How Do Car Companies Make Money?

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This is the first part of a series that I started writing last year. Most of the second part is written, too. Let’s see if I get to the third part.

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A full service car company is a busy, busy place. Technical development, engineering, engine development, refinement testing, crash testing, safety labs, exterior and interior design, marketing, public relations and much, much more. And it all costs money — a L-O-T of money.

There are three basic ways in which car companies make their money:
1) Vehicle Manufacturing and Sales
2) Parts and Accessory Sales
3) Financing Services

Let’s work through those in reverse order.

Financing Services can make a company some serious coin. Cashflow is the oil that lubricates the whole company, so a manufacturer that has its own finance arm has a distinct advantage over its non-financed competition, including the ability to earn money in a wider variety of ways.

There aren’t many dealers that have the liquidity to fully stock their dealerships. Dealers use credit facilities offered by the manufacturer’s finance arm to get cars in their showrooms at favourable interest rates. The dealer not only gets competitive financing, they also put more cars in their forecourts to sell and those vehicles are booked as sales for the manufacturer. When it works (ie: when the company has a desirable product to offer) — it’s a win-win situation.

The finance company can also underwrite lease deals, loans for customers and even insurance, earning the manufacturer ongoing interest revenue on top of the initial sale of the vehicle.

How much can financial operations contribute to a car company? In the third quarter of 2003, General Motors made just $15 profit per vehicle as a manufacturer. Its finance arm, GMAC, contributed three times more than manufacturing towards the company’s profits that year. Bear in mind that those were troubled times for GM with onerous labour contracts but still, there’s no doubt that GMAC carried the company through those turbulent times.

GM sold 51 per cent of GMAC in 2006 in order to raise some much-needed cash. No wonder there’s been talk for a few years about a restructured and financially stable GM wanting to buy it back.

Parts and Accessories are a matter for another article, but when Saab Automobile filed for bankruptcy in December 2011, the only arm of its operation that wasn’t included in that filing was Saab Parts. That should tell you something about how profitable spare parts can be.

That leaves us with vehicle manufacturing and sales.

Car companies exist to develop, build, and sell cars. This is essential for feeding the Parts and Finance arms of the business, but they can make bucketloads of money selling cars if they do it right.

Manufacturing is the spring from which all other elements of the industry flow and it’s also a good source of income if you have strong enough margins. That means building the price up and keeping costs down — neither of which are easy.

If you’re wondering why every car company wants to move into the premium/luxury segment, it’s all about the margins. This is why Toyota created Lexus, why Nissan has Infiniti and why GM is so fixated on making Cadillac a global brand. Essentially, companies can ask much more money for upmarket cars, even though the incremental added cost of taking what might be considered as a generic chassis and applying premium parts is relatively small.

Let’s look at an example from a company with which the writer is very familiar. I covered the operations of Saab Automobile for nearly seven years, including the sale from General Motors to Spyker Cars in early 2010. In addition, I worked for Saab Automobile in 2011 until their bankruptcy in December of that year.

In Saab’s case, it would make, on average, around US$5000 on its bread-and-butter model, the Saab 9-3. You can increase that amount by around US$3000 for a 9-5 large sedan, a 9-4x SUV or a convertible 9-3. You should note that that figure is a qualified estimate, but a reliable one that changes from country to country and according to currency fluctuations. Also note that other companies in the same segment would benefit from better economies of scale. Move either upstream towards the luxury segment or downstream towards volume and you can adjust those margins up or down accordingly.

Saab wanted a small car but did not have the money to develop it. If it had made that smaller vehicle, however, the margin would have been around US$2000 per vehicle.

With materials and labour accounted for, the remaining margin per vehicle has to cover all the other aspects of the company’s operations: technical development, safety, crash testing, NVH, global marketing resources, events, PR…. and many more functions.

Indeed, the car industry has an insatiable hunger for cash, so it’s important that companies develop a product mix that’s profitable and sustainable. That leads us to model/segment choice – in short, how to get the greatest output from your inputs.

Picking the right segment of the market is essential for remaining profitable because of the cost/margin relationships that prevail.

