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July 15, 2009

How Closing Car Dealerships Will Help the Auto Industry

Marcelo Olivares
Assistant Professor Decision, Risk and Operations
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With at least 2,000 car dealerships from Chrysler and GM slated to close this year (and more than 1,000 dealerships overall that closed last year), the existing American dealership model is in crisis. The closings appear to underscore just how over-extended — and over-stocked — the U.S. dealership system has become. One of the fatal flaws for dealerships has been an inefficient distribution network.

My research, conducted with my colleague Gérard Cachon at The Wharton School at the University of Pennsylvania, shows that the current structure of the U.S. brands’ dealership network led to inefficiencies in the distribution system. These inefficiencies add to the total distribution cost, which accounts for 30% of the price of a new car.

A major inefficiency is the pattern of holding inventory — an important part of the distribution cost. Most of the vehicles in the U.S. are purchased directly from dealer stock and holding inventory is expensive, especially when credit is scarce as it is now. The graph below illustrates important differences in the monthly days-of-supply for Chevrolet, Ford and Toyota.

The popular press suggests that 60-day supply is the ideal level of inventory for the auto industry. This is, in fact, the industry average, but the figures show that Toyota is consistently below that benchmark while Chevrolet and Ford are usually above it (other brands of Ford and GM also show a similar pattern). Overall from 2000 to 2004, Chevrolet held about 130,000 more vehicles in inventory relative to Toyota (300,000 compared to 170,000 units), even though the two brands sold about the same number of vehicles in the U.S.

The huge number of GM dealerships explains most of this difference in inventory performance. As of 2007, Chevrolet had around 4,000 dealerships compared to 1,200 Toyota dealerships. That means that an average Toyota dealership sells three times as many vehicles.

Auto brand No. of dealerships

Sales per dealership

Chevrolet 4,063 586
Ford 3,711 645
Honda 1,019 1,286
Toyota 1,224 1,821

Source: Automotive News 2007 Yearbook

Due to economies of scale, managing inventory for a Chevrolet dealership is much more costly than for Toyota. In general, dealerships from domestic manufacturers carry substantially more days of supply. Consequently, they require more cash to operate, their inventory is less fresh and they tend to have more overstock at the end of the model year, which in turn leads to more rebates. All of this translates into higher distribution costs and lower profits for the dealer.

How could U.S. auto dealerships be improved? Reducing the number of dealerships can do several things.

First, it will reduce cannibalization between dealerships, increasing average sales per dealership. Dealers can take advantage of economies of scale in the distribution process and have more frequent deliveries and lower safety stocks, thereby reducing the amount of inventory held without hurting (and possibly improving) customer service. It also helps to keep a fresher stock to better match customer preferences and to lower markdowns at the end of the season.

All of this leads to a more profitable dealership and a more efficient distribution network. Higher dealership earnings can be used to invest in better showrooms and better training of the sales force, which can improve customer service and further boost revenues.

Photo credit: never a safe second

Comments

by nina grody | July 24, 2009 at 11:34 AM

You mention several viable points: especially the cost of carrying larger inventories. A dealers average daily cost is a direct result of how effectively they maintain, trade and replenish inventory. What is not mentioned however, is that the American OEM's have been overproducing product for upwards of 15 years and have consistently strong armed dealers to take the inventory, thus passing on costs to the individual car dealers while mainintaining their union contracts at a detriment to overall business and incremental market share, which has been inflated by this "push" strategy for years. Dealers are not just handed franchises, they have invested, in some cases millions of dollars in real estate, fixtures and variable expenses in order to have the "right" to sell these products in overcrowded markets with substandard marketing and advertising support from the frachisor. GM and Chrysler waited for a bankruptcy court to do what they did not have the wherewithall to do on their own: shrink the dealer network to align with the reality of falling market share to the japanese and european OEMS.

by Mike | September 15, 2010 at 3:42 PM

A dealers average daily cost is a direct result of how effectively they maintain? this is overhead, every business has it and needs to maintain. The viable points is as an entirety the automotive industry has taking a dive effecting all industry status.

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