car can range from as little as 2 to 3% for your budget brands (Kia, Hyundai, etc.) to more than 10% for luxury cars (Mercedes-Benz, BMW, etc.).The more luxurious and expensive the car, the more margin is built into the recommended retail price.

This means that if you want to buy a new Kia and the total window sticker price is $18,000, there may only be $360 in profit built into the sale of that car. But at the other end of the spectrum, a $150,000 Mercedes-Benz could have more than $15,000 in profit built into the list price.

Used cars also follow this pattern. The cheaper the car, the less margin is built into the list price. The more expensive the car, the greater the potential for markup. But with used cars, there is no Monroney sticker (other than the original one the car received) that tells you exactly why the car is priced that way. With used cars, dealers have to base their prices on what the market is willing to pay (a new concept that didn't exist 40 years ago when I started in the business!) and that usually means there isn't much margin built in. in the prices of used cars. Most dealers use onesoftware such as vAutoto set the prices of used cars.

On average, there is usually somewhere between $1,500 and $3,000 of margin built into used car prices. If you want to know more about itHow much do used car dealers make?, you should readthis extensive blog post, or watch the video below.

So do dealers make money selling new and used cars? 99% of the time the answer is no. Do some people pay too much for a car and the dealer makes a lot of profit, yes. Does it happen often? No.

During my career I have sold cars where we lost thousands of dollars on the front end. Why did I let the customer get such a good deal? We did this to meet our monthly manufacturer sales target. Remember what I said earlier?Car dealers are a lot like supermarkets: they depend on volume.This reality could not be more true when dealers are incentivized to sell more cars, with the manufacturer building in less profit on each sale.

Manufacturer's incentives can influence both the customer and the retailer. Rebates, special financing and specific programs for recent graduates are all examples of producer incentives aimed at consumers. Their goal is simple: sell more cars. The manufacturer will subsidize these types of incentives to entice consumers to buy more cars.

Manufacturers are also encouraging dealers to sell more cars as well. How? By setting high monthly, quarterly, and annual sales volume goals (also called “staging goals”) that, if met (and exceeded),result in hundreds of thousands, if not millions, of dollars for the dealer.

By meeting these monthly, quarterly and annual sales targets, car dealers can make money selling cars. Crazy, right?

Why do manufacturers wave millions of dollars at dealers to get them to make losing deals to meet their volume targets? As with all “goals” or incentive plans, there is a psychological answer and a practical answer.

Manufacturers, including many publicly traded companies that have satisfied shareholders, need to show growth. How do you show growth? You sell more cars. How do you sell more cars? You encourage 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 about growth (selling more cars) than about profits (actually making money on every car sold). In my estimation, this practice (of waving millions of dollars at dealers to sell more cars) will not continue forever. It cheapens the brand, it is 'smoke and mirrors' and it is simply not sustainable. But for now, this is how the auto industry works.

Many dealers will take losses on trades (especially towards the end of a month) to reach their factory incentive limit. If a dealer doesn't meet their target from the factory, they run the risk of not making any money that month.

If you are considering buying a car, you may find this article interesting:3 ways to know how much you can negotiate on a new car

In my career I have seen manufacturer incentives that pay dealers based on the percentage of the target they achieve. For example, let's say a dealership has set a goal of selling 100 new cars in June. If they reach 95 to 105 percent of that goal (95 to 105 cars sold), the factory will pay them $1,000 per car sold. If the dealer achieves between 105 and 115 percent of its goal, the factory pays $1,250 per car. If they reach more than 115 percent of their goal, they will receive $1,750 per car.

Do the math. Not only is it financially feasible to take a loss on a trade to achieve your 'goal', it is also a smart investment.

Even with all that money being thrown around, new and used car sales still represent a very small (if at all) profit-generating segment of the dealership. Ultimately, new and used car sales exist to facilitate the other revenue-generating areas of the dealership, the F&I office (also called the backend), and the parts and service department.

Finance and insurance (also called backend)

An increasingly important area for car dealers is the financial and insurance office. R&I, as it is affectionately known, has always been an important source of revenue for car dealers, but now more than ever it is becoming a key profit driver.

If you've ever bought a car before, you're well aware of the paperwork you need to sign before the car is officially yours. It's a lot, and it can be quite scary. The process you went through was probably something like this:

1. test drive a car;
2. negotiate the price with the seller;
3. Agree on a price;
4. Determine how you will pay for the car (financing, leasing, cash payment);
5. The seller transfers you to the financial manager;
6. You spend hours reading (or rather looking at) hundreds of pages of documents;
7. You buy an extended warranty because you think you need it and the financial manager suggested it;
8. You drive home in your new car.

Yes, I know buying a car is a real pain...

Once you have been "handed off" to the financial manager, you will begin the second sales process. Did you think that now that the seller was gone, the sales process was over? Not really!

Car dealers make money from R&I in several ways.

Additional loan for car dealers

First, it's important to understand that if you finance your purchase through a dealer, they will make money on the loan. Don't be too angry about this.

Car dealers offer credit institutions something that you and I cannot; volume. In general, car dealers get access to loans at prices that individual consumers cannot obtain. The dealers then mark up these loans and resell them to customers.

Please note that you do not have to have your car financed through a dealer. The next time you buy a car, consider getting pre-approved for a loan from another lender and see what the dealer has to offer.

Car dealers emphasize the money factor in lease contracts

If you don't buy a car and lease it instead, dealers have a way to make money there too. Dealers make money by increasing the money factor on a lease contract. The lender charges the dealer a money factor of e.g. 0.00125 and the dealer increases this by 50, 75 or even 100 basis points. The difference between the purchase rate (what the lender charges the dealer) and the marked rate (what you are quoted) is an additional back-end profit on the lease for the dealer.