The costs for developing a small car and a large car don’t actually vary as much as you might think. The larger car will indeed cost more to develop, but it’s a matter of degrees. Call it a ratio of around 1:1.25. At the sales end, however, the company can command a price for the larger car that’s more in the 1:1.5 or even the 1:2 range, depending on the size and perceived luxury difference.

Customers will accept paying a lot more for a larger car without a thought given to the fact that both large and small cars go through the same development and manufacturing processes. The larger car’s ride and engine are usually more refined, the car is usually more powerful and there’s more space to give an impression of luxury, comfort and safety. All those extras justify the price difference in the mind of the consumer and importantly, if they’re well executed, they deliver a driving experience that builds brand loyalty.

Regulatory costs are remarkably similar. Both cars have to get government certification; both have to be crash tested, climate tested, pollution tested, economy tested and so on.

The costs to manufacture aren’t that different, either. Both cars need panels, four doors, glass, an engine, a gearbox, interior carpets, a dashboard, four wheels and tyres, et al. Getting some components in more premium materials and slightly larger for a larger vehicle does cost more, but the increment is fairly small compared to the price the end product can command. Fitting those parts together is basically the same process whether the vehicle is large or small.

Premium manufacturers can make a $2K margin on a small car or an $8K margin on a larger car. If you were allocating resources inside a car company, which one would you choose?

It’s logical to think that the smaller car will sell at a lower price and therefore may appeal to more people, but it’s also subject to more competition and, in the premium sector, reduced desirability.

For premium manufacturers, larger vehicles still outsell smaller vehicles. The Audi A4 outsells the A3 by a large margin. The BMW 3 Series Sedan is not a small car by any means and it outsold the entire 1 Series by nearly 70,000 vehicles in 2012. Both were outsold by the 5 Series.

The vehicle that saved Porsche early in the new millennium wasn’t the 911, it was the Cayenne SUV (which has been Porsche’s best-selling vehicle since it was first introduced). In the premium and luxury sectors, to an extent, bigger is better.

Another recent trend has been for companies to entrench their smaller vehicles even more firmly in premium territory. Hence we have the movement towards premium small cars: the Fiat 500 Abarth, RenaultSport models, Alfa Romeo’s MiTo and Giulietta, BMW 1 Series, the Mercedes A-Class and the car that started the whole movement, the MINI Cooper.

Margins for everyday small-class vehicles are much thinner than the $2K estimate for premium small cars and companies can’t make up losses by selling in greater volume.

Mainstream brands such as Toyota, Volkswagen, Holden, Fiat, Ford, Honda, Mitsubishi and others all face constant pressure to improve their vehicles whilst keeping them affordable. Now that Hyundai and Kia are mainstream, they have joined the others in trying to head off the next looming challenge from Chinese car-makers.

Making money in the car business is no easy task. You’ve got margins to play with, but they’re not huge and every decision you make involves a compromise.

Cost vs quality. Smaller segment vs brand perception.

The smaller your company is, especially in terms of model diversity, the finer the line you have to walk.

Get your formula right, including some genuine size and synergy (hello, Volkswagen Audi Group) and you can make a ton of money and secure your future.

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Next: Model Design And Development

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9 Comments

  1. Actually there is nothing new about making small cars “premium” items in order to increase their profitability.

    The compact Nash Rambler was marketed this way back in 1950, it cost about the same as a stripped standard-size U.S. car at the time but came in a premium body style (initially convertible only, then a small wagon), and with a lot more standard equipment. It was marketed and seen by the consumer as a classy small car, perhaps a second car for a successful person such as a doctor or lawyer. It sold quite well, in fact the Rambler was initially the only successful post-war compact in the U.S.

    Other manufacturers’ efforts such as the Henry J., the Hudson Jet, and the diminuitive Crosley (which were seen as “cheap wheels” with severe specifications that lacked style) crashed and burned in the marketplace. It took a severe recession in 1958 to get Americans really interested in small cars, though, and by the early 1960s all the U.S. manufacturers were in the compact market.

    As the 1950s turned into the 1960s though, the Rambler name took on the “cheapskate” patina in the U.S. market and faded away and was gone after 1969. From what I understand the Rambler name was used in Mexico, Australia, and other overseas markets through 1hte 1970s, not having acquired the stigma it had in the United States.

