The Bubble Is Bursting: Gross Profits Are Headed for a Fall

September 23, 2014

In my previous post I discussed why pre-owned profit margins are under pressure. The factors driving this trend include transparency from the Internet, market-based pricing, and rising overhead costs from new dealership buildings. And that’s not the bad news—the bad news is that the problem is only going to get worse over the next few years.

The NADA average gross profit of about $2,300 likely represents a bubble in used car profitability. Why? It’s a simple matter of supply and demand.

The Rubber on the Road

New car dealerships sell the bulk of late-model used cars, typically aged one to five years. That means the number of new cars sold in a particular year impacts the supply of late-model used cars over the next five years.

During the financial crisis from 2008 to 2010, new car sales fell dramatically. That means the supply of late-model used cars plummeted over the last three to five years, as depicted in the chart below. In the wake of the recession, consumers’ increased frugality also led to an increased demand in used cars at a time when there was less inventory available.

So in the last five years, while the supply of used cars decreased compared to the prior five-year period, demand was on the rise. As a result, used car prices have climbed. And because supply and demand moved in opposite directions, that led to an increase in the average gross profit per vehicle.

But over the last couple of years, used car units in operation have been on the rise and will be peaking over the next three to four years, climbing to levels last seen in 2006. Back then, according to NADA, the average gross profit per vehicle was less than $1,800—more than $500 less than 2013 average gross profits. Are you ready to take that kind of hit to your profit margin on every pre-owned vehicle you sell?

The good news is that there is one thing every dealer can fix to avoid eroding pre-owned gross profits.  In my next post, I’ll detail what that is.