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March 6, 2008

Found Your Dream Car? Thank the Competition

Whether consumers find the car of their choice in stock is directly related to the competitiveness of their local auto market.

Topics: Operations

Driving off the lots in their shiny new cars, auto buyers are not likely to spend much time thinking about how the car company’s dealership network structure and inventory strategies affected their purchase. A dealer’s inventory levels will be a primary concern, however, if the buyer’s first choice of vehicle is not available, meaning the buyer has to wait longer to get the vehicle, choose a replacement car or leave without making a purchase.

For auto manufacturers and their dealers, dealership network configuration and inventory strategies are crucial to business success. The number of dealerships carmakers operate, the market conditions where those dealerships are located and the inventory dealers keep on hand can mean the difference between closing a sale and losing the buyer to a rival dealership or a different carmaker.

Professor Marcelo Olivares recently studied this interplay between competition and inventory in U.S. auto dealerships and, with Gerard Cachon of the University of Pennsylvania, developed an econometric model to estimate the effect of market structure on inventory holdings. “Our main objective,” Olivares explains, “was to provide a tool to analyze the efficiency of auto distribution networks.”

The researchers culled data from a General Motors (GM) Web site that lets customers search new-vehicle inventory at local dealerships. Olivares and Cachon created a Web crawler to monitor the site daily, and they collected six months’ worth of inventory and sales data from GM dealerships in more than 200 rural markets. The researchers monitored when a vehicle was added or removed from dealer inventory, as well as when a car was transferred from one dealer to another. They focused on GM dealerships in markets with 5,000 to 120,000 residents, which made it easier to accurately measure competition.

After analyzing the GM dealership data on such dimensions as sales volume, market competition and local consumer demographics, the researchers found that competition had two main effects on inventory holdings: First, the entry or exit of a competitor in a market — either another GM dealer or a dealer for a rival car company — can increase or decrease demand (a sales effect); second, it can change the amount of buffer inventory a dealer chooses to hold, which influences the probability that customers will find the cars they desire in stock (a service effect).

Olivares and Cachon were particularly interested in exploring the service effect. “If you double sales, your inventory cost per unit sold is going to go down; this is very well known. But service matters too,” Olivares says. Indeed, one of the researchers’ key findings was that with fewer competitors — some of the markets they studied had only one or two dealerships — dealers could set lower inventory levels without losing sales. In these smaller markets, dealers did not need to not have a diverse inventory, because they were not competing with many rivals. “When there is more competition, customers have more choices, and when they have more choices, they become pickier. Dealerships raise their service levels when they face more intense competition to prevent losing customers,” Olivares notes.

But the presence or absence of a competitor alone does not explain the whole inventory picture. The impact of competition on inventory holdings, and thus on service levels, also depends on the number and types of products area dealers offer. “If a competitor offers models that are similar to the products offered by another dealer, it will trigger a larger increase in service level,” Olivares says. For example, a GMC dealer is more likely to hold a large inventory of its entry-level SUV if a neighboring Jeep dealer also offers a low-priced SUV. This strategy can help the GMC dealer prevent a customer from driving away in a Jeep.

Ultimately, dealerships must strike an optimal inventory balance to remain competitive. “You don’t want to have too little inventory, because then you don’t have enough variety for customers to get the car they want,” Olivares says. “But if you have a lot full of cars, you are spending fixed capital, you’re not turning inventory quickly and your profitability goes down.”

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

Read the Research

Marcelo Olivares, Gérard P. Cachon

"Competing Retailers and Inventory: An Empirical Investigation of U.S. Automobile Dealerships"

View abstract/citation  Download PDF   View Research  

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