Car dealers make money selling warranties and more

In addition to the profits generated by financing or leasing a car, dealers make money by selling various insurance packages or warranties: extended warranties, tire and wheel protection, and so on. With each sale of an additional item, the retailer earns a certain amount of profit.

Good financial managers are like gold in the car business, and dealers love them. Retailers are also keen to invest in technology and software that increase their R&I margins.

Currently, many retailers in the industry are investing in third-party vendors to make the F&I process more convenient for the customer. Solutions such asdocuPADhas been able to simplify the R&I process for the customer and at the same time increase the gross profit of the dealers. By letting the customer choose which warranties, protections and plans they want, dealers realize they can sell even more products during the R&I process than ever before.

As a rule of thumb, dealers can traditionally make much more on the back end of a car dealership than on the front end. Depending on the dealer, a “healthy” deal for the car dealer will result in a combined gross profit of $2,500 to $3,500 on the front end and back end. Remember, very little of that comes from the actual sale of the vehicle.

Spare parts and service are the real money makers

Now you're starting to see how car dealers really make their money. Selling cars is simply a means to sell other products and services, and it is from these other products and services that dealers make their money.

When it comes to products and services a car dealer has to offer, look no further than their parts and service department for a wealth of options. For all car dealers, their main source of revenue (and profit center) is the parts and service department.

Let's start with the parts department. Every car dealer's parts department stocks a range of relevant items required to repair, maintain or upgrade a vehicle. From tires to shocks, a dealer's parts department has hundreds, if not thousands, of unique items in stock at any given time.

The spare parts department sells these parts to three customers:

1. Consumers;
2. Other retailers; And
3. Your own service department.

Customer #1is easy to understand. Let's say you blow a tire on your Mazda 3 and you show up at your local Mazda dealer to have the tire repaired. The parts department will be happy to sell you a replacement tire, and in this case the dealer makes money by selling you the branded tire.

Customer #2is also easy to understand. Let's use the same example as above, but this time when you get to the dealer they tell you they don't have the specific tire you need. Instead of running around town to find the tire, ask the dealer to call another local dealer and buy the tire from them. In this case, the dealer who sold the tire made some money by selling the tire to another dealer.

Customer #3is less obvious to someone outside the industry, but represents the most common customer in the parts department; dealer's service department. To continue our example, instead of buying the tire directly from the dealer and then going to an independent tire shop, you simply decide to let the dealer install the new tire for you. In this case, you will see the costs for parts (the tire) and labor (mounting the tire) on your invoice. Yes, you, the customer, still pay for the tire, but the dealer was able to bundle the parts and service into one transaction. In these cases, the service department "purchases" the part from the parts department and charges you, the customer, for both the parts and labor.

For car dealers it is about the absorption of services

Car dealers make the most money in the service department. There is a concept in the industry called “service absorption.”Service absorptionis the percentage that the parts, service and body shop gross covers of the sum of the total operating costs of its own department PLUS the sum of the fixed costs and dealer wages.

Car dealers aim for 100% (or higher) service absorption, although most reach 70%.If a dealer achieves 100% service absorption, it means their parts, service and body shop makes enough to pay all of the dealer's costs.Let that sink in for a moment…

So how do dealers make money in the service department? By beating the booking time associated with each vehicle that comes through the service lane.

It doesn't matter to a service department whether a vehicle is under warranty or not (dealers like to bill the manufacturer for cars under warranty), what matters is that their technicians can beat the posted times for every job.

Auto repairs are charged based on the time a job should take multiplied by the shop's hourly rate. If a particular job takes four hours and a technician can do it in two, guess what the dealer charges you? Four hours of work. And they bill you at their hourly rate (which will generally be quite high).

This is how car dealers make their money by handling repairs, maintenance and more efficiently through their service drive. Here's a fun thought experiment for you...What happens when a new brand is launched in an area and there are no cars to service?

MINI is a perfect case study for this. In 2002, BMW owned the brandlaunched in the US, and there was an immediate problem for the first few MINI dealers: there were very few options for spare parts sales and service.

The service department depends on vehicles that are in use, that is, cars that need to be repaired or maintained. When a new brand is launched, there are no vehicles in use, making the entire service and parts department virtually redundant.

At launch, the parts and service division can help boost profits a bit by equipping cars that the new car division sells, but this is nothing compared to the revenue they normally bring in. For MINI, as with any brand new to the market, it takes years to get enough vehicles into service to build up a dealer's service and parts departments to where they should be.

In the case of MINI they recognized this and for years dealers were subsidized by BMW to open MINI dealerships. Today there are over 800,000 MINIs on the road in the US, and MINI dealers are taking advantage (MINIs are not very reliable cars).

Have you ever seen a car dealership without a service trip? Now you know why.

Other ways dealers can make money

So far we have discussed the traditional ways that car dealers make money. There are a few non-traditional ways that dealers (and more accurately, their owners) can make money.

Experienced dealers make money from their dealership by owning the real estate on which the dealership is located. This is another way dealers can make a lot of money. Many dealers own the land on which they build their dealerships, and then the dealer pays them rent every month to operate there. In my 42 years in the auto business, I've seen dealers of all sizes make money by paying their own rent.

I even know of dealers who have repurposed an existing facility and leased it to a competitor to sell another brand. You can't underestimate the value of the real estate a dealership sits on, that land is a real gold mine.

So there you have it, these are the numerous ways car dealers make money. If you are looking for a car, or simply have a question about the car purchasing process, please feel free to contact us. Call or email me today.