Monday, July 30, 2012

Understanding Car dealers


John Hempton asks why car dealers behave the way they do - fleece the customer. He has detailed the issue in that blogpost. I am going to attempt to answer this. But let me tell you it will be a convoluted answer.

First, you have to imagine the entire car business as a network of transactions. The transactions that make money for the car assembler (I refer to Fords, Nissans of the world) are way more upstream at supplier side based on economies of scale achieved in sharing parts etc. (where exactly depends on each assembler). Sales per se does not contribute the differential value and will not dramatically impact margin on the product as other drivers. Hence the recommendation is to reduce sales cost as much as possible. Let sales pay for itself. Invariably that means hiring people without testing their morals and skills.

Second, these types of people can turn against the company as well and fleece them. Hence strong processes are put in place to constrain them from fleecing the company. There is apparent lack of trust between sales person and the company (usually seen at the time cost is audited or controlled by finance people). For the salesperson, the only way to make extra money is to cheat the customer. The incentives are stacked that way. You can see the relative bargaining power stacking here. Bargaining power of company is higher than that of sales person and that of sales person is higher than customers.

Third, the incentives of sales person and that of company tie in well - sort of complement each other. Once customer buys the car, she is sort married to it for 4-5 years. That means parts, servicing etc. etc. 5 years of opportunity to milk the customer -  long-term fleecing. (ok I can use buzz word like customer lifetime value etc but you get the idea). For salesman the incentives match. He meets the customer once every 5 years and hence has no incentive to strike a long term deal. So short term fleecing happens here. Note the differences in Cash Flow Chain designs. The cash flow chain does not fully flow through sales network, it equally flows through service centers. This is what reduces the bargaining power of sales persons.

Fourth, if a sales person invents a new technique to enhance sales, then it is in the car companies and dealers interest to spread the idea to every other dealer and sales person. This nullifies the advantage that innovative sales person should ideally enjoy. The effect of any value add that spread across the entire product range, is that is ceases to be a differentiator. The only practices the company cannot promote are once it should actively demote. But even those do not remain differentiators.

Fifth, the buyer behaviour is not linked to salesman behaviour. When you buy a car, you buy the brand and particular model. You even have a specific colour in mind. You want a Honda Civic or you want a Toyota Land Cruiser or Specific colour in Mercedes E class etc. You are locked in to a certain extent. The salesman is not. I have said in the book that bargaining power extends right inside the customer's pocket. Here the branding and product differentiation and need segmentation has reduced the customer's power to a certain degree.

Sixth, there are few car dealers (hence collusion is easily possible). Further, the game happens within last 3-5% (usually) of the price. So customers give up as attraction of the product is higher than this. Sometimes sales person try to up the game to 10% (when they have done their target for the month/year or are confident of achieving the same). Scarcity in number of car dealers allows better bargaining power with dealers.

Seventh, at some points in the year the incentives of customer and car manufacturer match. For example at the end of financial year of the car maker. They want to push volumes and that allows customers to have a good deal. Similarly, slow months align the incentives of customer with those of the sales person.

It is convoluted but this is what I have concluded. Feel free to share your experience with car dealers and ask your questions in comments below. 

I discuss these issues in detail in my book "Understanding Firms - A Manager's model of the Firm". The book is available on amazon here. Now no longer free - but always valuable.