How Do Car Dealerships Make Money?

Car dealerships play a crucial role in the automotive industry by acting as intermediaries between manufacturers and consumers. While the process of buying a car might seem straightforward, the ways in which car dealerships make money are multifaceted. They don’t just rely on selling vehicles to make a profit; they employ a variety of revenue streams, each of which contributes to their overall business success.

In this article, we’ll explore the multiple ways car dealerships generate income, from vehicle sales to financing and add-ons, and break down the economics behind how they stay profitable.

1. New Car Sales

The most obvious way car dealerships make money is through the sale of new cars. However, the profit margins on new car sales are often slimmer than you might expect, due to several factors.

a. Manufacturer’s Suggested Retail Price (MSRP)

The MSRP is the price set by the car manufacturer and is essentially a guideline for what dealerships should charge. However, dealerships rarely sell a car at the full MSRP. The actual price is often negotiated down by the customer or influenced by promotions, rebates, and discounts offered by the manufacturer.

b. Dealer Invoice Price

The dealer invoice price is the amount that the dealership pays to the manufacturer for a vehicle. In many cases, this price is lower than the MSRP, giving the dealership a profit margin between what they paid for the car and what they sell it for. However, the margin here is usually small, typically ranging from 3% to 5% of the car’s price.

c. Factory Incentives and Dealer Holdbacks

Dealers often receive incentives from manufacturers to sell certain models or reach specific sales targets. These incentives can include bonuses for selling older inventory or particular models that the manufacturer wants to push. Additionally, dealerships benefit from holdbacks, a percentage of the vehicle’s invoice price that is returned to the dealer after a car is sold. Holdbacks are designed to give dealers a buffer to cover operating costs and can range from 2% to 3% of the vehicle’s price.

d. Volume Sales

For many dealerships, success isn’t just about making a profit on each car sold; it’s about selling a high volume of cars. Manufacturers often offer bonuses for reaching specific sales quotas, and these bonuses can significantly increase a dealership’s revenue. Even if individual car sales result in low profit margins, selling a large number of vehicles can still lead to substantial overall profits.

2. Used Car Sales

Used car sales are another significant revenue stream for dealerships, often yielding higher profit margins than new cars.

a. Trade-Ins

Many dealerships acquire used cars through trade-ins when customers buy a new or another used vehicle. The dealership typically offers less for the trade-in than the car’s market value, allowing them to mark up the price and sell the car at a profit. For example, if a customer trades in a car for $10,000, the dealership might sell it for $13,000, generating a $3,000 profit on that sale.

b. Auction Purchases

Dealerships also purchase used cars from auctions or through wholesale channels. At auctions, dealers can often buy cars at a lower price and then mark them up for sale at the dealership. The profit margin on used cars can be significantly higher than new cars, sometimes ranging from 10% to 15%.

c. Certified Pre-Owned (CPO) Programs

Certified Pre-Owned programs offer additional profitability for dealerships. These are used vehicles that have undergone a thorough inspection and come with extended warranties backed by the manufacturer. Dealerships can charge a premium for CPO vehicles because they are viewed as more reliable and trustworthy, giving customers peace of mind.

3. Financing and Leasing

Financing and leasing are some of the most lucrative revenue streams for car dealerships. In fact, many dealerships make more money from arranging financing than they do from the actual sale of the vehicle.

a. Interest Markups

When a customer finances a vehicle through the dealership, the dealership often works with third-party lenders, such as banks or credit unions, to secure the loan. The lender offers the dealership an interest rate (called the buy rate), and the dealership marks up that rate when offering the loan to the customer. The difference between the buy rate and the customer’s rate is pure profit for the dealership.

For example, if a lender offers a 5% interest rate to the dealership, the dealership might offer the customer a 6.5% interest rate. The 1.5% markup on the loan is added profit for the dealership over the term of the loan.

b. Leasing Arrangements

Leasing is another profitable venture for dealerships. In a lease, the customer essentially pays for the depreciation of the vehicle over the lease term, along with interest and fees. Dealerships make money from leasing by marking up the money factor (the equivalent of the interest rate on a lease) and often receive incentives from manufacturers to promote leases on specific models.

Additionally, when a leased vehicle is returned to the dealership at the end of the lease term, it is often resold as a used or Certified Pre-Owned vehicle, generating further profit for the dealership.

4. Service and Maintenance

One of the most consistent and profitable areas of a car dealership’s business is the service department. Once a customer buys a car, they often return to the dealership for routine maintenance and repairs, especially during the warranty period. The service department provides several income opportunities, including:

a. Repairs and Maintenance

Routine services such as oil changes, brake replacements, and tire rotations are significant revenue generators. Dealerships often charge a premium for these services compared to independent repair shops. Even small services like oil changes are often used as an entry point to recommend more expensive repairs or maintenance services, further increasing profit margins.

b. Parts Sales

Dealerships make money by selling OEM (Original Equipment Manufacturer) parts for repairs. OEM parts are typically more expensive than aftermarket parts, allowing the dealership to charge higher prices and increase their profit margin. Since many customers prefer OEM parts for quality and warranty purposes, dealerships often have a near monopoly on this market for their specific brand of cars.

c. Extended Warranties and Service Contracts

When a customer buys a new or used car, they are often offered extended warranties or service contracts. These warranties provide additional coverage beyond the manufacturer’s warranty, typically at a higher cost. Dealerships earn commissions on the sale of these warranties, which can be highly profitable, as many customers never fully utilize the extended coverage.

5. Add-Ons and Upsells

Dealerships make a significant portion of their revenue through add-ons and upsells during the car buying process. These add-ons include a variety of products and services that may be presented as essential or beneficial, but are often marked up considerably.

a. Gap Insurance

Dealerships often sell gap insurance, which covers the difference between what a customer owes on a vehicle and what the insurance company will pay if the car is totaled. Dealerships can make a significant profit on gap insurance, as the premiums are often marked up compared to what the customer could purchase independently.

b. Paint Protection and Extended Services

Additional services like paint protection, rustproofing, or fabric protection are frequently offered at the time of sale. These services are often bundled into packages and sold at a high markup. For example, a paint protection package that costs the dealership $100 may be sold to the customer for $500, generating a $400 profit.

c. Accessories

Dealerships also offer car accessories, such as floor mats, roof racks, or performance enhancements. These accessories can be ordered through the manufacturer or purchased independently and then sold at a higher price to the customer, adding another layer of profit.

6. Car Dealership Business Model: Summary

The business model of a car dealership is multi-layered, relying on several income streams to remain profitable. Here’s a quick summary of how car dealerships make money:

• New Car Sales: Small margins, but bolstered by volume sales, factory incentives, and holdbacks.
• Used Car Sales: Higher profit margins, particularly through trade-ins, auctions, and CPO programs.
• Financing and Leasing: Significant revenue from interest markups and leasing deals.
• Service and Maintenance: Consistent revenue from repairs, parts sales, and extended warranties.
• Add-Ons and Upsells: Profitable through gap insurance, protection services, and car accessories.

7. Conclusion: The Profit Formula for Car Dealerships

Car dealerships are far more than just places to buy and sell vehicles. Their profit formula involves a combination of vehicle sales, financing, service, and strategic upselling. While the margins on new cars are relatively low, the sheer volume of sales, combined with high-margin areas like used cars, financing, and service departments, ensures that dealerships can remain highly profitable. By diversifying their revenue streams, car dealerships can withstand fluctuations in the auto market and continue to thrive in an ever-competitive industry.