Monday, January 17, 2011

Auto Manufacturers Partly to Blame for Dealers’ Deceptive Car Pricing

For many years manufacturers have employed a device called “stair-step incentives” to motivate their dealers to sell more cars. A stair-step incentive is bonus money paid directly to the dealer to reward him for selling a certain quota of cars within a certain period of time, typically one month. The number of cars in the quota is decided upon by the manufacturer and is a higher number than the dealer would normally sell.

For example, a dealer who would normally sell 150 cars in one month might be given a quota of 200. If he hits his quota, he earns $250 retroactively on all 200 (or more) cars he sells that month, or $50,000+. If he sells only 199 or less, he earns nothing! It’s easy to understand why this would strongly motivate any car dealer to “do whatever it takes” to try to sell his quota.

Unfortunately “whatever it takes” sometimes translates into “irrational and crazy pricing” and those are the words of Mike Jackson, the CEO of AutoNation (the largest retail chain of car dealers in the USA}. He spoke before the World Automobile Congress recently and announced that he will make it his mission to end stair-step incentives by auto manufacturers.

At first, one might ask what’s wrong with incentivizing a car dealer to sell lots of cars by paying him a large bonus. The answer is that there’s nothing wrong with the concept, just with how the concept is applied. In my example above, the dealer gets $250 per car. If he got $250 every time he sold a car in that month, he would be inclined to discount each car by up to $250. But, the dealer only earns that $250 per car if he sells at least 200 cars and that’s more than he would normally sell. You can understand how the very first customer of the month might get a different price from the last customer, especially if the last customer was buying the 200th car! How can a car dealer tell a customer at the first of the month that this is the best price and give him his best price when even the dealer doesn’t know what he can afford to sell the car for? On the last day of the month, it’s perfectly feasible for a dealer to sell a car thousands of dollars below his cost if that’s the sale (200th car) that will allow him to hit his $50,000 bonus.

It might seem at first that this can be a great opportunity for the car buyer…just come in at the end of the month and buy the last car a dealer must sell to hit his quota. This does happen but the car buyer cannot plan for it any better than the car dealer can. The dealer may not hit his quota at all or he may have hit it earlier in the month. These stair-step incentives are secret incentives and aren’t advertised by the dealer or the manufacturer. In fact, usually the salesmen don’t even know about them. But the managers who control the price that is given to the customer do.
This kind of incentive makes it even more mandatory to do comparison price shopping. If you want to buy a new car or truck, you should shop and compare prices with no less than three other dealers of the same make. But, you have no way of knowing which dealers will make their stair-step bonus that month. The dealers that know they have no chance to sell their quota will maintain their normal pricing. Those that are committed to reaching their quota number (and believe they will) can discount their cars substantially more than the other dealer(s). The dealer that believes he can’t hit his quota can give you his lowest price but it won’t be as low as the dealer who will hit his quota.

The stair-step incentives favor larger volume dealers because they can earn larger bonuses. Imagine two dealers selling the same make of car the first of whom is a small dealer with a quota of 50 cars and the larger dealer has a quota of 500 cars. The first dealer earns $12,500 when he hits his quota but the larger dealer earns $125,000! Assume both dealers are “stretching” to hit their quotas in the last week of the month. Which dealer will likely offer you the best price? It’s pretty obvious that the larger dealer can literally give away one or more cars in order to earn his $125,000 bonus. This sort of thing is why the president of AutoNation referred to stair-step incentives as “irrational and crazy pricing”. And I wholeheartedly agree.

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