Can “Friction” Be Eliminated in the Buying/Selling Equation?

Ruggles in WARDS October 2013

At the recent J. D. Power event held in Las Vegas in October Scott Painter, TrueCar CEO, introduced a new theory, something most of us had never heard. According to Painter, elimination of “friction” from the car buying process could lead to a 20 million SAAR in the near term. He seems to believe that the “agony” and trepidation car buyers feel about the car buying experience costs the industry sales, as if many consumers are so fearful of the car buying process that large numbers of potential car buyers essentially hold on to their current vehicle so they don’t have to venture into a punishing game where there is a chance they might not “win.” According to Painter, there are many things that the industry would have to do to achieve the elimination of the harmful “friction.”^{Note 1}

One of those “friction” causing items, according to Painter, is the practice of OEMs offering “trunk money” to dealers,

which makes it difficult for consumers to know the true cost of a vehicle to the dealer. “Trunk money” includes any payment back to the dealer from the OEM that reduces the dealer cost of new vehicle inventory below that of invoice less hold back. Invoice and holdback information is already readily available to consumers. He seems to think that the consumer is entitled to know dealers’ bare cost information so that only the dealer gross profit margin is negotiated. Somehow he believes this would help reduce the harmful “friction.” Of course, this flies in the face of the needs of OEMs who would also like to build new vehicles at a profit, and need to be able to negotiate prices from suppliers based on volumes that sometimes have to be “forced” via various “back of invoice” incentives. This includes “stair step” programs and other incentives designed to boost volume. After all, OEMs need to achieve volume commitments made to suppliers to achieve the best pricing, as well as other economies of scale.^{Note 2}

Painter seemed to be longing for the days when TrueCar used their infamous bell curve to advise consumers of what they should pay for a new vehicle while relying on dealers for the revenue to fund that initiative. This caused extensive pushback from dealers and forced TrueCar to adopt a different business model, one more conducive to dealers being able to achieve a more acceptable gross profit on a transaction. Despite the dealer push back against TrueCar, other vendors have picked up on the “bell curve” model. Many analysts believe these self serving initiatives to reduce friction in the purchase process have not increased volume but have resulted in the same volume being done at decreased dealer gross profit.

In addition to OEMs changing their own business model and giving up their tools to balance their production, what else could be done to eliminate the harmful “friction?” Consumers don’t seem to mind a dealer making money as long as they don’t have to hear about someone else getting a better deal than they received. Isn’t the answer to that “price fixing?” If everyone pays the same margin, won’t that satisfy consumers? Perhaps TrueCar and certain other vendors, who are bent on creating a frictionless efficient market in new vehicles, should spend their time and resources lobbying the FTC so dealers won’t have to go to jail for “price fixing.” After all, isn’t the most righteous objective happy consumers, not real competition with consumers having the ability to shop? The FTC (Federal Trade Commission) holds the impression that competition at the dealer level benefits consumers. Maybe they’re wrong?^{Note 3}

Is there another business where consumers have as much information about the products they buy? Aren’t car buyers free to shop? Aren’t they free to use their own buying strategies? How can they ever be completely satisfied?

In recent times, dealerships would take cheap deals as a way of achieving increased market penetration and providing “plus business” they wouldn’t otherwise have received. These special “cheap deals” have often been funneled through a dealership’s fleet department. To achieve an acceptable average, some buyers had to pay a higher margin than others to achieve a reasonable average. But instead of “frosting on the cake,” these “cheap deals” have become more the norm as evidenced by the extreme margin compression seen on dealer’s financial statements.

It is amazing to many auto retail veterans that those who have set out to make money by reducing “friction” in the auto purchase process can be characterized by one glaring deficiency. Very few, if any of them, have any real experience dealing with real car buyers on a day to day basis. These are not people who understand customers. They don’t know the difference between what consumers say and what they really mean. Steve Finlay’s recent column, “Consumers hate dealers, love theirs” provides excellent insight on this.

Let’s do the math. We have margin compression brought about by the proliferation of dealer’s proprietary information via the Internet and vendors focused on making money for themself by reducing transactional “friction” with the resultant dealer gross profit reduction. We have margin compression on the used car side, again brought on by the Internet. We have increased margin compression on dealer rate participation through CFPB (Consumer Financial Protection Bureau) initiatives. At the same time we have OEMs working to raise dealer’s costs through their image programs. Is there anything wrong with this picture?

Notes by Smitka

Note 1: This is synoymous to a claim that the short-term price elasticity of demand is extraordinarily high – a 4% reduction in price ($1K with an average $25K price) will lead to a 25% increase in sales. Nonsense! Furthermore, big rebate programs pull forward sales – examples include cash for clunkers in the US and short-term government tax rebates, such as the "Eco-car" program in Japan.

Note 2: As someone who works on suppliers, such incentives may be tied to "take or pay" pricing with suppliers, but is more likely due to the benefits of keeping assembly plants running at a steady pace.

Note 3: I am teaching "Industrial Organization" this term, which examines topics such as collusion. As per Ruggles' rhetorical question, there's no particular reason to think the FTC is wrong. Indeed, we have an experiment in this in the initial Saturn dealership network. The evidence (papers presented at the MIT IMVP) suggest that the reason this model worked was because the car was popular (= little need to discount) and dealerships were "thin" on the ground so that it was challenging in those pre-internet days for consumers to play one dealership against another. One either of those two pieces of the equation is taken away, fixed price retailing doesn't work.