Dealing with Detroit

Consolidating dealerships is a painful but essential step to rehabilitating the U.S. auto industry, argues Marcelo Olivares.
July 28, 2009
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When GM emerged from bankruptcy in early July, the deal included severing franchise agreements with about 2,400 dealerships. An alliance of dealerships responded by lobbying Congress to reinstate franchise rights in an effort to keep the dealerships open; as of this writing, one such measure had passed the House.

Franchise laws give broad protections to dealerships, regardless of their profitability and efficiency. In the case of GM, bankruptcy laws allowed it to bypass these laws and carry out necessary restructuring. But the dealerships themselves aren’t owned by the auto manufacturers. So why is reducing the number of dealerships a key part of restructuring? And how will the consolidation of the dealership network help manufacturers?

Distribution costs account for approximately 30 percent of the price of a new vehicle. GM has many more dealerships than Toyota and Honda combined, even though the dealers all sell about the same total number of new vehicles. Consequently, individual GM dealerships sell fewer cars than their counterpart Toyota or Honda dealerships, and because there are significant economies of scale in managing inventory, GM also carries more inventory relative to sales. During 2000-2004, GM carried an average of 70 days-of-supply versus 40 days-of-supply for Toyota and Honda. This pattern is more general: U.S. auto manufacturers tend to carry much higher inventories than the industry average. It is likely that part of these higher distribution costs gets passed on to customers.

Dealers need cash to finance inventory in their lots. Making dealers leaner would also facilitate their access to credit, which would reduce dealerships’ capital costs. Moreover, leaner dealerships will be able to match supply with demand much more effectively: dealers won’t be stuck with a bunch of unpopular cars at the end of the season, which leads to heavy markdowns, and customers are going to be happier with the cars they buy.

Having a large number of dealerships is convenient for customers because it reduces the need to travel. But the current design of the U.S. brands’ dealerships seems outdated. U.S. manufacturers established dealerships in the 1920s and 1930s, when there was no interstate highway system. Today travel is easier and a greater proportion of us live in urban environments; fewer dealerships are needed to reach the same number of people. Half the number of dealers would probably attract the same number of customers.

Reducing the number of brands will help, too; some Pontiac models were almost identical to Chevys, but were sold at different dealerships. It’s hard to argue that manufacturers are really reducing product variety when these cars were so similar to each other; eliminating the cannibalization between similar models will also eliminate inefficiencies and reduce the need for dealerships. Brands will also be consolidated under common dealerships. In the past if you wanted to buy a GMC, you had to go to one dealer, and if you wanted to see Chevy trucks you might need to go to another dealer. Now you’ll be able to see Chevy and GM trucks in the same showroom.

These changes would make dealerships more profitable, and manufacturers, dealers and customers will probably all save money that is propping up the current system.

But if GM doesn’t own dealerships, why does GM care if dealerships are profitable? Because if dealerships aren’t profitable enough, they are not going to make the needed investments to provide good customer service — when you have too many dealerships, some are bound to be bad — and that hurts the GM brand. A customer that has a bad experience at a Chevy dealership will lose interest in the brand.

Fewer dealerships probably mean better dealerships, since some of the money saved can be used to invest in the dealerships themselves. Toyota has far fewer dealerships and lower overall inventories but hasn’t sacrificed good relationships with their dealers or good customer service — Toyota dealerships have better inventory flow, can invest in customer service training and have less reason to subject customers to haggling.

Of course, all of this raises the question of whether franchise laws should change. In the 1950s increasing concerns that manufacturers were abusing the dealership system led states to pass laws designed to keep manufacturers in check, preventing them from forcing dealers to take on unwanted inventory, and imposing strict penalties on manufacturers for closing dealerships. Today, these laws, which enforce mandatory buy-backs of equipment and payment of future forgone profit to dealers, make it expensive for manufacturers to close unprofitable dealerships. Consequently, hundreds of not-very-profitable dealerships remain.

In Europe, consumers can buy cars on the Web. Consumers may also go to a dealer (where there are probably just a few cars to look at), say which car they want made to which specifications, and take delivery a few weeks later. Ford tried Web sales in 1999 and was slapped with a lawsuit from the dealerships on the basis that this would violate franchise laws, which block direct-to-consumer sales. But Toyota’s experience with the Prius — customers waited because they really wanted the car — suggests that franchise laws are worth revisiting in the United States.

Proponents who call for reinstating the franchise rights eliminated by GM’s bankruptcy have argued that fewer dealerships mean fewer car sales, which they say would hurt manufacturers. This assertion belies the fact that the number of dealerships in the United States peaked in the 1930s and has been dropping ever since — even as the overall rate of car ownership has risen — long before the current crisis and throughout many intervening booms and busts.

Just as closing plants has been a painful but necessary aspect of adjusting to new circumstances, so too is the consolidation of dealerships. The current dealership network saddles dealers, manufacturers and customers with the cost of its inefficiencies — inefficiencies that, especially in today’s economy, no one can afford.

Marcelo Olivares is assistant professor of decision, risk and operations at Columbia Business School.