Thursday, March 4, 2010

Two Things Car Dealerships Don't Want You to Know

I have written before about how most of us (including me) have little experience dealing with large purchases, like car and home purchases. My recommendation when facing one of these deals: talk to someone who knows more about the process than you do and learn what they know.

As fate would have it, I recently had a chance to talk with many people who know a lot about car purchases as part of a managerial accounting assignment. It was a fascinating discussion. There are two pieces of information that really amazed me. Here they are.

1) Most people believe that having your car serviced outside of an official dealership voids the warranty. That belief is completely false.

I did not even know that this belief existed. However, I was exposed to it and convinced of it for a brief time during my discussion. Then a very knowledgeable person (my professor) set the group straight. He explained that not only can you have your car serviced by the mechanic of your choice without voiding the car's warranty, it is illegal for companies to claim otherwise. So when you buy a new car, have it serviced by your favorite cheap certified mechanic. Your warranty will be fine.

2) Trade-in values and purchase prices are pulled out of thin air (but they are related to each other).

Have you ever heard one of those commercials that claims a "$5,000 minimum trade-in value for your car. It doesn't even have to run! You can push, pull or drag it in! We'll give you $5,000 for it toward the purchase of a new car!"?

Have you ever thought, "How can companies do that without losing money?"

The following (slightly long) example shows how.

Let's pretend that John has a crappy 1984 Toyota Camry that just died. He needs a new car to replace it. He takes the Camry to a dealer for trade-in and picks out a new Lexus that he might want to buy. Then he starts to negotiate.

Here is how John thinks about the purchase:

  • Maximize trade in value of crappy Camry - Expectation: $1,500
  • Reasonable sale price of new car - Expectation: $35,000 or so
So John is looking at two values: he wants "trade-in value" to be big, and "sale price" to be small.

Here is how the dealer looks at the sale:
  1. Cash + financing payment we will receive from John: Unknown
  2. Value of trade-in when dealership re-sells it: Assume that it is $1,600
  3. Cost of Lexus when dealership bought it: Assume that it is $25,000
The amount of money that the dealer receives is (1) + (2), and the amount the dealer spent on the sale is (3).

Total profit for dealer: (1) + (2) - (3) = Unknown + $1,600 - $25,000.

Notice what is missing from the car dealership's list of important considerations: sale price of Lexus, and quoted trade-in value . . . the two items that John cares about!

The rest of the deal is entirely psychological.

Let's say that John cares more about the price of the Lexus than he does about the value of the trade in. The dealer says that he'll give John . . .

Deal Number 1:

Price on the Lexus: $34,000
Quoted trade-in value for Camry: $600

John thinks to himself, "Woah! $1,000 cheaper than I expected on the Lexus price! I'd better take this!"

However, from the dealer's point of view, John's cash payment is $33,400 = ($34,000 - 600)

Dealer's profit = cash payment + sale price of Camry trade-in - Cost of Lexus

That equals $33,400 + $1,600 - $25,000 = $10,000. Pretty good profit.

Now pretend that John cares more about the trade-in value of the Camry than he does about the price of the Lexus. The dealer says that he'll give John . . .

Deal Number 2:

Price on the Lexus: $38,400
Quoted trade-in value for Camry: $5,000

John thinks to himself, "Woah, that's $3,500 more than I expected to get for the Camry! Sure, the price of the Lexus is a little high, but when I look at the extra money from trade-in, I'm still only paying ($38,400 - $3,500) = $34,900, which is lower than my $35,000 price point! I should do this!"

However, from the dealer's point of view, John's cash payment is $33,400 = ($38,400 - $5,000)

Dealer's profit = cash payment + sale price of Camry trade-in - Cost of Lexus

That equals $33,400 + $1,600 - $25,000 = $10,000.

That looks a lot like the profit on the last deal. It should, because from the dealer's point of view, the two deals are exactly the same!

The lesson: don't be fooled by trade-in price gimmicks. Trade in prices will always be related to the sale price.

A final thought.

Dealerships are motivated by profit. Don't forget it. They know a lot about cars, and a lot about psychology. Double and triple-checking your reasoning is worth the effort on purchases of this size.

Oh, and if a dealer ever asks if you want the "under-coating," "rust protection," or something silly like that after you've agreed to the sale price, it's okay to get angry.