ruggles: the following is a collection of notes and has not a published column.
NADA recently published a long awaited white paper on incentives. While it is chock full of salient data and information, there are some things missing. I will try to fill in some blanks based on my own experience and perception. Before getting into the discussion, it is important to understand that the conclusion of the report, that incentives degrade residual values and therefore brand equity, is unassailable. My purpose is to add to the discussion.
I began my auto business career in 1970 in a Chrysler Plymouth dealership. Markup on full sized vehicles was 22.5% with a 2% holdback. At GM and Ford, I believe the holdback was 2.5%. There was an annual carry over allowance of 5% that Chrysler dealers counted on to move end-of-model-year inventory. At the low end, the markup was 14.5% on a Valiant or Duster.
No one was too worried about Toyota and Datsun in those days, but Volkswagen was certainly a factor. I have no idea what incentives and marketing strategies those auto makers used in those days.
My first recollection of “stair step” incentives was in the middle 1970s, perhaps as early as 1974. I recall a stair step incentive based on an assigned objective on Plymouth Valiant models. I recall a Guaranteed Value Program (GVP) on Chrysler Imperial leases that provided a $900 payment on leased Imperials to even out their resale value with a Cadillac Sedan de Ville. Those leases were privately capitalized lease company transactions. “Showroom Leasing” as we know it today hadn’t yet been invented.
To add additional perspective, a “long term” finance contract was 36 months in those days, with some 24 and 30 month terms occasionally used by borrowers. Borrowed down payments were fairly common, with a buyer trip to the “mouse house for a dip” being common in the vernacular of the day. An average interest rate was 6% ADD ON, which was about 12% APR. The Federal Truth in Lending Act had been passed in 1968 and even though the payment books of the day were based on an “Add On” interest calculation, the actual APR had to expressed on the bank contract along with the finance charge and the total of payments.
The first consumer rebate came about as a consequence of the recession triggered by the 1973 Middle East war and the OPEC oil embargo. Ex major league baseball player Joe Garagiola was everywhere with Chrysler/Plymouth advertising in 1975 with, “Buy a Car, Get a Check.” Chrysler led the auto industry in pulling the U.S. economy out of recession. There was considerable pent up demand and the new purchase activity quickly cleared dealer inventory, prompting them to order more. Soon the auto plants were humming again.
An ongoing problem in the economy was “stagflation” and the resulting MSRP price increases spawned the advent of 48 month term auto loans. In the run up to the 1979 Iran hostage crisis, and another spike in fuel prices, Chrysler was near death. They continued to build cars on speculation, as they had done for years, but the dramatic slowdown in sales stopped dealers from ordering inventory. That didn’t stop Chrysler from continuing to build. They stacked the unsold vehicles in every parking lot they could find. They booked the vehicles as assets, but they were running out of cash. It was common to see weeds growing up through the gap between the fenders and hood of these vehicles waiting for a dealer to order them. Thermostats rusted shut, resulting in engine damage when the vehicles heated up when they were loaded and unloaded for transport. These vehicles were largely odd ball color and equipment combinations as they were built with whatever parts Chrysler had available at the time. To move this inventory and produce sorely needed cash, Chrysler paid its dealers big money per vehicle up front, as well as offering a large consumer rebate. Chrysler drafted the dealers’ floor plan accounts immediately before shipping the vehicles, while paying the dealer for the purchase incentives and consumer rebates months later.
Of course, all of this crushed the company’s already weak resale values. I recall paying $4250 for a 1979 Dodge St. Regis in 1980. I bought the car for my parents. The vehicle had an original MSRP of about $10,400 and had 6,000 miles on it. As a percentage of original MSRP, these incentives must have set “all time” records. So did warranty claims. The best values were the low mile pre-owned vehicles that were everywhere.
While I don’t have “first hand” knowledge, I have reason to believe that similar measures were in place at the other domestic OEMs.
The industry saw another period of extreme production pushed via incentives when the domestic OEMs, in particular, short-cycled rental vehicles, producing large volumes of off-rental units at really cheap prices in the late 1990s. This situation created an opportunity for some of the most compelling pre-owned lease payments the world has ever seen. Lenders failed to account for the drop in residual value precipitated by the flood of rental returns to the market. So did the common residual guides. It wasn’t uncommon to see a lender guarantee the value of a vehicle 36 months out at a higher value than it could be purchased from auction a year old. The industry saw reverse amortization leases.
