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Cutting Expenses Leads to Record Dealership Profitability

In my early years in the auto retail industry a dealer told me, “You cannot cut your way to a profit.” At the time, the comment perplexed me. It seemed to ignore a fundamental business fact. Specifically, profit is simply the difference between your sales and expenses. If you cut expenses while maintaining sales, you increase profits. What was I missing?

I was missing the fact that most dealers (before the Great Recession) spent their time and energy on sales, not expenses. Traditionally, dealers maximized the top line in order to grow the bottom line. The management philosophy was, “Grow sales and profits will come.” Few were focused on the middle lines, the expenses. To many dealers, cutting expenses limited a dealership’s ability to increase sales. As a result, dealers really didn’t worry much about operational efficiency and productivity. Instead, it was sales, sales, and more sales, particularly new car sales.

Since the credit crisis, this philosophy has been upended. Today, dealers are squarely focused on each and every dollar they spend. Dealers have dramatically cut their largest expenses (advertising and staff) to levels they did not think possible during the boom. The efficacy of these streamlined dealerships has surprised many. A dealer recently told me his business is running better than ever with half the staff.

Cutting expenses has served dealers well in 2010. It turns out you can cut your way to a profit, and not just a small one. According to NADA, the average dealership is expected to earn record profits in 2010 (see Chart One). Based on annualized data for the first five months of the year, the average dealership is tracking toward $669,000 in annual net profit before tax, as compared to just $398,000 in 2009. How are dealers achieving such profits when the industry may only sell 11 million new cars for the whole year? Clearly, not from sales growth.

Chart One: Net Profit Before Tax in Dollars and as a Percentage of Sales
(2010 represents YTD May results annualized)
Source: NADA

Expense cuts are the primary driver of an expected 53% jump in the average dealership’s income in 2010. To give you a sense of how meaningful the expense cuts are to a dealership’s bottom line, consider this fact: if dealers had kept their expenses at 2009 levels (13.7% of sales), dealership profits on a proforma basis would decline 7% (rather than grow 53%) in 2010, as compared to 2009. To this point, Chart Two shows the changes in total dealership expenses since 2007 and their positive effects on dealership profitability.

Chart Two: Total Expenses versus Net Profit Before Tax 2007 versus 2010
(2010 represents YTD May results annualized)
Source: NADA

I think we would all agree that historically dealerships have not been the most efficiently managed organizations. This recession has put a glaring spotlight upon dealership inefficiencies. It turns out there was a lot of fat to cut. From shifting advertising to cross-training staff, dealers are reengineering their businesses for “The New Normal” economy and reducing their monthly expenses along the way.

On so many levels, this is good news. Efficient, productive dealerships will garner higher profit margins (see Chart Three). The marketplace traditionally values higher margin businesses at higher valuation multiples. Higher multiples mean better valuations (which are helpful to those dealers looking to exit in the near future). Also, increased profitability may improve dealers’ access to credit.

Chart Three: Net Profit Before Taxes as a Percentage of Gross Profit and Sales
(2010 represents YTD May results annualized)
Source: NADA

In conclusion, cutting expenses is like going on a really tough diet. It is extremely hard at the beginning, but when you start looking and feeling better, it is worth the pain. I once saw a bumper sticker that said, “No food tastes as good as thin feel.” Today, dealerships are thin and profits sure feel good. Let’s keep it that way.

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