    1. The funny thing is that selling the Nash Rambler as a premium compact came about really as an accident of history rather than prescience on the part of Nash management.

      For several years after the war, raw materials such as steel were rationed to manufacturers based on previous production. As the Rambler was a new model there was no production history and it was difficult to obtain the resources needed to build it as a volume model. Nash therefore decided that, given restricted production, it was best to move their compact car upmarket where profits would be higher. So offering premium body styles and high levels of equipment (for the time) was the approach taken.

  2. Swade,

    You haven’t mentioned tooling, which often gets mentioned as the biggest auto company expense, ahead of R&D, marketing, and maybe labour.
    Tooling is the main reason why auto makers are going to modular platforms. The tooling for the original Beetle could only be used to build that car. That’s why it remained essentially unchanged for most of the 20th century. VW’s new modular architecture allows them to build a wide range of models using the same tools. The additional investment for a new model is minimal.

    As far as size is concerned, there’s a sweet spot that maximizes sales. I have read that almost every post-war top-selling car in the US was within the 180 to 200 inch range (4.6 to 5.1 meters), the only exceptions being the 1960s. I am almost the same age as you (mid-40s), and remember that my mother and her friends could not wait to be rid of those impractical “full size” dinosaurs. Having a smaller car was a sign of success in 1970s suburbia. It signified that you had the luxury of choice.

  3. On a retail basis generally around 85-95% of contribution to margin is generated by service- and aftermarket. The contribution to margin seems to spread a bit when comparing manufacturer, importers and retailers. The chain is not equal i wil lsay.

  4. Manufacturers with pickup trucks & SUVs to sell (in the US anyway) also make huge profits on these trucks. And they ARE trucks.

    The basic vehicle gets all tarted up with options, and the companies make a killing on the poor fools who spend upper 5-figure money on these things. The Cadillac Escalade is a prime example of this.

    A USD$70-80k sales price for basically a GMC truck. They are laughing all the way to the bank.

    Serioulsy…an Escalade STARTING at USD$ 71,695? Another P.T. Barnum moment.

    http://www.cadillac.com/future-cars/2015-escalade.html

  5. I was discussing this with a friend who is in the industry. His take is “did the person who wrote this work for GM?” (answer: sort of, Saab) “that’s why he thinks you can’t make money selling a small car. GM never figured out how to make a profitable small car.”
    His example is the original 1960s Fiat 500: that car was built using 7 major panels, and it was extremely profitable. GM at the time (and even today) tried to build scaled-down big cars, which cost as much to build as their regular cars. They then de-contented until they could almost see a profit margin.
    The flip-side to that is that Fiat could never figure out how to make a profitable big car. While GM was producing millions of pushrod V8s, Italians were handcrafting DOHC masterpieces that really didn’t perform any better.
    I agree with Saabdude that $40K pickup trucks are crazy, but that what GM is good at. You could argue that they represent better customer value than a $40K VW Amarok.

    1. No disrespect to your friend, but did he have an example that wasn’t 50 years old?

      I imagine the Koreans, Thais and Chinese would be making some money on their small fleet, but I imagine that in the higher-cost western countries, manufacturers are very happy that they can now offset their higher labour costs by selling premium small vehicles to wealthy customers.

      1. Actually, the conversation started with modern cars. He showed how my 500 doesn’t have any component of value behind the firewall, which saves quite a few steps during assembly. His explanation of GM’s way of doing things is “a bracket attached to another bracket, with CPUs stuffed into every available cavity. The team that designed the HVAC never met with the engine electronics team, who are in a different country from brakes, who don’t get along with the suspension group. All of them use different fasteners, connectors, and assembly methods.” GM has to build small cars in low-cost countries, because they are very fussy designs. Fiat could build their small cars anywhere because the workers have very little to do.

        In his opinion, VW, Honda and Fiat build the best-integrated cars. Toyota is good at some things (Landcruiser derivatives, Yaris), but terrible at others. Kia/Hyundai build “safe” cars, but cut corners under the surface.

        He really likes Saabs, but his take on them is “Saab failed because they sold $30,000 cars for $30,000.”

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