In the last issue I wrote about getting your house in order, to be ready to tackle any storm clouds headed your way. This time I will discuss some expanded benchmarks to assist you in reviewing your dealership's overall performance - specifically, an expanded view of absorption in today's dealership environment.
Absorption has long been a measure of the power of your fixed operations to cover your dealership's expenses. The theory is, as your absorption rate gets closer to 100 your dealership is less vulnerable to cyclical swings in the front end of your store.
Today's dealership operations have changed to the point where there are many other important business variables that contribute to profitability. So I'd like to discuss those and introduce some new absorption benchmarks for you to consider.
Fixed absorption
In its purest sense fixed absorption measures the gross profit generated from your parts, service and body shop departments and compares that total to all your dealership expenses except for variable selling expenses.
As you know, many OEM standard financial statements provide an absorption calculation. The problem, however, is that there is no one industry standard and as such different OEMs calculate absorption differently. Each has their own reason why they calculate absorption the way they do, but for the purposes of this article and managing your downside risk we are going to include the full basket of dealership expenses as our target to be absorbed.
Depending on your individual dealership circumstances, traditional fixed absorption, in my experience, falls within in a very wide range: from 55 percent to 110 percent or more. To achieve the high end of the range, your dealership must have very low overhead expenses and very strong, fully-utilized fixed operations. Many strong performers are smaller stores in smaller communities where facility costs are still reasonable and recurring customer count is high due to years of providing high quality customer service.
On the lower end of the traditional fixed absorption scale, the volume of business does not match the facilities investment and related overhead. Often these are stores that formerly had significant sales, customer volumes and market share much larger than they do today. Another scenario is a new build or renovated store not yet realizing its new fixed operations capacity and opportunity.
I mentioned earlier that the business has changed and there are possibly other items we should take into account in benchmarking our dealership's performance. To do this we must look at variable operations and also some accounting anomalies practiced by certain franchise standard accounting requirements.
The items I would like to introduce into the absorption calculation are:
- Used Vehicles
- F&I Income
- Holdback
- Dealer Principal Compensation
- Non-Arms-Length Rent Factor
- Notional Interest of Free Capital
Used vehicles
In addition to producing used vehicle gross margin, the used vehicle department also provides revenue, gross margin and net departmental profit for the parts department, service department and body shop in performing vehicle reconditioning. The effects of this, however, are already included in the gross margin of the fixed operations departments and are taken into account in the absorption calculation.
Some dealers have very elaborate profit reallocation policies and try to credit the used vehicle department and charge back the relevant fixed operation department(s). In theory there is nothing wrong with doing so. But how this is done could impact the absorption calculation. In situations where the chargeback is above the gross profit line, the fixed operations gross profit is thus reduced and is never included in the absorption calculation.
The fact is, the used vehicle department is a separate business, independent of the new vehicle department, not dissimilar to fixed operations. For this reason I would include the used vehicle department's net selling gross (gross profit after deducting direct variable selling expenses) as an addition to the gross profit generated in the traditional fixed absorption calculation. For the purposes of this article let's call that used and fixed absorption coverage ratio (UFAC).
F&I income
In today's competitive retail world where prospective customers, through their online research, can obtain your invoice cost on practically any vehicle, dealers have turned to F&I to generate a significant portion of their new and used vehicle gross profit.
Not dissimilar to used vehicle and fixed operations, the business office is a separate and important profit centre for all dealerships.
Unfortunately the impact of F&I is often lost in some OEM standard operating statements and the resulting management information benefit is diminished. Generating F&I profit is an important element in new and used vehicle profitability. It is usually measured in terms of a dollar amount per unit. The range in the marketplace is significant where some dealers struggle to earn $150 per unit while others earn in excess of $1,000 per unit.
Again accounting comes into play. Some dealers do not accurately split their F&I activities between the new and used departments. In totality they get to the right number, but for analysis purposes in identifying departmental profit opportunities, they do not.
