How Do Dealers Set Car Prices?

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It seems like an easy question: What is the true price of a car?

But as anyone who’s purchased a vehicle knows, setting car prices is a complicated game. Even experienced buyers may not completely understand all of the rules.

Cars are some of the few goods Americans purchase that do not have fixed prices. Whenever you purchase a box of cereal, bike or book, you just pay the market price. But buying a car is more like buying a house – you need to negotiate. And the way that manufacturers and car dealers calculate their costs making money complicates things.

Simply put, car dealers are middlemen. They’re buying their inventory from automakers, then margin the costs and sell to consumers. Dealers also get bonuses, awards and incentives from automakers which help cover the expense of promoting the cars and add to dealerships’ profit. Dealerships also make money – a lot of money – from selling used cars which were trade-ins, arranging automotive loans through financial partners, and charging for service and parts.

Knowing all of the factors at play prepares you to definitely negotiate a good price. We’ll take you step-by-step through the important thing elements, including:

  • What may be the car or truck, or MSRP?
  • What is the dealer invoice price, or “dealer cost”?
  • How much did other consumers pay for this model?

What is the sticker price, or MSRP?

That dollar figure you see in large print in ads or on the window sticker of a new car may be the manufacturer’s suggested retail price. It’s also referred to as car or truck, because every new car leaves the factory with a federally mandated window sticker listing the MSRP for the car, and for each option or accessory on that car.

Sticker price is an important number, but most cars cost less. It’s set through the manufacturer, and includes some room for that dealer to make a profit. Roughly speaking, it may be around 20% greater than the dealer’s invoice cost (more on that below). Treat this high price as what it really is: an indicator by the manufacturer that’s designed to influence you to definitely pay a higher price.

With the sticker price, automakers are attempting to “anchor” negotiations at a high starting point. Anchoring is a psychological effect that occurs in negotiations once the parties involved cluster near the first number that’s on the table. To counter the anchoring effect, some consumer advocates suggest you need to do your negotiating a long way away in the car and its window sticker, which means you won’t be as likely to be swayed by suggestion.

There are rare instances when cars do sell in the sticker price: whenever a hot new model hits the market to great demand, for example. However, there are also scams by which dealerships claim that customers must pay a higher price because the car is in popular or simply because they have a bad credit score.

You’re liberated to disregard the car or truck and begin your negotiations from a lower point. Keep in mind that the goal ought to be to reach a good price: one that permits the dealership to make a reasonable profit over the wholesale price it paid, without gouging you.

What may be the dealer invoice price, or ‘dealer cost’?

So, what is the dealer’s cost on the car? The best guideline consumers may use may be the dealer invoice price, sometimes known as “dealer’s cost.” This is the price around the manufacturer’s invoice when the factory offers a car to a dealer. You are able to look up the invoice price of a particular model online.

But like a lot in car sales, this is not because it seems. Dealer invoice price is typically greater than what the dealer winds up paying. The invoice comes with the knowning that the manufacturer pays a percentage to the dealer through discounts and incentives.

“The dealer has many expenses associated with each car. Confirmed dealership likely has to finance their inventory and might need to pay interest on the cars they’ve, or they may have to purchase 10 other less-popular cars just to obtain the one car you really want. Therefore, they’ve already to offer the unpopular models in a steep discount simply to sell them,” says?Brian Moody, executive editor of Autotrader.

Manufacturer-to-dealer payments take great shape:

Holdbacks: Payments to pay for dealers’ costs and supplement their profits. They do not appear on any window sticker and therefore are typically not revealed to consumers, however they may amount to about 2% to 3% of either invoice price or MSRP, according to Edmunds.com.

Dealer cash incentive: This is a cash rebate provided to the dealer through the manufacturer. The dealer is not obligated to pass this on to the customer.

Sales target incentives: These are generally called “stair-step incentives.” The maker agrees to pay the dealership more when the dealer hits a specific sales target. These payments could be high enough the dealer may not care if she loses money on your specific sale.

These incentives make it easy for dealers to advertise attractive sales. Should you hear of cars for sale “at invoice price” or “just $1 over invoice price,” understand that this marketing-speak doesn’t actually mean the dealership is making no profit.

How much did?other consumers purchase this model?

With MSRP and invoice price as benchmarks, and keeping in mind the incentives listed above, you’ll have a sense of how to arrive at a good price.

You can also add a third price benchmark for your research: market price, or what others in your town are spending money on exactly the same model. Car prices fluctuate because of factors including supply and demand, seasonality and geography. A particular model might?cost more in a wealthier ZIP code, for example, according to a J.D. Power spokesman.

Many auto websites list estimated market prices, each having its own formulas and methodology, so it’s a good idea to check several. Kelley Blue Book has a tool called “Fair Purchase Price” that provides a range according to purchase data collected across the nation and is updated each week, based on Allan. Other sites offer similar information.

“Always have a very good handle on which others are paying before visiting the dealer, as selling price is typically hundreds or thousands below MSRP,” says Jason Allan, managing editor for Kelley Blue Book’s KBB.com.

The bottom line

To negotiate a good deal for the car, you need to know the way the dealer set its price. When you’re getting ready to buy, be sure to take a look at all the factors which go into manufacturer’s suggested retail price, invoice price and selling price. And, when you are negotiating, be sure you make reference to all of your collected price research. This way, the dealer knows he’s dealing with an educated and prepared buyer.

Jeanne Lee is really a staff writer at NerdWallet, a personal finance website. Email: jlee@nerdwallet.com.


Image via iStock.