Astonishingly, the lenders, who took great pride in their “risk mitigation” departments, failed to pick up on this. The result was predictable. Many banks refrain from pre-owned leasing today because they think pre-owned leasing is risky. If they think they can guarantee the value of a vehicle 36 months from now at a higher value than it can be purchased for today, it might be a little risky. This same anomaly happened again in 2008 when fuel prices killed the current market on pre-owned "heavies."
...invoice hasn’t been “Invoice” for over 30 years
Against this historical backdrop lies my major point: Through all of this, banks still used “Invoice” as their “advance” or “amount financed” lending guideline. They still use it today. Invoice hasn’t been “Invoice” for over 30 years, as is well-observed in the NADA report.
Since the late 1970s, dealer transactional gross profit has moved from above invoice to below invoice. The average consumer pays less for a new vehicle than the dealer pays the factory when the OEM drafts on the dealer’s floor plan account. Gross profit has moved from “over invoice” to “trunk money.” The amount financed is MUCH higher as a percentage of dealer NET vehicle cost than it ever has been, while at the same time, loan terms have increased from 48 to 60 and now 72 months and higher. Now we see 84 and 96 month terms becoming common. Negative equity on a trade in is much more common than not, despite the recent strengthening of used vehicle values. That will be temporary, as it reflects a pre-owned inventory shortage resulting from slow new-car sales during the Great Recession amplified by Cash for Clunkers.
Bottom Line: Rebates go with extended term financing like peanut butter goes with jelly. Certainly, the approach imports have taken is preferable to that taken by OEMs who use customer cash. But as long as extended term is what is used to provide low monthly payments, consumer rebates and trunk money will remain with us, for better or worse.
But there’s more to this story! As mentioned in the NADA White Paper, there was a point where the OEMs began to reduce dealer markup over invoice. This has certainly contributed to dealership sales staff turnover as well as reduced new vehicle margin as a percent of sales. We used to make $1300 gross profit on a new vehicle when the MSRP was $10K - $12K. Reduced margin over invoice also helped fuel the move to gross profit as “trunk money” instead of gross profit over “Invoice.” Hell, some dealers START their deals from “Invoice” these days. Most consumers have been trained to feel they have the “right” to know the dealer’s invoice, and the industry has a plethora of vendors eager to give it to them. That genie isn’t going back in the bottle. But I find it interesting that so many dealers actually fund the same vendors who demonize them to the consumer one minute, while providing the dealer’s proprietary information the next.
The point is that our industry, on purpose or inadvertently, has made it a highly complex task to determine the actual net cost of a new vehicle. Dealership staff themselves have a difficult time figuring it out, as evidenced by the regular charge backs that occur as a result of factory incentive audits. The world seems to be clamoring for even more transparency while dealers know that if their own staff know their true net cost, they couldn't wait to give that away too. And there are always vendors to help that process along.
With the “stair step incentives,” Customer Satisfaction Index kickbacks, and purchase cash money on top of “First Time Buyer,” “Plumber,” "Realtor,” “Glass Company,” “Loyalty,” “Conquest,” “College Grad,” "Friends and Family" and “Military” incentives, who can figure it all out? To a consumer, it’s like drinking through a fire hose. A skeptic might think this is by design. I think it’s the only way our industry holds on to the embarrassingly low gross profits it maintains today.
While the NADA White Paper on incentives is salient, I’d like to add these points to mix for consideration.
Smitka adds that the transaction pricing variance – still there in the earlier days of larger differentials in bargaining skills – makes econometric studies of vehicle demand a challenge. Indeed, AutoFacts (now part of PwC?) began as an effort by a former GM economist William Pochiluk to build a database of prices that corrected as best as possible for invoice versus list and rebates by marketing region and date. Yet I've read papers published in top economics journals that use list price, though it's well-known that there are systematic and non-trivial price differences across the model year. Some is laziness in searching for better data, some may be the lack of budget to buy the cooperation of AutoFacts. Take statistical studies of auto demand with a large grain of salt!