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It’s All about Service: The Back End is the New Front End

Here is a riddle for you. The average dealership saw its sales decline by 14% in the third quarter of 2009 and yet its gross profit dropped only 8%.  How is this possible if the largest portion of sales, the new car department, experienced a 25% decline in gross profit?  The answer is quite simple. It’s called fixed operations, the high margin, recurring revenue business that many dealers surprisingly ignore.

In a period when the market for new cars has plummeted, service and parts sales are tracking either flat or up (see Chart 1).  In fact, average revenue per repair order has increased steadily, even in this difficult economic climate (see Chart 2).  Why is this?  Partly because service and parts’ sales are not reliant on credit, thus the recent crisis has had less of an impact.  Also as the age of the U.S. fleet continues to rise, these older cars require more service. (In 2009, the average age of a passenger car was 10.4 years, the highest average since World War Two.)

Finally, at some level, service is a “need” not a “want”, whereas a new car is usually a “want”, not a “need”.  Most Americans require a functioning car and therefore must service their vehicle in order to live their lives.

Chart 1: Sales by Department Through 2008
Source:  NADA
Chart 2:  Average Sales per RO
Source:  NADA

Fixed Operations, the Profit Engine

Fixed operations has once again proven its resilience to market cycles. Not only has it resisted the Great Recession, the department’s’ margins have held up strong. The service and parts’ profit margin is 10 times larger than that of the new car department (45% versus 4.5%).  In other words, the new car department has to work 10 times harder to earn the same gross profit.

Because of these sales and margin dynamics, even though the new and used departments saw sales plummet and losses mount in 2008 and 2009, dealerships on average remained profitable.  In fact, according to NADA data, the average dealership generated a remarkable 225% of its profits from fixed operations in 2008 and similar numbers are expected for 2009 (see Chart 3).  Given these facts, dealers might begin to ask themselves why they spend the majority of their time on the least profitable part of their business, car sales.

Most retail businesses bend over backwards to create what is already embedded in the car business – an ongoing, lucrative relationship with their customers (think retail membership/rewards programs).  Dealers have rarely capitalized on this customer relationship opportunity.  Instead, once a car is sold, most dealerships are squarely focused on the next car deal, instead of how to make sure each car sale becomes a lifetime annuity stream of service profits and future car sales.

Perhaps it is time to change the model?

Chart 3:  Fixed Operations Departmental Profit as % of Total Dealership Profits
Source:  NADA

Become a service organization

By centering the dealership around the service department, dealers may find their whole organization is more customer focused and profitable.  If service writers were transformed into customer relationship managers and were incented based on customer retention, the fixed operations business would grow (particularly customer pay post warranty) and repeat car sales would rise.

Furthermore, if car sales were generated organically from within the dealership, advertising expenses would decline, resulting in a significant increase in profitability (advertising expense generally equals dealership profit – meaning total profit would double if the expense was eliminated).  American’s have grown accustomed to demanding great service – if they received it from their car dealership, it would likely make them want to return, rather than dread the visit.

This service shift would have several effects on dealership operations:

  1. An increase in service department hours of operation, including weekends and evenings;
  2. A staffing shift out of car sales and into customer service (including the potential elimination of the commissioned sales department – which would likely reduce expensive employee turnover)
  3. Structural changes in the physical layout of the dealership, with the service department taking center stage.

I realize this is a radical concept – but as we have learned in the last two years – the unthinkable can become the thinkable. It may be time to think outside the box.

The reality is that the new car department has lost money for the last 4 years.  Average new car gross margins have declined from 8% in 2002 to just 4.5% in 2009.  Even the used car department lost money in 2008.

The front end is a loss leader.  It is credit reliant, unpredictable, susceptible to the manufacturer challenges and generally driven by forces for which dealers have minimal control.  By contrast, fixed operations is a profit engine.  It is credit resistant, recurring, predictable, and if done well, it should be the pipeline for future car sales.

Thus, dealers may want to reorient their business model, thinking of the front end as the high-ticket, low margin loss leader (the printer) and the back-end as the recurring, low-ticket profit generator (the toner).  Most of us know that printer companies make all of their profits selling expensive toner.  These companies still work hard to produce and sell the best printers, but they are most focused on the recurring profit stream generated by the toner.  It’s a really great business model – maybe dealers should try it.

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