How Car Dealers Make Their Money

“Follow the money,” is good advice for someone trying to understand the hidden side of any business. Nowhere is this more important than on a car lot. Rows of shiny new cars on a dealer’s lot make consumers believe that’s where the big money is. But if you follow the trail of dollars, it leads in a surprising direction. And knowing where the profit is will make you a better shopper.

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, says most car buyers don’t think about how the dealership makes money. One example? “The trade-in is a huge profit center for the dealer,” Weintraub said. “They can pick up $2 grand in the blink of an eye.”

Weintraub also explained that there are many fees in leasing, as well as inflated interest rates, alarms, maintenance plans, gap insurance and extended warranties. All these elements need to be negotiated effectively in order for you to get a good deal.

Invoice as Guidepost

The pricing of cars is a complicated process. To simplify things, consumers have been told to look at the invoice price of a car and assume that’s what the dealer paid for the car. Offer a small amount over the invoice and you have a great deal. While invoice provides a valuable reference point, both holdback and dealer cash increase the dealer’s profit with financial sleight of hand.

Holdback is usually either 2 or 3 percent of either the invoice or the sticker price of the car. On a $20,000 car that’s either $400 or $600 that is held out of the initial deal until after the car is sold. This allows dealers to sell a car at invoice price and still make a profit. Check the holdback percentage before going shopping but don’t try to negotiate on holdback, since dealers consider this money sacred. Still, knowing it is there will help you press for a better price.

Dealer cash is even more significant. When a car isn’t selling well, the manufacturer will sometimes offer an incentive — often as much as $2,000 — but only let the dealer know about it. This is like a wild card in negotiating, and it lets the dealer claim he’s taking a loss while still actually making a nice profit.

Used Car Cash Cows

While most people ogle the new vehicles on a car lot, the used cars are far more profitable for a dealer. One dealer reported, “In my experience…$5,500 markup on a used car would be considered a nice profit.” While that seems high, the point is that used cars have the potential to make the dealer far more profit than new cars, where the typical windfall is only $700-$1,000.

Weintraub said that used car buying is difficult because “it’s a blind negotiation” since it’s difficult to know what the dealer paid for the used car, and what its current market value is. Buyers need to get Edmunds’ True Market Value (TMV®) appraisal of the used car. But while TMV adjusts for regions, local markets have quirks that are difficult for the car shopper to spot. Only by thoroughly researching the market and comparing prices can you understand what a good price is for a used car.

Salesmen and Internet Managers

While the dealer tries to make as much profit as possible, the salesman is trying to get his slice of the pie as a commission. These two desires actually go hand in hand. The salesman’s job is to boost the dealer’s profit by being a savvy negotiator so his percentage of the commission will be greater.

In “Confessions of a Car Salesman” Chandler Phillips wrote, “Commissions were based on the ‘payable gross’ to the dealership and were applied in three tiers. If the payable gross was from $0 to $749, our commission was 20 percent of the profit; from $750 to $1,249 the commission was 25 percent of the profit. Above $1,250 the commission was 30 percent of the profit. In other words, the higher the profit for the dealership, the higher the commission I would earn.”

Phillips observed, “Naturally, the salespeople tried to hit that point where the commission was bumped to the higher percentage. That might mean moving you into a higher-level vehicle. It might mean increasing the profit by financing sleight of hand. In both cases, this smiling salesperson, with the personable air, didn’t have your best interests in mind.”

While the traditional sales staff works on straight commission, Internet sales managers earn a salary plus a bonus on volume. This means that more sales — not more profit — equals a bigger paycheck. This sets up a very favorable situation for car buyers. Buy from the Internet sales manager, if you can.

The F&I Room

Once the price of the car has been established by negotiations with a car salesperson, the buyer is routed into the F&I (finance and insurance) office. This is the last place the dealer can make money before the consumer leaves the car lot.

As described by Nick James in “Confessions of an Auto Finance Manager,” the F&I manager poses as a financial advisor who is on your side while arranging a loan. However, they are really there to make extra profit for the dealership by increasing interest rates, selling extended warranties and add-ons such as fabric protection and paint sealant.

How much does the F&I room contribute? In a typical deal, an average of $947 is generated in the finance and insurance office, according to F&I Magazine. The National Automobile Dealers Association (NADA) estimated that 28.5 percent of the profit from selling a new or used vehicle came from F&I.

The Service Bay

If an aggressive car buyer is able to get a rock-bottom price, the dealer knows there is still profit to be made when the car is serviced. It’s so profitable that, in economic hard times, the service bay has kept many dealerships afloat.

Here, too, commissions play a big part in getting the service staff to boost sales. The service advisor, who positions him or herself as a trusted advisor” is actually receiving a commission on all the parts and services you agree to.

One former service advisor said that high-profit jobs such as brake pad replacement were often sold by pitching them as a safety issue. In other cases, oil changes and fluid flushes are done before they are needed. This is costly for the consumer and wasteful.

How To Guard Your Wallet

“There is a built-in conflict of interest when buying a car,” says Weintraub. “Of course you want to believe the clean-cut guy in the nice suit with a sparkle in his eye. But while many dealerships out there want to give the consumer a good experience, who knows if what they are telling you is true or not?”

Instead of questioning the dealer’s integrity, understand the flow of money. Remember these points:

  • Dealer profit is based on the car but also on related products and fees.
  • A salesman’s commission is dependent on the percentage of profit.
  • A car’s invoice price is a useful reference, but other behind-the-scenes monies are in play.
  • The salesman, F&I manager and service advisor are all commission-based positions.
  • Information and negotiation are always the keys to getting a good deal.

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Posted in Auto, Employment, Finance.

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