In order to compare apples to apples I would recommend that the financial impact for all F&I activities be isolated in its totality. This means backing out the F&I margin included in net variable selling expense in the used vehicle department calculated in the previous section in order to measure the entire business office operations in the same way you would measure any other department. F&I is a profit centre and as such makes a contribution to the coverage of expenses to be absorbed.
At this point our second analytical calculation includes the following items collectively to be compared to dealership expenses to be absorbed as follows:
- Parts department gross profit
- Service department gross profit
- Body Shop gross profit
- Used vehicle direct variable selling gross less used vehicle department F&I contribution
- Used vehicle department F&I Contribution
- New vehicle department F&I Contribution
- Interdepartmental chargebacks in the used vehicle, parts and service & body shop departments
Including the above items as a benchmark against expenses to be absorbed will begin to give you a very good idea how productive and profitable the departmental profit centres you manage are performing in meeting your expectations. Let's call this the almost full absorption (AFA) calculation.
Holdback
Virtually all OEMs have a holdback arrangement with their dealer network. These range from 1.5 percent to 4 percent of the new vehicle invoice amount. Again OEM accounting varies from factory to factory and within each factory dealer network as well. The holdback is properly accounted for if it is included in the determination of new vehicle gross profit. For dealerships that do this, there is no further adjustment required.
For dealerships, however, that show the recovery of holdback either as a reduction in non-variable selling expenses and/or net add and deducts (other income), I propose we make a further adjustment to our new absorption calculation. To the items listed above in the previous section I would recommend that you add the holdback amount in arriving at margins to offset expenses to be absorbed. To the AFA outlined above add the holdback amount to top up the gross margin pool earned by the dealership and compare this combined amount to the expenses to be absorbed.
One final adjustment
Expenses to be absorbed, in their purest sense, include not only a whole host of dealership expenses but also dealer principal compensation and non-arms-length rent expense.
As you all know dealer principal compensation is all over the map and can easily distort any inter-dealership comparisons you might be trying to perform. For this reason I would not include dealer compensation of any kind in the calculation of expenses to be absorbed. If you happen to be an active dealer principal and your store does not employ a general manager, then it could be appropriate to include a reasonable charge for a general manager equivalent salary.
The same holds true for non-arms-length rent factors calculated at anything other than fair value. An adjustment to expenses to be absorbed should be made for dealer principal compensation and the difference between fair value rent and the rent that your dealership is being charged.
Notional interest on free capital
One item that dealers rarely include in their expenses to be absorbed is the notional interest charge on their dealership's net worth.
Dealership net worth does not bear an accounting charge and thus is free financing. In order to ensure you earn a return on capital employed in the business, you should add a reasonable charge for that free capital being used to the expenses to be absorbed.
Therefore, expenses to be absorbed (ETBA) should be calculated as follows:
- + All expenses of the dealership
- - Variable selling expenses of the new car department
- +/- Dealer principal compensation
- +/- Fair value difference of rent factor
- + Return required on free equity used in the dealership.
Using this definition of expenses to be absorbed will give you a truer picture of the job that must be done. Let's call this full absorption (FA).
The resulting full absorption formula is therefore: AFA / ETBA=FA percent.
Summary
Financial analysis is just that, analysis. In order for it to be effective the analysis must include all the elements applicable. For dealerships there are many benchmarks in existence today; however, the full absorption model above will give you an all-inclusive view of your dealership.
Go back five years and perform the calculations. See how yourdealership is tracking. Set personal benchmarks for each component and review the results monthly with your managers on a go-forward basis. Hopefully this will give you another way to look at your store and help you manage equally during both tough and good times in order to maximize your dealership profit opportunity.
Chuck Seguin is President of Seguin Advisory Services, a company focusing on automotive retail. To receive a copy of his regular e-newsletter, "Connecting," or to comment on this article, please contact Chuck via e-mail at This e-mail address is being protected from spambots. You need JavaScript enabled to view it or by phone at (416) 565-9493 or visit www.seguinadvisory.ca.
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